Doubt on yields may ruin this sector’s power trip

Bloomberg

Investors assailed by trade-war worries and slowing growth have turned in recent weeks to defensive stocks, which are by nature less volatile. Utilities, boosted by falling yields, have done particularly well, and outperformed all sectors. Their relative haven status may be in for some wobbles though, especially as bond yields could be near a tipping point.
Utilities have performed in line with the broader market this year, but looking at the returns since October, when markets became jittery, they are clear winners, alongside food and beverage shares.
“It is not surprising that defensive sectors led the market as it fell in May due to concerns that trade negotiations with China were faltering,” says Edward Perkin, chief equity investment officer at Eaton Vance, noting that the domestic nature of utilities, REITs and telecom shares makes them less vulnerable to trade tensions. This month’s rally led by Treasury yields and expectations of Federal Reserve easing is good for defensive dividend-yield stocks, he says.
That might come to an end, according to Morgan Stanley strategists, who say the strength of the upward trend makes utilities vulnerable to any reverse in the “momentum” factor. The broker had already downgraded the sector to neutral in April, calling it “overowned, overbought and expensive.”
Since then, utilities have rallied even more versus peers and investors’ positioning has increased.
There might be a good sell signal ahead if the US 10-year bond yield bottoms out, Morgan Stanley writes. Treasury yields look oversold, which has been a good tipping-point indicator in the past. In fact, the yield is approaching its September 2017 inflection point, a strong technical level.
That’s not all. The regulated business accounts for 50% of the sector’s Ebitda, and regulators tend to claim back extra cash generated by the low-rate environment by periodically adjusting policy, according to Citi strategists. So while the low-rate environment is supporting stock valuations, it’s also adding pressure to utilities’ medium-term earnings and may distort the perception of risks from rising capex and leverage, Citi says. Looking at the chart below, utilities are trading at a premium relative to the broader market.