Seeking Shelter from Recession in the Utilities Sector
Boring is better in a recession. Fed Chair reaffirmed his steely resolve to fight inflation. In short, he wants to break the back of inflation "at any cost" to subdue it down to Fed’s target of 2%. Soft-landing is desired. But overcorrection to fend off sticky inflation could tip soft-landing into a hard one.
In a recession, economic activities shrink resulting in declining outputs and softening demand across consumers and businesses. Recession leads to rising unemployment and reduced consumer confidence.
History has ample evidence demonstrating that defensive sectors typically outperform the broad market index by more than 10% on average.
This paper posits a long position in Utilities Select Sector SPDR ETF ("XLU") to harvest potential outperformance gains plus a dividend yield of 3.3% and combined with a short position in CME Micro S&P 500 Index Futures.
INFLATION REMAINS HOT; FED RESOLVED TO FIGHT IT CAN LEAD TO RECESSION
Last week, Federal Reserve Chair Jerome Powell reaffirmed his determination to tame inflation down to its target 2%. He reasserted his singular focus on restoring price stability in the US. If that requires higher interest rates for longer to get back to 2% target, then so be it. That was the key takeaway from Jackson Hole Central Bankers Symposium in Wyoming.
US inflation is much cooler than a year before. History has taught policymakers an expensive lesson to avoid declaring victory too soon.
Softening inflation combined with record low unemployment, strong business climate and resilient consumer balance sheets point to a potential soft-landing. However, over correction could tip into a hard landing.
WHAT HAPPENS IN A RECESION?
During a recession, non-cyclical sectors, like Consumer Staples, Utilities, and Health Care, have historically performed well. The fortunes of these sectors hinge on non-discretionary spending and hence less sensitive to economic fluctuations.
These defensive sectors have outperformed the broad market by more than 10% on average during six of seven past recessions.
Tech & Real Estate rank among the worst-performers. Dependant on discretionary expenditure, these sectors are the first to face the heat when businesses and consumers cut spending as incomes shrink.
UNPACKING THE S&P SELECT SECTOR UTILITIES INDEX
The Utilities Select Sector Index ("Utilities Index") is market-cap-weighted and tracks the performance of the largest thirty utility firms in the S&P 500. It aims to deliver exposure to firms from the electric & water utility, independent & renewable power producers, and gas utility industries.
The Utilities Sector includes firms that provide essential services such as electricity, natural gas, and water. These firms marshal stable cash flows and low debt levels. Consequently, the sector is described as a defensive play which performs well during economic downturns.
The Utilities Index was launched on 16th December 1998. Over the last decade, the index has delivered an average annual return of 5.5%. It exhibits lower risk with a volatility of 12.5%. It is popular among long term investors looking for a defensive investment vehicle.
As of August 2023, the Utilities Index reveals an aggregate price-to-cash flow ratio of 10.1x, price-to-earnings of 19x, and one-year forward price-to-earnings ratio of 17x.
Largest firm in the index weighs in with a market cap of USD 136.6 billion. The smallest firm has a market cap of USD 8.5 billion. Weighted average market cap of the index stands at USD 51.15 billion. Top ten constituents forming 59% of the Utilities Index as of 22nd August 2023 are:
• NextEra Energy (14.85%)
• Southern Company (8.03%)
• Duke Energy (7.5%)
• Sempra (4.88%)
• American Electric Power (4.40%)
• Dominion Energy (4.34%)
• Exelon Corporation (4.32%)
• Constellation Energy Corporation (3.75%)
• Xcel Energy Inc. (3.47%)
• Consolidated Edison Inc. (3.37%)
Twelve-month price targets for the top-10 in the Utilities Index looks compellingly strong except for Constellation Energy and Consolidated Edison. Mean 12-month price targets are on average 14% above the closing price as of August 25th.
Investors securing a long position in the index can expect to generate positive returns from capital gains in addition to a healthy dividend yield.
RESILIENCE OF UTILITIES SECTOR IN A RECESSION
Experts who have been calling recession have been stumped and humbled with the resilience demonstrated by corporations and consumers.
A recession may be round the corner. Or we are living through a rolling recession and rolling recovery which impact one sector at a time.
The chart below produced by State Street Research powerfully captures various sector performance across business cycles. If a recession is round the corner, then holding a long position in Utilities is an astute investor choice.
COMPREHENDING UTILITIES SELECT SECTOR SPDR ETF ("XLU")
XLU is a convenient low-cost option for investors to secure exposure to the U.S. utilities sector. It was launched in Dec 1998 and has a low expense ratio of 0.1% of AUM.
XLU's AUM stands at USD 14.39 billion. Over the last six months, XLU has had a net inflow of USD 150.2 million.
XLU has a 20-day volatility of 12% and a beta of 0.52x. It pays out an annual dividend of USD 2.10 amounting to an annual dividend yield of 3.31%.
TRADE SET UP
A sector's outperformance does not necessarily mean that it will appreciate during a recession. Since, equity prices generally decline during recessions, outperformance can also mean that the decline in defensive and non-cyclical sectors will be less severe than the decline in growth sectors.
Investors can use a spread position to benefit from sectoral outperformance even when equity prices decline. This is because the losses from the long leg will be offset by profits from the short leg which is likely to perform worse.
The proposed trade set up comprises of a long position in XLU and a short position in CME Micro E-Mini S&P 500 Index Futures expiring in December 2023 (MESZ2023).
The XLU ETF settled at USD 63.63 per share on August 25th.
Each lot of MESZ2023 provides a notional exposure of index value times USD 5. MESZ2023 settled at 4463 on August 25th delivering a notional value of USD 22,315.
