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JEF's Strategy Summary: Utilities Sector

Core Content Overview

The Jefferies strategy team provides a detailed analysis of the Utilities sector, focusing on sentiment, valuation, earnings, and the impact of market factors such as interest rates, GDP growth, and FTSE Russell rebalancing. The team has diverging views, with Desh favoring the sector in large caps and Steven advocating for underweighting it in small caps.

Main Views and Key Insights

Sentiment and Performance

• Sentiment remains strong, with inflows into ETFs and funds supporting the group.
• The sector has held up well relative to indexes following the Fed rate cuts.
• Recent sentiment has weakened, which is viewed as a positive development, indicating potential for a pause before renewed inflows.

Rate Environment and Performance

• Higher for longer does not necessarily hurt the Utilities sector, especially in large caps.
• The Fed is expected to cut rates three times in 2025, starting in September.
• Large cap Utilities are more sensitive to rate changes, with a correlation of -0.16 to the 2-year rate and -0.32 to the 10-year rate.
• Small cap Utilities are less correlated with rate changes, with a correlation of -0.62 to the 2-year rate and -0.19 to the 10-year rate.

GDP and Economic Impact

• GDP growth below 2% is expected to negatively impact small and large cap Utilities.
• Utilities tend to lag the market more than average when the economy slows.
• However, small cap Utilities show better performance when GDP is below 2% compared to the overall Russell 2000.

Valuation and Earnings

• Valuations are stretched, especially in small caps.
• Utilities are the second most expensive sector in both large and small caps, behind Industrials.
• Earnings growth remains stable, with a 7.2% forecast for large caps and 3.3% for small caps in 2025.
• The dividend yield is lower than the 10-year Treasury yield, making it less attractive for yield-focused investors.

FTSE Russell Rebalancing Impact

• Rebalancing season has minor impacts on the Utilities sector.
• Talen Energy (TLN) and NRG Energy (NRG) are expected to see buying pressure, while Constellation Energy (CEG) and NextEra Energy (NEE) face selling pressure.
• Vistra Corp (VST) will remain in the Mid Growth index with a 1.6% weight.
• Independent Power & Renewable Electric Producers are likely to receive the most inflows during rebalancing.

Key Recommendations

• Large Cap Utilities: OW (Overweight) due to attractive valuations, strong earnings visibility, and lower correlation with rate changes.
• Small Cap Utilities: UW (Underweight) due to expensive valuations and lack of economic torque.
• Dividend Yield: Not a strong attraction for large cap Utilities, but better than the 2-year rate.

Investment Implications

• Utilities are seen as a low-risk, defensive sector, but their performance may lag in a slower economy.
• Earnings revisions are more positive than the overall S&P 500, indicating better visibility.
• Passive investors are likely to increase exposure to the sector, particularly in Mid Growth and Independent Power & Renewable Electric Producers.

Tables of Key Changes and Performance

• Table 1: Highlights the surprising performance of Utilities in different GDP environments.
• Table 2: Lists the top 10 Utilities names with buying pressure from passive investors.
• Table 3: Lists the top 10 Utilities names with selling pressure from passive investors.
• Table 4: Shows the new index weights for Utilities across different market caps.

Analyst Certification

• Steven G. DeSanctis, CFA, and Jane Gibbons, Equity Strategist and Associate, respectively, certify that the views expressed reflect their personal opinions and are not tied to compensation.

Disclosure and Ratings

• Important disclosures are provided for companies mentioned, including potential conflicts of interest related to investment banking services.
• Ratings include:
  • Buy: Expected total return of 15% or more.
  • Hold: Expected total return of ±15%.
  • Underperform: Expected total return of 10% or less.
  • NR: Rating and price target temporarily suspended.
  • CS/NC: Coverage suspended or not covered.
  • Restricted/Monitor: Describes issuers with communication restrictions or ongoing monitoring.

Valuation Methodology

• Ratings are based on market capitalization, growth/value, volatility, and expected total return.
• Price targets use DCF, EBITDA, EPS, P/E, and other financial metrics.