What new growth dynamics mean for an equity sector often treated as a bond proxy
The S&P 500 is up just over 18 per cent year to date, a bull market by any standard. So is the Dow Jones US Utilities Index. That is not normal.
Utilities are the textbook defensive stock, often held as a bond proxy by investors. They offer volatility offsets with big competitive moats, large scale, and a tendency to pay high income in the form of dividends. Their notable periods of historic outperformance come when other markets are falling, even crashing. Investors buy utilities stocks for ballast, for stability, and not for growth.
This year, they got growth. While not moving at the pace of some technology giants, the utilities space has been remarkable for much of 2024. That has been driven, almost entirely, by US power utilities. Kathrin Forrest, equity investment specialist at Capital Group, explained the myriad forces at work in this run and how a new growth dynamic in utilities stocks could impact future investment in the space.
“Changes in both supply and demand as well as the broader environment are contributing to some of the underlying strength,” Forrest says. “On the supply side, traditional power plants continue to retire so there isn’t a ton of net new capacity coming online. On the demand side, after years of stagnation, we’re now seeing growth in power demand, and that is supported by various structural trends, including data centre buildouts, EVs, electrification, and the reshoring of manufacturing activity.”
Data centres have been a core part of the US utilities story this year as a key piece of infrastructure in the continued adoption of artificial intelligence (AI). AI requires a huge amount of computational power, which itself requires massive amounts of electricity. Data centres running AI software have therefore been drawing more and more power from US grids.
Through elective choice and government incentives, more of that power being generated in the US is renewable, or at least net zero. Many tech companies have their own elective net zero targets. As well, legislation in both the US Infrastructure Investment and Jobs Act and the Inflation Reduction Act, heavily incentivize renewable power generation.
Renewable power generation offers some supply advantages. Solar and wind power plants, for example, can now be set up far faster and at less cost than traditional power generation stations. The incentive structure, however, has many traditional US power plants retiring early. At the same time, many renewables lack the “always on” nature of fossil fuels, making the power grids potentially more intermittent.
It's crucial to note that this is a primarily US story, and one with several winners and losers. US power generators have stood out, while water utilities have been much more standard. There is also some risk of US power utilities becoming overbought as they get caught up in some of they hype around AI related stocks. Forrest notes, however, that given the competition for power among data centres many contracts involve prepayments and even refunds, which can help protect these utilities’ revenue streams if AI spending pulls back.
Utilities investors also tend to advocate for broad geographic diversification. Natural disaster risk, regulatory risk, and other tail risks related to infrastructure, can be mitigated through a wider array of holdings in different jurisdictions. While this growth run has been heavily concentrated in US power companies, Forrest acknowledges the importance of diversification based on the outcome a particular investor is seeking.
Those investors typically seek out utilities as something of a bond proxy: a stable source of capital preservation, income, and some non-correlation with other equities. This recent performance, however, has made utilities far more like typical equities. Forrest notes, however, that both the dividend yields and lesser economic sensitivity that typified utilities continues to hold true in this environment. She notes, however, that there are many more investors in this space now driven by a tailwind of expected earnings growth. She believes that the entry of these investors should result in a utilities sector that behaves a bit more like traditional equities going forward but will still retain some of the characteristics that investors have come to know utilities by.
As asset managers look at this sector, following a significant bull run, Forrest still believes there are opportunities to be found in utilities, depending on the goals and outcomes desired.
“I would say that valuations within utilities still don’t look particularly stretched in absolute terms or index relative terms. From there I would add that each company is different within utilities, so understanding the nuances from a bottom-up fundamental perspective is really important,” Forrest says. “Utilities have an opportunity to serve a broader set of objectives as we look ahead. It might be insightful to draw a broader circle around utilities and really think through the implications across industries and geographies, especially over longer periods.”
