Offense, Defense and the Same Old Normal

Is a fundamental change afoot in the markets? Some say so, arguing categories previously considered “defensive” and stodgy are now more cyclical and sensitive to economic conditions, which makes it hard to know how to allocate a stock portfolio. What do you buy if you expect fast economic growth? Slow growth? One Wall Street Journal piece tried to answer this over the weekend and ended up in a predictable, even logical place: Buy companies whose earnings are sensitive to discretionary spending when you anticipate a stronger economy and more steady, stalwart businesses when you don’t. Yet in doing to, it accepted as fact that “the crosscurrents from tech and war” have permanently altered sector fundamentals.^[i] This, friends, needs correcting.

The line referred primarily to Utilities and Energy, allegedly transformed by artificial intelligence (AI) and geopolitics, respectively. Energy, supposedly, isn’t cyclical anymore because it is too “sensitive to Middle East tensions and OPEC politics, which interfere with its link to global growth.” Traditionally defensive Utilities, meanwhile, are allegedly “an AI play thanks to the surge in demand for data centers.”^[ii] The first misunderstands what has always really driven Energy stocks, in our view, while the second sees a change in Utilities that isn’t really there.

Let us start with Energy. The article notes that some index providers classify the sector as defensive because some recessions started with high oil prices, benefiting Energy stocks. The article disagrees, casting Energy as traditionally cyclical because of “the obvious link between faster economic growth and demand for oil.”^[iii] But then its geopolitical sensitivity messes this up, driving Energy stocks up last week while other cyclical sectors allegedly took a hit from diminishing rate cut expectations. It is enough to make one dizzy—unnecessarily.

Stocks are a share in future earnings. Energy’s earnings depend on one simple variable: oil prices. Not production volumes, not barrels sold to China and other economically important regions. Just the price of crude and whether it is high enough to offset oil drilling’s high up-front costs and drillers’ debt service payments. So if investors expect higher oil prices, Energy will typically outperform, and vice versa.

In this light, the alleged contradictions plaguing Energy stocks vanish. Oil prices move on supply and demand. Economic growth is the demand side. War and OPEC chatter represent the supply side. When investors fear supply disruptions, that sentiment can lift oil prices, which lifts expectations for Energy earnings—and therefore Energy stocks. When oil’s move proves to be an overreaction as supply stays resilient, then the effect on stocks proves similarly temporary. And if supply and demand end up being roughly in balance, regardless of the global economy’s growth rate, OPEC’s whims (whose effect is overrated) and regional conflict, then the traditional narratives are probably going to fall apart to a degree.

Furthermore, let us consider the notion something fundamentally changed here. OPEC’s ability to influence supply dates to its inception over 60 years ago. It is arguably less important now than at any time in that span, considering several of its members’ production difficulties and the vast rise in production from non-OPEC regions like the US, Canada, Brazil and Guyana. And war? We ask you, is war in the Middle East, ummmm, new?

As for Utilities and AI, we have covered this before and won’t rehash in great detail here. The Utilities AI boom thesis rests on data centers’ electricity needs supposedly driving big growth in electricity demand and generation. The latest story in this arena is all the chatter about restarting idled nuclear power plants—most famously at Three Mile Island—and how Utilities are sure to benefit.

When we covered this back in the spring and summer, we explained the hard reality: Even if the widely hyped electricity demand surge happens (so far it is a hope, not a reality), it isn’t auto-bullish for Utilities. Meeting rising demand requires increasing electricity generation, which isn’t cheap. New power plants require high up-front costs that take years to recoup. A lot of it is debt-financed, which would require borrowing at today’s relatively higher rates—likely offsetting a lot of the anticipated revenue increase. The last time Utilities endured a big demand boom, in the 1960s and 1970s, the sector underperformed the vast majority of the time because of these factors.

The Three Mile Island restart frenzy largely proves our point. Last week, the news emerged that the power company involved is seeking $1.6 billion worth of taxpayer-funded loan guarantees to fund the project.^[iv] This isn’t even building a new plant! It is reopening one that idled a few short years ago. Even this, it seems, is too costly for the firm to want to undertake without federal assistance. If the revenues were as huge as everyone seems to anticipate, this probably wouldn’t be the case. The project would be self-evidently viable without government financing. Instead, it turns out Utilities have the same old obstacles and headwinds as always.

So no, it isn’t different this time, for Energy or Utilities. These sectors have the same drivers as ever. Energy still depends on oil prices. Utilities are still interest rate sensitive and still do best when people are cutting back on all but the basics, making steady demand a source of resilience. Same old normal.