Can Utility ETFs Regain Their Lost Momentum? - ETF News And Commentary

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Somebody's pain is often someone else's gain, and the utility sector seems to be no exception. After the U.S. economy recorded impressive job growth this June indicating the best performance since September 2008 , many global investors, along with renowned brokerage firm Goldman Sachs, have started to expect sooner -than-later interest rate increases by the Fed (read: 3 Sector ETFs for This Shaky Market ).

While better-than-expected job data cheered the market, some rate-sensitive investing corners like utilities got hit hard. In the first three days of July, yields on two-year treasury bonds increased 5 bps to 0.52% while yields on 10-year securities increased 7 bps to 2.65% .

The utility space has been a clear winner so far this year thanks to its defensive approach to the stock market and low long-term interest rates. The high beta pain and the resultant sell-off in momentum stocks, the face-off between Russia and the West, and slowdown in China elevated the risk-off trade sentiment in the markets and utility stocks soared.

Following solid job data, some economists even started to feel that attainment of 4.0% annual growth rate for Q2 is possible. If this happens, the Fed might raise interest rates sooner-than-previously expected. Goldman Sachs' chief economist commented that the Fed will hike its key interest rates in the third quarter of 2015, instead of the first quarter of 2016.

Market Impact

The largest ETF of the space - Utilities Select Sector SPDR ETF ( XLU ) - gained more than 15% in the first four months of the year against the 2.42% return delivered by SPDR S&P 500 ETF ( SPY ). However, over the last one month, XLU shed 0.50% to buck the trend while SPY added 1.93% on an uptick in U.S. economic indicators.

Over the last 10 days, utilities ETFs including XLU, Vanguard Utilities ETF ( VPU ), iShares Dow Jones US Utilities ( IDU ), Guggenheim S&P 500 Equal Weight Utilities ( RYU ), and First Trust Utilities AlphaDEX ( FXU ) lost 2.84%, 1.03%, 2.49%, 1.68% and 2.38%, respectively (read: A Comprehensive Guide to Utility ETFs ).

Is a Turnaround Possible?

The utility sector depends heavily on long-term interest rates. While upbeat data will prompt the Fed to hike short-term interest rates which have been at record low levels for more than five years, there will be fewer gyrations in the long end of the yield curve.

In fact, the Fed has also lowered the longer-term rate forecast to 3.75% from about 4%. So, from a long-term rate rise stand point, the utility sector should not be badly hurt in the coming days (read: 3 Sector ETFs to Avoid as Interest Rates Rise ).

Project-wise, the U.S. utility sector is in good shape. The industry is now slowly shifting its focus toward natural gas and alternative energy sources for power generation purpose. Along with domestic demand, higher export demand should also benefit the natural gas utilities.

Utilities is one of the few sectors that is likely to log double-digit earnings growth in Q2. As of now, the earnings from the sector are expected to increase about 11.5% in Q2 as per the Zacks Earnings Trend. This would be the second highest growth rate among the 16 sectors classified under the Zacks Earnings Trend report.

For 2014 and 2015, earnings from this sector are expected to increase at rates of 9.9% and 4.9% year over year. In 2014, the Utility sector is expected to surpass the S&P 500 growth of 7.1% but lag the 2015 projection of 11.5%.

Bottom Line

After slipping 2.9% in Q1, the U.S. economy is yet to show concrete evidence for sustained improvement. As the frenzy over rising yields settle down, investors can cherry pick some utility ETFs to cash in on prospective earnings growth but with a short-term focus.

The coming year might prove a little difficult for the space with the Fed fully wrapping up its QE program and leaving the world of rock-bottom interest rates (read: Utility ETFs: Winners After the No Taper Announcement? ).

Investors should note that the biggest utility ETFs XLU, VPU and IDU have a Zacks ETF Rank #4 (Sell) while RYU has a Zacks ETF Rank #5 (Strong Sell). Thus, investors can go for FXU - a utility ETF with a Zacks ETF Rank #3 (Hold) if they want to bet on this in focus sector right now.

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SPDR-UTIL SELS (XLU): ETF Research Reports

ISHARS-US UTIL (IDU): ETF Research Reports

VIPERS-UTIL (VPU): ETF Research Reports

GUGG-SP5 EW UTL (RYU): ETF Research Reports

FT-UTIL ALPHA (FXU): ETF Research Reports

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs
Referenced Symbols: XLU , IDU , VPU , RYU , FXU

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