• Entry: 0.0142
• Target: 0.0160
• Stop Loss: 0.0135
• Profit at Target: USD 5,347
• Loss at Stop: USD 2,200
• Reward/Risk: 2.43x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
In a recession, economic activities shrink resulting in declining outputs and softening demand across consumers and businesses. Recession leads to rising unemployment and reduced consumer confidence.
History has ample evidence demonstrating that defensive sectors typically outperform the broad market index by more than 10% on average.
This paper posits a long position in Utilities Select Sector SPDR ETF ("XLU") to harvest potential outperformance gains plus a dividend yield of 3.3% and combined with a short position in CME Micro S&P 500 Index Futures.
INFLATION REMAINS HOT; FED RESOLVED TO FIGHT IT CAN LEAD TO RECESSION
Last week, Federal Reserve Chair Jerome Powell reaffirmed his determination to tame inflation down to its target 2%. He reasserted his singular focus on restoring price stability in the US. If that requires higher interest rates for longer to get back to 2% target, then so be it. That was the key takeaway from Jackson Hole Central Bankers Symposium in Wyoming.
US inflation is much cooler than a year before. History has taught policymakers an expensive lesson to avoid declaring victory too soon.
Softening inflation combined with record low unemployment, strong business climate and resilient consumer balance sheets point to a potential soft-landing. However, over correction could tip into a hard landing.
WHAT HAPPENS IN A RECESION?
During a recession, non-cyclical sectors, like Consumer Staples, Utilities, and Health Care, have historically performed well. The fortunes of these sectors hinge on non-discretionary spending and hence less sensitive to economic fluctuations.
These defensive sectors have outperformed the broad market by more than 10% on average during six of seven past recessions.
Tech & Real Estate rank among the worst-performers. Dependant on discretionary expenditure, these sectors are the first to face the heat when businesses and consumers cut spending as incomes shrink.
UNPACKING THE S&P SELECT SECTOR UTILITIES INDEX
The Utilities Select Sector Index ("Utilities Index") is market-cap-weighted and tracks the performance of the largest thirty utility firms in the S&P 500. It aims to deliver exposure to firms from the electric & water utility, independent & renewable power producers, and gas utility industries.
The Utilities Sector includes firms that provide essential services such as electricity, natural gas, and water. These firms marshal stable cash flows and low debt levels. Consequently, the sector is described as a defensive play which performs well during economic downturns.
The Utilities Index was launched on 16th December 1998. Over the last decade, the index has delivered an average annual return of 5.5%. It exhibits lower risk with a volatility of 12.5%. It is popular among long term investors looking for a defensive investment vehicle.
As of August 2023, the Utilities Index reveals an aggregate price-to-cash flow ratio of 10.1x, price-to-earnings of 19x, and one-year forward price-to-earnings ratio of 17x.
Largest firm in the index weighs in with a market cap of USD 136.6 billion. The smallest firm has a market cap of USD 8.5 billion. Weighted average market cap of the index stands at USD 51.15 billion. Top ten constituents forming 59% of the Utilities Index as of 22nd August 2023 are:
• NextEra Energy (14.85%)
• Southern Company (8.03%)
• Duke Energy (7.5%)
• Sempra (4.88%)
• American Electric Power (4.40%)
• Dominion Energy (4.34%)
• Exelon Corporation (4.32%)
• Constellation Energy Corporation (3.75%)
• Xcel Energy Inc. (3.47%)
• Consolidated Edison Inc. (3.37%)
Twelve-month price targets for the top-10 in the Utilities Index looks compellingly strong except for Constellation Energy and Consolidated Edison. Mean 12-month price targets are on average 14% above the closing price as of August 25th.
Investors securing a long position in the index can expect to generate positive returns from capital gains in addition to a healthy dividend yield.
RESILIENCE OF UTILITIES SECTOR IN A RECESSION
Experts who have been calling recession have been stumped and humbled with the resilience demonstrated by corporations and consumers.
A recession may be round the corner. Or we are living through a rolling recession and rolling recovery which impact one sector at a time.
The chart below produced by State Street Research powerfully captures various sector performance across business cycles. If a recession is round the corner, then holding a long position in Utilities is an astute investor choice.
COMPREHENDING UTILITIES SELECT SECTOR SPDR ETF ("XLU")
XLU is a convenient low-cost option for investors to secure exposure to the U.S. utilities sector. It was launched in Dec 1998 and has a low expense ratio of 0.1% of AUM.
XLU's AUM stands at USD 14.39 billion. Over the last six months, XLU has had a net inflow of USD 150.2 million.
XLU has a 20-day volatility of 12% and a beta of 0.52x. It pays out an annual dividend of USD 2.10 amounting to an annual dividend yield of 3.31%.
TRADE SET UP
A sector's outperformance does not necessarily mean that it will appreciate during a recession. Since, equity prices generally decline during recessions, outperformance can also mean that the decline in defensive and non-cyclical sectors will be less severe than the decline in growth sectors.
Investors can use a spread position to benefit from sectoral outperformance even when equity prices decline. This is because the losses from the long leg will be offset by profits from the short leg which is likely to perform worse.
The proposed trade set up comprises of a long position in XLU and a short position in CME Micro E-Mini S&P 500 Index Futures expiring in December 2023 (MESZ2023).
The XLU ETF settled at USD 63.63 per share on August 25th.
Each lot of MESZ2023 provides a notional exposure of index value times USD 5. MESZ2023 settled at 4463 on August 25th delivering a notional value of USD 22,315.
• Entry: 0.0142
• Target: 0.0160
• Stop Loss: 0.0135
• Profit at Target: USD 5,347
• Loss at Stop: USD 2,200
• Reward/Risk: 2.43x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Full Disclaimer - linktr.ee/mintfinance
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