Inside the Big Rally in Utilities Stocks

The normally sleepy utilities sector is experiencing a powerful rally in 2024. These dividend-paying names are riding a wave of enthusiasm thanks to falling rates, rising electricity usage, and hopes that the sector will benefit from increased data center demand sparked by the artificial intelligence boom.

This translates to big gains among exchange-traded funds and mutual funds focused on utilities. The $18.9 billion Utilities Select Sector SPDR ETF XLU has returned 31.7% so far in 2024, the most of any of the benchmark SPDR sector funds. The $237 million Virtus Reaves Utilities ETF UTES is the best-performing utility fund this year, returning 47.3%. And while Nvidia NVDA has soared, it’s only the second-best-performing stock in the S&P 500 for 2024, outdone by more than 40 percentage points by power company Vistra VST.

Vistra is the third-best performer in the Morningstar US Large-Mid Cap Index, while Nvidia is in fourth place. Ahead of them are mobile software firm AppLovin APP and MicroStrategy MSTR, a self-described “bitcoin development company.” (For a look at the best-performing utilities stocks so far in 2024, see the table at the end of this story.)

The Best-Performing Sector

While the technology sector has been hogging headlines amid the run-up in semiconductor stocks, the best-performing sector in the US market has been utilities. The Morningstar US Utilities Index has returned 33.6%, compared with the Morningstar US Market Index’s 22.1%. These stocks’ strong fundamentals, rising power demand, and falling interest rates have combined with a burst of enthusiasm and attention from investors hungry for AI-related plays to send the sector soaring.

“Utilities have rebounded sharply since their October 2023 low as the market began anticipating a shift toward lower interest rates and an increase in US energy demand,” says Travis Miller, an energy and utilities strategist for Morningstar. “AI data centers and manufacturing growth represent the biggest sources of potential energy demand growth for utilities in decades.”

Morningstar analysts identify three tailwinds driving this rally.

Falling Interest Rates

Because many utilities are reliable dividend-paying stocks, they are popular with income-oriented investors. When interest rates rise, as they did throughout 2022 and 2023, it often hurts utility stocks. In 2023, the year rates peaked, the SPDR Utilities ETF lost 7.2%, following a return of just 1.4% in 2022, when rates began rising.

“Utilities’ correlation with the bond market is much higher than any correlation with the equity market,” says John Kohli, portfolio manager of the $6.8 billion Franklin Utilities Fund FKUTX, which is up 31.6% this year.

Falling rates also have helped utilities rebound from poor performance coming into 2024. In 2023, the Utilities Index was down 7%. “Going back over the last 30 years, [2023] was the worst-performing year relative to the S&P 500,” explains Kohli.

Rising Electricity Demand

“We forecast 1.4% annualized US electricity demand growth through 2032, including data centers (higher than most forecasts). This would be the fastest growth in two decades,” says Miller and Morningstar equity strategist Andrew Bischof.

Bischof explains that 18% of that growth will come from electric vehicles, while 7% will come from data centers. This strong and rising demand has allowed utilities to post mid-to-high-single-digit earnings growth, on top of a sector yield of about 3%, according to Kohli.

The AI “Turbo Drive”

The tailwind generating the most headlines comes from the knock-on effects of the AI gold rush. There is interest in “all things AI, and it seems like in 2024, a lot of new ‘experts’ have come and started looking at the utility industry,” says Kohli. “There’s been quite a ramp-up of people trying to understand the supply and demand dynamic around the power needs for the chips that Nvidia produces, along with other data center or AI-driven devices driving this [power] load.”

The breakout star has been Vistra, up 227% in the year to date, which has grown enough to be chosen for the S&P 500 earlier this year. The firm is an independent power producer getting particular attention due to its nuclear plants. Earlier this year, Amazon AMZN announced a deal to buy power from a Talen Energy TLN nuclear power plant, while Microsoft MSFT made a similar deal with Constellation Energy CEG to bring the Three Mile Island nuclear plant back online.

“Nuclear plants’ year-round, low-cost, emissions-free power matches well with data centers’ constant energy needs,” says Miller. Under these deals, pending regulatory approval, firms with data centers will pay a premium to access more reliable power. Kohli believes the Talen deal is reasonably likely to be approved, but it’s unlikely many others will be. One reason is the risk that such a deal could lower power reliability for other consumers, which regulators are keen to avoid.

Valuations Looking Rich

While potential data center power demand is a boon for the industry, Morningstar analysts think the market may have gotten ahead of itself in its exuberance for anything AI-related. Looking at the fair value estimates for utility stocks under Morningstar’s coverage, the sector’s median name is 6% overvalued. “We think the market is overenthusiastic about growth—particularly data center investments, which we think will take time to fully materialize,” says Bischof.

Vistra trades at a 174% premium to its Morningstar fair value estimate. “We don’t include any nuclear data center contracts in our fair value estimate, in part due to regulatory risk. The Amazon-Talen deal faces regulatory opposition from other utilities. We expect a regulatory update in early November,” Miller wrote in a September note.

“I think AI has provided boosts to the performance in utilities that probably would have occurred regardless, it’s provided a little bit of a turbo drive impact for the sector,” says Kohli. “We think things look at least fairly valued. Maybe they’ve gotten ahead of themselves and look slightly overvalued today. We’re not super bullish on putting new money into the sector at these prices, but would look for some type of pullback.”