By Caroline Valetkevitch
NEW YORK (Reuters) -Investors looking for ways to protect themselves from a potential market downturn and rising inflation have been warming to utilities, sometimes seen as bond substitutes, as attractive alternatives.
The S&P 500 utilities index has outperformed the broader market this month, rising 9.3% so far compared with a 4.3% gain in the benchmark index and leading gains among sectors for March.
Driving the gains may be a defensive move by investors to position themselves against a potential slide in equities, with worries mounting over higher inflation as seen in the jump in 10-year Treasury yields and over pricey stock valuations, some strategists say.
Utilities tend to do better in a downturn because they pay dividends and offer stability.
"It's a little defensive positioning," said Joseph Quinlan, head of CIO market strategy for Merrill and Bank of America Private Bank in New York.
"We have some clients who want to be more defensive but want to stay in the market."
While the economy is expected to rebound sharply this year from the impact of the coronavirus, that optimism may be dampened by next year if unemployment remains elevated and growth slows more than expected.
Some investors say utilities also may be benefiting from hopes that there will be a bigger push toward green energy under the Biden Administration. President Joe Biden is expected to unveil next week a multitrillion-dollar plan to rebuild America's infrastructure that may also tackle climate change.
"If you get any acceleration of the decarbonization rhetoric, that's a positive for utilities," said Shane Hurst, managing director and portfolio manager at ClearBridge Investments.
But whether the recent surge in utilities has further room to run is a matter of debate, and many strategists and investors, including Quinlan, still favor cyclicals that benefit from economic growth over defensive-leaning groups such as utilities.
The gains in utilities have come amid a rotation from technology and other growth stocks into so-called value stocks. The Nasdaq Composite has fallen in March after four straight months of gains.
Cyclicals, which investors dumped during the early part of the pandemic, have benefited the most from the rotation. An end-of-quarter rebalancing of investment portfolios by institutional investors may be adding to the recent rotation from growth into value.
While utilities still sharply lag gains for the year compared with many cyclical sectors, including energy, they are also considered inexpensive at this point by some investors.
After a weak performance in 2020, utilities "are just really, really cheap at the moment," Hurst said. "And that is an attractive place to be when you're in a market that's very much earnings driven."
The utilities sector is trading at 18.3 times forward earnings compared with a price-to-earnings ratio of 22.1 for the S&P 500 index and 26 for technology, according to Refinitiv's data.
David Bianco, Americas chief investment officer for DWS, which has an overweight rating on utilities, said interest rates are still low, but utilities offer inflation protection because they would be able to raise their prices.
As of Friday, the S&P 500 utilities sector had a dividend yield of 3.3%, the second-highest among S&P sectors after consumer staples, and well above the 1.5% yield for the S&P 500, according to data from S&P Dow Jones Indices.
Benchmark 10-year note yields were at 1.660% on Friday after reaching a one-year high of 1.754% the week before.
"Utilities is our most preferred bond substitute," said Bianco.
(Reporting by Caroline Valetkevitch; Editing by Alden Bentley, Dan Grebler & Shri Navaratnam)