Are Utilities The New Must-Own Equity Sector?

Recent stock market turbulence has left two equity sectors outperforming this year: communications services and utilities, based on set of ETFs through Monday’s close (Aug. 19). The remaining sectors are trailing the broad market, albeit with positive results.

The top performer in 2024: Communication Services ETF (XLC), which is up 20.7%, moderately ahead of the 18.5% rise for US shares overall via SPDR S&P 500 (SPY).

A more interesting story is the rally in utilities, which are in second place year to date with a 20.3% increase, which is only fractionally behind XLC’s advance. Meanwhile, XLU is now outperforming the US stock market broadly defined by a comfortable margin.

Several reasons are cited for the recent strength in utilities. The sector is seen as a “safe” play on relatively high dividend yields, which is all the more alluring given the expectations that the Federal Reserve will start cutting interest rates at next month’s Sep. 18 policy meeting. Lower Treasury yields offer stronger comparisons for payout rates in utility stocks.

XLU’s trailing 12-month yield is 3.01%, according to Morningstar. Thanks to a sharp decline in the US 10-year Treasury yield in recent months, the benchmark bond’s premium has slipped to less than 90 basis points over XLU’s trailing yield.

There’s also a view that utilities will benefit from the rise of artificial intelligence (AI), digital currencies (bitcoin, etc.), and other technologies with an increasingly voracious appetite for energy – electricity in general. The mix of relative safety, high payouts and prospects for AI-fueled growth has convinced investors that utilities offer a win-win outlook of capital gains and yield.

“You have this inflection in power demand, whether it be data center driven or other things driving power demand in the US like EVs,” says Aaron Dunn, co-head of value equity at Morgan Stanley Investment Management. “For two decades, you’ve had flat power demand that was driven by the efficiency of your appliances at home. Today we have this inflection and we see a doubling of power demand increases over the next 10-plus years.”

He adds: “They’re defensive, but I would prefer to own something where I think we’re getting mid-single digit to upper-single digit growth in earnings and a yield that now sort of approximates the ten-year yield.” 

It doesn’t hurt that the forward price-to-earnings ratio for utilities still looks relatively modest, especially when compared with the market overall (S&P 500), reports Yardeni.com.

Not that long ago the situation was reversed and utilities’ p/e was at a premium over the S&P’s valuation. The sector’s discount is starting to narrow after this year’s rally, but for the moment utilities still look reasonably valued compared with its history over the past decade.

The caveat is that XLU’s had a strong run lately and so it’s open for debate if the sector’s vulnerable to some short-term profit taking. The longer-term narrative, on the other hand, sounds compelling to the crowd.

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