The stock market has rocketed higher this year, led by big tech stocks like Nvidia, Meta Platforms, and Broadcom. But if you scratch the surface, you find a surprising group of stocks that are even hotter than tech: utilities. That’s right.

Let’s dig into what’s happening to bolster those stocks’ performance, and why the utility sector could finish the year as the market’s top-performing sector.

Image source: Getty Images.

How utilities have performed so far this year

As of this writing, the S&P 500 has generated a total return of 17.8% year to date. The utility sector, as measured by the Utilities Select Sector SPDR ETF (XLU -0.79%), has generated a total return of 20.7%. That’s better than any other sector, including the tech sector, as measured by the Technology Select Sector SPDR ETF.

XLU Total Return Level data by YCharts.

But why is it outperforming? The answer lies in several bullish trends.

First, the utility sector is gaining a tailwind from the growing use of artificial intelligence (AI). In a nutshell, AI applications are power hungry — extremely power hungry. Some reports estimate that AI applications currently consume roughly 8 terawatt hours (TWh) of power. That’s roughly equal to the amount of energy produced by the state of Rhode Island in 2022.

What’s more, AI’s energy use is expected to skyrocket over the next few years. Some predict it could reach 52 TWh by 2026 — similar to the entire yearly energy production of Massachusetts. By 2030, it could truly explode — requiring more power than the entire 2022 output generated by Florida, California, and New York.

In other words, there’s an enormous demand coming for additional energy production thanks to the skyrocketing demand for AI applications. Obviously, this could be a boon for utility providers.

However, there are some caveats. For one thing, many utilities are highly regulated owing to their monopolistic character, meaning it’s difficult for them to raise prices. Second, it’s time-consuming and costly to add new power plants. So even with added demand, utility providers will have to spend big bucks on capital expenditures to construct or expand their power plants.

Why utilities could finish the year as the top sector performer

Yet, there’s more than just AI driving the price of utility stocks higher. The second factor at play is the cost of borrowing: interest rates.

10-Year Treasury Rate data by YCharts.

After bumping along at multi-decade lows, long-term interest rates swung back upward in 2022 as inflation surged and the Federal Reserve boosted its benchmark rates in a bid to get it in check. But inflation has cooled, and now long-term interest rates are easing back downward as the market looks forward to cuts in the federal funds rate.

10 Year Treasury Rate data by YCharts.

That’s great news for utility stocks for two reasons:

1. Lower interest rates mean lower borrowing costs. Utility companies prefer lower borrowing costs because — as noted — it’s expensive to build new power plants or expand existing ones.
2. Lower interest rates drive down the appeal of fixed-income securities like bonds. That can encourage income-seeking investors to shift more of their investments to utility stocks, which generally have solid dividend yields.

Of course, falling long-term interest rates can also signal slower economic growth — or even the possibility of an upcoming recession. However, utility stocks, as a defensive sector, often outperform in recessionary environments.

In sum, there are a number of reasons why utility stocks are having such a great 2024, including falling interest rates, rising energy demand, and the potential for slower economic growth. Investors who may have been overlooking the sector before may want to give it a second look now.