Utilities Sector Shows Potential for Outperformance Amidst AI-Driven Demand and Valuation Discount

Utilities Sector Signals Potential Outperformance Amidst AI Infrastructure Surge

The Utilities Sector ETF (XLU) has recently drawn attention from investors, exhibiting an unusual price movement that has positioned it as "opportunistically cheap." Last month, the XLU experienced a nearly 5% decline, contrasting with a 30-basis point drop in interest rates, a deviation from the sector's typical inverse correlation with bond yields. This unexpected decoupling, coupled with robust growth forecasts driven by the burgeoning artificial intelligence (AI) infrastructure, suggests a potential for the sector to outperform the broader market.

Valuation and Growth Drivers

Currently, the XLU is trading at 18.1 times forward earnings, representing a significant four-turn discount compared to the S&P 500's forward earnings multiple of 22.1 times. This valuation disparity is notable, especially as the utilities sector now projects a faster revenue growth rate of 6.4%, marginally exceeding the S&P 500's forecast of 6.1% for the coming year. The primary catalyst for this accelerated growth is the escalating electricity demand stemming from the rapid buildout of AI infrastructure.

Analysts project a substantial increase in electricity consumption, with U.S. power demand from data centers expected to surge by 20-40% in 2025, followed by strong double-digit growth through 2030. This demand is translating into above-average earnings growth forecasts for utilities, anticipated at 16.6%, significantly outpacing the S&P 500's projected 11%. Despite advancements in energy efficiency through new algorithms and processors, the near-term rapid adoption of AI tools is expected to outweigh these efficiency gains, leading to a projected fourfold increase in U.S. data center power demand by 2032, consuming approximately 7% of total U.S. electricity demand. In a more aggressive AI adoption scenario, this could escalate tenfold by 2032, accounting for closer to 20% of the total.

Defensive Positioning and Interest Rate Sensitivity

Beyond growth prospects, the utilities sector offers inherent defensive benefits and recession resistance, qualities that enhance its appeal in uncertain economic environments. Utilities are traditionally considered interest-rate-sensitive due to their steady dividend income competing with bonds. Historically, lower interest rates tend to increase the attractiveness of utility dividends for income-focused investors. The expectation of potential interest rate cuts in 2025, which would further benefit dividend investors, adds another layer of support for the sector.

Specific electric utilities identified as potentially undervalued opportunities include Dominion (D), American Electric Power (AEP), and Pinnacle West (PNW). For instance, American Electric Power (AEP) closed at $111.60 on September 30, 2025, representing a 1.66% gain for the day, with its 52-week range indicating a low of $89.91 and a high of $115.36.

Broader Market Context and Expert Outlook

The current forward 12-month P/E ratio for the S&P 500 stands at 22.5, which is above its 5-year average of 19.9 and 10-year average of 18.6, indicating a relatively higher valuation for the broader market. This contrasts with the more attractive valuation observed in the utilities sector.

UBS Global anticipates a downward trend in the 10-year U.S. Treasury yield as economic growth moderates. The firm projects that ongoing softness in the U.S. labor market will enable the Federal Reserve to implement further rate cuts, potentially by 75 basis points through January 2026. In this environment, UBS Global recommends increasing exposure to preferred sectors, including utilities, alongside U.S. IT, financials, healthcare, and communication services.

Looking Ahead

The trajectory of the utilities sector will largely hinge on several key factors. The pace and scale of AI infrastructure buildout, particularly concerning data centers, will continue to dictate electricity demand growth. Investors will also closely monitor the Federal Reserve's monetary policy decisions and their impact on interest rates, as lower rates could further enhance the appeal of utility dividends. The interplay between energy efficiency advancements and the accelerating demand from AI will be crucial in shaping the sector's long-term growth profile. Upcoming economic reports and earnings releases from key utility companies will provide additional insights into the sector's performance and future outlook.