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Expectations and the delivering of the Federal Reserve’s first interest rate cuts in four years have had the desired impact of boosting equity prices as confirmed by the fact that for the 20 days ending Sept. 27, the S&P 500 gained about 2.7%.
As advisors know, some sectors are more rate-sensitive than others. Undoubtedly, utilities are part of that group and the sector’s reputation for correlations to interest rates has been affirmed of late. For days ending Sept. 26, the Utilities Select Sector SPDR® Fund (NYSEARCA: XLU) is up more than 6%. That exchange traded fund is also beating the S&P 500, long-term Treasury and a wide swath of tech ETFs over that period.
The resurgence of the utilities sector is pertinent to advisors for multiple reasons. These stocks have long been known as bond proxies, indicating the group can be a fixed income substitute for income-needy clients and retirees. Need to move some cash off the sidelines? Utilities are a sound idea, particularly at a time when yields on cash instruments are likely to decline.
Plus, there’s the potential for significantly more upside with utilities stocks and ETFs than there is with bonds without having to taken on much more risk. Over the past three years, XLU’s annualized volatility was just 30 basis points higher than ICE U.S. Treasury 20+ Years Bond Index.
Utilities: A Conservative AI Play
No one is going to deny the merit of the communication services and technology sectors as inroads to artificial intelligence (AI), but utilities have AI leverage too for a simple, valid reason: AI requires copious amounts of electric power.
“While attention has been focused on AI and the hyperscalers, a new wave of energy demand has created an unlikely market leader year-to-date: utility stocks,” notes Stephanie Aliaga, global market strategist at J.P. Morgan Asset Management. “The continued increase in data, compute, cloud migration and now, AI, have fueled growth in data centers and the electricity needed to power them up, providing a powerful catalyst for many companies along this value chain.”
Just look at the chart below, included in Aliaga’s piece, regarding how data center growth, driven by AI, could be a long-term boon for the utilities sector.
Cost of Admission Is Low
There’s another slice of good news for advisors and investors considering utilities stocks or ETFs. Valuations in the sector aren’t stretched. That’s noteworthy because sectors with above-average dividend yields and below-average volatility often command premium multiples, particularly when interest rates are low.
Rates aren’t low today, but they’re expected to continue declining through 2025 and that bolster the appeal of utilities payouts.
“At 18.7x next 12-month earnings, the sector is trading at a 13% discount to the S&P 500 and is only slightly above its own 5-year and 10-year averages,” concludes Aliaga. “Falling interest rates could provide a further boost for the sector as their dividend yields become relatively more attractive and stronger long-term earnings growth could justify further upgrades in their valuations. For investors looking to diversify tech exposure, utilities could provide an attractive way to invest in the infrastructure buildout underway, with a very different wrapper.”