With all the uncertainty surrounding the ongoing eurozone crisis, anaemic recovery in the US and slowdown in China, investors have been seeking the sanctuary of safe-haven sectors.
Contrary to conventional thinking, the utilities sector is among the most at risk from a eurozone break-up
One widely perceived safe haven is the utilities sector, which is known for its defensive characteristics – namely consistent revenues, stable earnings, decent dividend payments and inflation-hedging potential.
Therefore, perhaps understandably, some investors have allocated an increasing share of capital to ETFs tracking this sector. The DB X-trackers STOXX Europe 600 Utilities ETF (XS6R), for example, has seen its assets under management increase by almost 85% this year alone. During the same period (31/12/2011 to 15/06/2012) the fund has returned -4.22%, thus emphasising the impact of positive flows into the fund.
Other utilities ETFs, such as the STOXX Europe 600 Optimised Utilities Source ETF (XSPS), the SPDR MSCI Europe Utilities ETF (STU) and the Amundi ETF MSCI Europe Utilities (CU5), have no doubt, too, been the beneficiaries of inflows from investors seeking relative safety.
However, analysis by Fitch Ratings, looking at the likely repercussions of a Greek eurozone exit, suggests that utilities are most at risk from a eurozone break-up. Due to their high leverage and mix of regulated domestic revenue streams and large foreign creditor bases, utilities could be among the worst performers should the eurozone crisis escalate. This view is in stark contrast to the conventional wisdom that utilities are safe.
With few instances of recent sovereign defaults with large corporate sectors, in making their assessment Fitch examined Argentina’s 2001/2002 default, subsequent currency devaluation and forced conversion of dollar deposits and local debt into pesos to shed some light on the likely performance consequences of a Greek exit from the euro. While the analysis specifically looked at a hypothetical Greek exit, a similar scenario would likely play out if any other country were to exit the eurozone.
Fitch found that the devaluation of the peso immediately increased Argentine corporate debt and put pressure on free cash flow generation, especially for smaller, domestically focused companies. A similar situation could be expected in Greece; limited export ability, price controls, a potentially long recession and restricted local market refinancing options could all limit the ability of companies to meet interest and principal repayments.
Greek companies could be even more exposed to a fall in trade because an exit from the euro would complicate broader relations with the EU free trade area, suggests Fitch
As well as de-pegging from the dollar, the Argentinian government introduced several other emergency measures that damaged the financial flexibility and credit profiles of Argentinian corporates. These included: restricting the transferability of foreign currency, which caused some companies to miss scheduled debt payments; prohibiting price adjustments based on foreign currency indexation; and government regulation of prices of critical goods and services.
The combined impact meant that, by the middle of 2002, most of the Argentinian corporates Fitch rated that had not already defaulted were rated in the ‘C’ to ‘CCC’ range. While sharply increased debt burdens and weak cash flows created an incentive to default, most of the companies that did so were forced through inability to pay, rather than unwillingness.
Several utilities were among the companies that defaulted by mid-2002 due to their high leverage and mix of regulated domestic revenue streams and large foreign creditor bases, underlining previous analysis by Fitch that utilities are the most at risk from eurozone turmoil.
In contrast, the few companies that kept up their foreign debt obligations in the Argentinian crisis were those that were internationally diversified and able to generate export revenue in dollars – generally in the oil & gas sector.
Perhaps, then, investors with a necessity to maintain exposure to Europe would be wiser favouring oil & gas ETFs over utilities ETFs. Of course, the great thing about ETFs is the huge breadth of choice; it goes without saying that there is an abundance of European oil & gas ETFs. Examples include the DB X-trackers STOXX Europe 600 Oil & Gas ETF (XSER), the STOXX Europe 600 Optimised Oil & Gas Source ETF (XEPS), the SPDR MSCI Europe Energy ETF (STN), the iShares STOXX Europe 600 Oil & Gas (DE) (EXH1) and the Amundi ETF MSCI Europe Energy (CU5), to name but a few.
For sophisticated investors wishing to temporarily hedge out utilities exposure, they could consider the DB X-trackers STOXX Europe 600 Utilities Short Daily ETF (XS6S). This fund is linked inversely to the daily movements of the STOXX 600 Utilities Index, in effect replicating a short position in European utilities. The fund could also be used sparingly to implement a more speculative, shorter-term negative stance on utilities.