The Utilities Select Sector SPDR ETF (XLU 52.44, +0.30, +0.6%) is up 8% year-to-date versus a 19.8% gain for the S&P 500. The stark underperformance wasn't so stark roughly a month ago when the XLU was up 15% and the S&P 500 was up 16%. The sector, however, has unraveled in December.
A jump in interest rates, a rotation away from some defensive-oriented sectors, concerns about potential liability exposure for some utility companies in the wake of the California wildfires, and a belief the highly-regulated -- and highly leveraged -- sector won't benefit as much from tax reform have served as selling catalysts.
A look into 2018:
The utilities sector contains companies that generate stable cash flow and provide secure, slow-growing dividends that often translate into attractive dividend yields for income-oriented investors. If risk-free interest rates pick up along with economic growth in 2018, that could create a competitive problem for the dividend-paying companies.
In turn, tax reform could end up curtailing cash flow for regulated utilities in the event tax savings get passed on to customers via lower rates. Also, changes to the amount of interest on debt that can be deducted could pinch profitability for highly-leveraged companies.
The sector has a defensive orientation given its low, and steady, growth and could get left behind in a market inclined to add risk exposure due to cyclical growth. Conversely, the sector's defensive orientation could afford it a measure of relative strength in the event a market correction prompts an increase in risk aversion.
Key sector risks: Rising interest rates; high debt loads; less risk aversion