XLU - IDU: A Long Road Ahead For Utilities

2023-10-04 17:07:13 ET

Summary

• iShares U.S. Utilities ETF is an equity exchange-traded fund.
• The IDU ETF has experienced a deep drawdown in 2023, exceeding -18%.
• Utilities are historically a defensive sector, but they have been negatively affected this year by investor positioning and higher rates.
• P/E ratios are now beginning to normalize in the sector, with a mean reversion expected.
• IDU has a very high correlation with 10-year rates, with conservative investors now being able to move away capital from IDU into treasuries.

Thesis

The iShares U.S. Utilities ETF ( IDU ) is an equities exchange-traded fund ("ETF"). The vehicle seeks to track the investment results of an index composed of U.S. equities in the utilities sector. Historically a defensive sector, utilities have experienced a massive drawdown in 2023:

Coming into 2023, most market participants were expecting a Q1 market selloff, hence positioning among many institutional and retail accounts was very defensive, with utilities and healthcare as the main portfolio choices. We can see how both IDU and the Utilities Select Sector SPDR® Fund ETF ( XLU ) have recorded substantial negative performances this year. IDU has slightly outperformed this year it's much better known peer XLU, and has also exhibited a slightly better annualized volatility of 18.2% versus 19.2% for XLU.

With the artificial intelligence ("AI") revolution and the outperformance of tech mega-caps, risk appetite has percolated back into the markets, leaving defensive sectors with substantial drawdowns. Although IDU has had a violent move down in the past few days, we do not see a "V" shaped recovery in this sector, with a long road ahead for P/E ratios to normalize on the back of much higher rates.

In this article, we are going to look at valuation metrics for IDU, its risk drivers, and its prospects based on the current economic cycle.

Utilities as a defensive sector has worked against IDU this year

As per the classic portfolio construction theory, there are three main defensive sectors:

Due to the constant demand for their products, defensive stocks tend to perform better in a declining market. There are three main defensive sectors: Utilities, Consumer Staples, and Health Care.

In a recessionary environment, companies from the Utilities, Consumer Staples, and Health Care sectors are supposed to hold up better due to the consumer's strict needs from these enterprises when compared to discretionary purchases.

The problem with defensive sectors this year is that we have not yet seen a recession. Despite having a plethora of leading indicators indicating one, we are yet to see one materialize:

A recession is a significant, widespread, and prolonged downturn in economic activity. A common rule of thumb is that two consecutive quarters of negative gross domestic product ((GDP)) growth mean recession, although more complex formulas are also used.

GDP is still growing, albeit at a more muted pace. The resulting market theme has, therefore, been of a relief rally, mainly driven by tech mega caps, a theme which has taken capital away from funds such as IDU.

We expect this theme to continue for the rest of the year, with managers chasing the theme, and thus allocating capital to the " Magnificent Seven " and removing it from utilities funds such as IDU.

Positioning was overly defensive coming into 2023, and it became a crowded traded which has unwound in a spectacular fashion.

IDU Holdings

The fund contains a portfolio of utilities equities, mainly from the electricity sector:

The ETF is concentrated, with the top-10 names accounting for over 45% of the portfolio:

The top holding in the ETF, NextEra ( NEE ), has just been in the news for cutting its growth outlook and experiencing a significant equity sell-off.

Correlation to yields

IDU has had a very close correlation to 10-year yields in the past twelve months:

We are using the US Treasury 10-Year Note ETF ( UTEN ) as a proxy for constant maturity ten-year yields. As yields have moved higher, UTEN has moved lower, closely followed by IDU.

IDU has a high 30-day SEC yield as compared to other equity classes:

Just like any other fixed yielding asset class, IDU has been under pressure as yields have climbed. Expect this dynamic to persist, with utilities under pressure until the Fed starts cutting rates. As per the current market pricing, that is not set to occur until mid-2024:

The above graph sourced from Bloomberg presents the market pricing for Fed Funds, and the market sees the Fed moving lower in FF only starting with June/July 2024. Based on the historic correlation between utilities and rates, do expect valuations to be under pressure until mid next year.

When rates are higher, investors have alternatives that can generate high, safe yields:

As regulated monopolies with mechanics in place that provide for the recovery of costs, as well as the recovery of and on new investments, utilities are often seen as a lower-risk defensive investment, with a healthy cash flow and stable dividends. Rising interest rates can impact utilities more than other sectors because they can make bonds more attractive to conservative investors seeking that yield. The high capital cost/debt levels of operating a utility also increases borrowing costs with rising interest rates eating deeper into earnings.

Source: S&P .

P/E Ratio normalization

Higher rates have triggered a mean reversion in the asset class P/E ratio:

We can see a secular bull market here in utilities that started after the great financial crisis, with the P/E ratio hitting 20x earlier in 2022. We have now moved lower to 15x, and historical precedents suggest there is more to go:

Mean reversion takes time, and usually overshoots. Another eerily similar period was the 2000/2003 time frame, when the market was coming from an overbought technology theme into a multi-year bear market. Utilities experienced a significant de-rating then, moving to a 10x P/E valuation range.

While this time around the de-rating might not be as significant, we do expect it to go below 15x.

Conclusion

iShares U.S. Utilities ETF is an equities exchange-traded fund. The ETF focuses on the utilities sector, and is the main fund offering in the space by iShares. IDU has experienced a deep drawdown in 2023, a drawdown which is now exceeding -18%.

There are a number of factors responsible for the fund's performance, ranging from an overweight investor positioning into this defensive sector coming into the year, to higher treasury yields. IDU has a very strong correlation to ten-year yields, and when treasuries pay higher rates they become a viable alternative for conservative investors who usually allocate capital to IDU.

In the article we also had a closer look at IDU's P/E ratio in light of its historic band, and the further expected de-rating based on mean reversion. There will be no "V" shaped recovery here, and we actually expect more short-term weakness before we bottom out. IDU will only become attractive when P/E ratios move to extremely cheap levels and the Fed starts cutting rates. We are, therefore, of the opinion that investors should further lighten up on this fund, even though the bulk of the losses are now behind us.

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