Key Takeaways
- Utilities stocks experienced poor performance in 2023 as investors favored mega-cap growth stocks over defensive sectors.
- However, that sluggish performance has led to low valuations for the stocks, which could come back into favor should the U.S. economy weaken.
- Over the longer term, the gradual transition toward renewables and away from carbon-based energy sources could provide a tailwind for utilities.
- Electric utilities that are moving toward decarbonization could be particular beneficiaries of the shift to renewables.
For 2024 and beyond, the outlook for the utilities sector is strong. While the sector—along with other defensive sectors—was not in favor with investors over the past year, that could change if 2024 sees a weakening of the economic picture. Moreover, after a year of sluggish performance many utilities stocks have recently sported compelling valuations.
But the sector's long-term growth story is perhaps even more compelling: The U.S. (and the world) is gradually shifting from an oil-driven economy to an electricity-driven economy. Utilities are poised to be primary beneficiaries of that shift.
Out of favor in 2023
Utilities pulled back in 2023 as investors shifted their favor away from defensive stocks (which shined in 2022) and toward mega-cap growth companies. Gains in the S&P 500® were largely driven by a handful of companies in the technology and communication services sectors. Amid that narrow leadership, utilities simply weren't in the right place at the right time. As of mid-December, utilities were on track to be the weakest performing sector in the S&P 500.
Past performance is no guarantee of future results. Utilities sector performance is represented by the S&P Utilities Select Sector index. Data as of December 8, 2023. Source: S&P Dow Jones Indices, a division of S&P Global.
But past performance is never a guarantee of future results, and investors should remember that the upside of poor performance is often lower valuations. By late 2023, valuations among utilities stocks had fallen significantly lower—and the sector was trading at one of its largest discounts to the S&P 500 in the past 20 years.
Near-term outlook for 2024
As we look to 2024, the sector's near-term performance may continue to be driven by investor sentiment and preferences. If the economy manages the delicate feat of a soft landing, and an era of strong growth and low inflation returns, then utilities could remain out of favor.
On the other hand, if the economic picture weakens, investors could turn back to defensive stocks. Utilities comprise one of the most defensive segments of the economy, because households and businesses, by and large, keep the lights on even when the economy is in its darkest hour. Should market volatility return, investors may again seek the stability, durable cash flows, and dividends that utilities have historically provided. A decline in interest rates could also be positive for utility stocks, as it would make the dividends they pay more attractive relative to bonds.
A long-term tailwind
Over the longer term, the picture looks potentially even brighter. Utilities are at the epicenter of the gradual transition away from carbon-based fuels and toward renewable energy sources. Generating power from renewable resources is now more economical than generating power from fossil fuels, thanks to technology improvements and increased economies of scale among renewables.
The Inflation Reduction Act of 2022 is expected to continue to catalyze and accelerate this transition over years to come. That legislation aims to put the U.S. on a path to substantially reduce greenhouse gases and make clean-energy options more accessible and affordable to consumers and businesses—via tax credits and other incentives to broaden adoption of renewables.
Meanwhile, consumers, businesses, and governments are actively seeking to reduce their carbon footprints. Forecasts estimate that the portion of U.S. power generation that comes from renewable sources could roughly double by 2030.
Source: U.S. Energy Information Administration.
As this energy transition continues, companies that are investing to expand their renewable-energy fleets could benefit. Such companies have seen solid earnings and dividend growth. There could also be advantages for companies focused on nuclear energy, as nuclear could help bridge the energy gap as generation from renewables ramps up.
An uncertain short-term but strong long-term outlook
To be sure, it's impossible to predict which market segments investors will favor over short periods, and it's always possible that utilities could face another poor year. But low valuations and the possibility of defensives coming back into favor may contribute to a more constructive near-term outlook.
And over the long term, the outlook for utilities looks bright. In my opinion, renewable energy growth is no longer a question of if but rather of when, and of how much renewable energy will fuel future generations. As the U.S. and other countries worldwide march toward decarbonization, the utilities sector is at the center of the energy-generation transition from fossil fuels to renewables.