Are Utilities Becoming the New Equity Sector When Fed Cuts Rates?

As of Monday's close, recent market swings have resulted in strong gains for the Communication Services and Utilities sectors. The other sectors have seen positive results too but haven't kept up with the overall market.

Interestingly, the utilities sector has risen 20.3% this year, making it one of the best performers. Overall, it's doing much better than the broader U.S. stock market - the utilities sector has become one of the hottest sectors in the U.S. stock market.

Several factors explain the recent strong performance of the utilities stocks.

First, an interest rate cut can make utilities stocks more attractive to conservative investors who favor bonds. For example, after the 2008 financial crisis, low bond yields led many income-focused investors to utilities stocks with an average dividend yield of around 4.8%.

The utilities sector stocks are considered "safe" investments with good dividend yields. With the Federal Reserve likely to cut rates in September, these dividends look even more attractive compared to lower bond yields.

Another idea is that utilities will gain from the growth of AI, digital currencies (like Bitcoin), and other technologies because these innovations drive the need for energy, especially electricity.

The relative safety, high returns, and growth potential driven by AI make investors believe that utilities can offer both capital gains and income.

"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 valueequityat 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."

Yardeni.com reports that the expected P/E ratio for utilities companies still looks relatively moderate, especially compared to the overall market (S&P 500 Index).

So far, utilities stocks have had lower P/E ratios than the S&P 500. The sector's discount has reduced after this year's rebound, probably suggesting they are still reasonably priced compared to their historical levels over the past ten years.

It's important to note that the utilities sector has performed strongly recently, so it's uncertain whether it might be vulnerable to short-term profit-taking. On the other hand, the long-term outlook remains very appealing to investors.