Lagging REIT & Utility ETFs At Crossroad

February 27, 2018

The stock market is on the mend. After witnessing its worst correction in two years earlier this month, the S&P 500 has shot back up during the past two weeks. From a low of 2,533 on Feb. 9, the index recovered to 2,780 on Feb. 26, putting it up a solid 4.3% for the year.

The interest rate fears that spurred the most recent convulsion in the stock market still linger, but they’ve diminished as the yield on the U.S. 10-year Treasury bond slipped from 2.95% at its high to around 2.87% currently.

Yet while the overall stock market has brushed off interest rate worries for now, two sectors are still paying close attention to every tick in the Treasury market―utilities and real estate.

The $6.7 billion Utilities Select Sector SPDR Fund (XLU) is down 4.7% this year, while the $2.5 billion Real Estate Select Sector SPDR Fund (XLRE) is lower by 6.5%.
 

YTD Returns For XLU, XLRE, SPY

 

Considered two of the most interest-rate-sensitive sectors, utilities and real estate have struggled as the benchmark U.S. 10-year Treasury bond yield has climbed almost half a percentage point from 2.41% at the start of 2018.

Both sectors were popular during the past few years as interest rates fell to ever-lower levels, prompting income investors to stretch for yield. Now that rates are rising, some of those same investors are selling first and asking questions later.

Bond Substitute

“The utility market has been very much moving in lock step with the 10-year Treasury,” said John Bartlett, portfolio manager and utility analyst for Reaves Asset Management, the issuer of the actively managed Reaves Utilities ETF (UTES).

Bartlett says that the correlation between utilities and the 10-year Treasury is extremely strong on a day-to-day basis, even going as far as to call utilities a “bond substitute.”

Currently, XLU, which tracks all the utility stocks within the S&P 500, is yielding 3.5%, or 0.65% more than the 10-year Treasury.

In his view, utilities will continue to track the Treasury market short term: “If you think interest rates are going to turn down sharply, utilities will work pretty well from here, but if you think interest rates are going up, that’s going to be a real head wind,” Bartlett explained.

For investors without a strong opinion on where Treasuries are going―Bartlett counts himself among them―the best course of action may be to focus on the long term. He says the correlation between the 10-year Treasury and utilities is much weaker over long-term time periods because utilities have the ability to grow their dividends year after year, through good times and bad.

In fact, as long as interest rates don’t spike up too far and too fast, utilities could overcome higher rates with earnings and dividend growth. But if rates spike dramatically in short order (to 4.5% this year, for example), then growth “isn’t going to bail you out,” Bartlett warned.

Economy Matters

Like utilities, the real estate sector has gotten hit hard this year on the back of rising interest rates. Yields on real estate ETFs, such as the aforementioned XLRE, have become less attractive to some investors in this year’s higher rate environment. XLRE, which primarily holds real estate investment trusts (REITs), currently yields 3.5% as well.

Higher rates also make financing more expensive for REITs, which typically own, operate and lease real estate properties.

That said, interest rates shouldn’t be looked at in a vacuum when it comes to real estate, according to Alexander Goldfarb, senior REIT analyst at Sandler O’ Neill.

“REITs are a derivative of credit and the economy. It’s not just where interest rates are going, it’s also what’s happening with the economy,” he remarked.

Goldfarb says that if interest rates are rising for the right reasons―namely, stronger economic growth― that could actually bode well for real estate stocks.

“The question is, do we get sustained economic growth at or above 3%? If that’s sustained and that’s why interest rates are going up, REITs should start to gain traction mid-to-later this year as the ripple effects flow through: businesses expand and need more office space; consumers feel more comfortable so they shop more; and retailers do better, so that translates into more store reinvestment,” Goldfarb explained.

On the other hand, he notes that if there are inflation concerns without a parallel increase in the economic backdrop, that would be seen as negative for REITs, because you would start down the worrying path of inflation without a commensurate economic growth.

Key 3% Level

As with utilities, the pace and magnitude of any interest rate changes matters, too.

Matt Kopsky, REIT analyst at Edward Jones, believes that “REITs will perform well in a stable to moderately rising 10-year environment, but will likely underperform if the 10-year yield continues moving higher to 3%-plus.”

REIT “fundamentals are still healthy and valuation levels look attractive. For long-term investors, we believe the REIT sell-off makes an attractive entry point. However, in the near term, it’s all about interest rates, and that’s difficult to predict,” he added.

Follow Sumit Roy on Twitter @sumitroy2

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