Higher-for-longer inflation could hit this safe-haven sector hard, Morningstar strategist warns

Published Mon, Jul 18 20228:48 PM EDT

Snap up defensive stocks when things gets rough — this popular investing strategy has been a mainstay in times of market volatility, but what happens when a traditionally defensive sector ceases to be so? Morningstar strategist David Sekera believes the utilities sector — long seen as a safe-haven — could be "most at risk" if inflation remains higher for longer. The utilities sector is widely viewed as a safe bet in times of market upheaval, given its steady, regulated earnings and higher dividend income relative to other sectors. It has certainly outperformed the wider S & P 500 this year, down just over 1% year-to-date, while the S & P 500 has fallen close to 20% over the same period. The sector is the second-best performer among the 10 major sectors on the index, and enjoys the second-highest dividend yield, according to FactSet data. It is also commonly viewed as an inflation hedge, but Sekera is not convinced. "The utilities sector is one where it's still within the range of what I consider to be fairly valued, but it's definitely skewing to the high side of that range — close to being at the point where it's getting to be overvalued," Sekera, who is chief U.S. market strategist at Morningstar, told CNBC Pro Talks last week. Read more This fund manager oversees $10 billion. Here's where he's investing as inflation stays high These global stocks have a track record of earnings growth — and analysts love them ‘Outright cheap': JPMorgan says there's a tactical buying opportunity in these global stocks "I may not necessarily be underweight [utilities] at this point, but it's certainly one that I would be very cautious of. That's also the sector that I think, if inflation ends up being more persistent and lasts longer and higher than expected, that's probably going to be the most at risk," he added. It comes as prices continue to soar in the U.S. The consumer price index rose 9.1% in June from a year ago — the fastest pace for inflation since 1981, and above estimates. Inflation the biggest risk Morningstar believes utilities' outperformance this year has papered over what it considers the sector's biggest long-term risk: inflation. "Utilities are the most sensitive to inflation because of their mostly fixed revenue, large capital investment budgets, and borrowing needs," the Chicago-based financial services firm said in its 3Q market outlook released on Jul. 1. Sekera said utility firms also enjoy limited pricing power, as they require regulatory approval to raise rates — a process that he said could take between six to 12 months. Stock picks Investors looking to have utilities exposure in their portfolio should thus focus on those in constructive regulatory environments that offer the most protection from inflation, Sekera added. His top picks within the sector include California-based Edison International , which he thinks is trading at a "sizable discount" relative to its peers, despite having a better growth outlook, dividend yield and clean energy profile. He also likes Entergy Corp , which operates in the south of the U.S. It's a stock he believes will be less impacted by inflation compared to its competitors. Rounding off his picks is Virginia-based Dominion Energy , which Sekera also said has less regulatory risk in an inflationary environment.