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Utility ETFs: More Pain Ahead?

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After witnessing a bullish run for most part of 2016, the utility sector encountered a broad-based selloff especially after Donald Trump won the election. Utility ETFs - Utilities Select Sector SPDR Fund (XLU - Free Report) , Vanguard Utilities ETF (VPU - Free Report) , iShares U.S. Utilities ETF (IDU - Free Report) and Fidelity MSCI Utilities ETF (FUTY - Free Report) have lost 4.5%, 3.5%, 3.8% and 3.5% respectively in the last 10 days as of November 22, 2016 (read: Utility ETFs to Shelter Portfolio from Market Turmoil).

Why the Downturn?

While global growth slowdown, geopolitical turmoil, unimpressive domestic data, see-sawing oil prices, the unseen impact of Brexit and high broad-based volatility haunted the markets, these increased the appeal for utility stocks. One of the primary factors driving the utility sector was low yields on bonds across the globe. In a low yield environment, investors turned to the sector offering solid dividend payouts and excellent capital appreciation over the longer term. However, of late, yields on debt instruments across the globe including in the U.S. are increasing from record lows.

In fact, Federal Reserve Board Chair Janet Yellen has hinted at a rate hike in December. The chances of the first interest-rate increase in the year are high, considering that inflation has accelerated in the recent months and job market data is encouraging. Subdued inflation and growth concerns were among the major factors keeping the bond yields low (read: Global Treasury Yields Dive: Play These Sector ETFs).

The U.S. president-elect plans to increase economic stimulus, which is likely to push long-term interest rates higher. Bank of America Merrill Lynch estimates that 10-year Treasuries will yield 2.65% percent by the end of 2017, about 34 basis points higher than the current level of 2.31% (recorded on November 22, 2016). Higher bond rates usually are inversely proportional to utility valuations.

Another factor that drove the utility stocks was volatility in the market owing to growth slowdown and see-sawing oil prices. The situation has changed following Trump’s victory in the presidential election. iPath S&P 500 VIX ST Futures ETN (VXX - Free Report) measuring volatility in the market shed over 13.3% in the last 10 days as of November 22, 2016 (read: Should You Play Market Zest with These Momentum ETFs?).

More Pains Ahead?

Though the above mentioned factors have tarnished the appeal for utility ETFs, utilities provide basic services like electricity, gas and water that are always in demand, and this is their most fundamental strength. Their ability to boost shareholders’ value through consistent dividend payments makes them all the more attractive. Apart from that, the defensive nature of operations insulates these ETFs from market turbulence.

There is still a lot of uncertainty in the market that could make the global equities may go berserk. One such upcoming event is Organization of the Petroleum Exporting Countries (OPEC) deal slated to be finalized at the end of this month. The OPEC is expected to cut an output curb deal to shore up long-ailing oil prices. If it fails to sign any such agreement, oil prices may once again see a downtrend (read: Oil ETFs Jump on Renewed Hopes of OPEC Cut).

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