Utilities Have Been Electrifying — Evening Brief – 08.30.24
The recent stock market volatility has resulted in two equity sectors excelling this year: telecommunication services and utilities. The Communication Services ETF (XLC) is the top performer in 2024, with a 20.7% increase and slightly higher than the 18.5% advance in U.S. equities, as measured by the SPDR S&P 500 ETF Trust (SPY).
The advance in utilities is a far more captivating narrative, however. Using the Utilities Select Sector SPDR Fund ETF (XLU), the sector has increased by 20.3% thus far this year. The XLU is currently outperforming the broader US stock market by a significant amount.
A “safe” bet on comparatively high dividend yields is placed on the sector, which is appealing considering the Federal Reserve will begin to reduce interest rates at the September meeting. Stronger comparisons for payout rates in utility equities are provided by lower U.S. Treasury yields.
The trailing 12-month yield on the XLU is 3.01%, according to Morningstar. The bond’s premium has decreased to less than 90 basis points over XLU’s trailing yield because of the significant decline in the US 10-year Treasury yield in the past few months.
Additionally, there is a belief that utilities will capitalize on the advancements in artificial intelligence (AI), digital currencies, and other technologies that have an escalating demand for energy, particularly electricity.
“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.”
“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 10-year yield,” he added.
It helps that utilities’ forward price-to-earnings (P/E) ratio still appears moderate, particularly when compared to the overall market using the S&P 500, according to Yardeni.com.
The scenario was different not too long ago, with utilities having a higher P/E ratio compared to the value of the S&P 500. The sector’s discount is starting to narrow after this year’s rally, but it still appears to be reasonably priced when compared to its historical performance over the past 10 years.
The recent performance of XLU has been impressive, leading to speculation about the sector’s susceptibility to short-term profit-taking. However, the long-term story appears to be highly convincing.