The unlikely stocks that became a hot bet on AI

The climb in shares of power companies is in part a rebound from a bleak 2023. But their move upward also reflects the growing belief that the U.S. economy can power through higher interest rates and turn the hype around artificial intelligence into reality.

Data in recent weeks has shown job growth cooling and inflation resuming its gradual slowdown, without any alarming deterioration in economic conditions. That has turned power generators, which are set to supply a wave of increasingly energy-hungry data centers needed for AI, into a bank-shot bet on the projected tech boom.

The S&P 500’s typically staid utility sector has advanced 18% over the past three months, while the second-place energy industry has climbed 11%. Of the index’s top five performers this year, three are power producers. Texas-based Vistra’s 138% surge in 2024 has made Nvidia’s much-celebrated 91% increase look pedestrian.

Few if any investors think power stocks, prized for their steady dividends, are en route to the high price/earnings multiples commanded by the chip makers and large tech companies vying to dominate AI. On Wall Street, though, a growing cohort feels the sector will ride higher as new data centers drive what many analysts believe will be the first sizable growth in U.S. electricity demand in a generation.

“That’s where the puck is going," said John Bartlett, president of Reaves Asset Management.

A longtime utility investor, Bartlett now trains much of his focus on the development plans of cloud-computing giants funneling billions into AI, including Alphabet, Amazon.com and Microsoft.

“Those are the people that you really need to pay attention to on what’s going on with the demand for electricity," he added.

Data centers could account for 10.9% of U.S. electricity demand by 2030, according to Citi analysts, up from 4.5% today. If power needs grow as much as many anticipate, it will also mean more plants, transmission lines and other infrastructure—and more returns for the companies that build them.

Utility stocks’ rise marks a U-turn from last year, when the Federal Reserve’s interest-rate hikes created a world awash with tempting high-yield investments. The shift turned basically risk-free Treasurys into cash machines, drawing investors away from utilities and their solid dividends.

That dynamic hasn’t relented this year; investors still take home less income from utility dividends than government debt. Even so, more traders have flocked to the sector after tech analysts and power providers put out a slew of projections of ballooning electricity demand in the years ahead. It has turned power companies, which are usually seen as defensive stocks, into a surprising bet on growth.

The rally began early this year with independent power producers that sell electricity into wholesale markets and has since expanded to regulated utilities.

Analysts warn that companies with less exposure to data centers and businesses that manufacture equipment for the grid may lag behind. There is also the possibility that the U.S. economy slows or AI hype dissipates before utilities—a rare sector where investors often applaud capital expenditures—can get into build mode.

“Nothing in the world of electric power is a sprint," said Pavel Molchanov, a Raymond James analyst.

The longer-term threat to investors: Higher electricity prices or dirtier power generation could push regulators to clamp down.

In states including Georgia, utilities’ plans to build new fossil-fuel-burning power plants have drawn the ire of consumer groups and climate advocates. If growth projections for power demand don’t materialize, critics warn that ratepayers would be stuck with higher costs for decades.

“The risk is always that this build-out is very inflationary," said Jim Lydotes, deputy chief investment officer of equities at Newton Investment Management. “It’s going to have to come on the backs of consumer bills."

That tension between ratepayer concerns and shareholder returns could grow as more utilities propose construction. Regulators might effectively cap utility returns, hurting the investment appeal of companies that will likely have to issue stock to finance projects.

“The utilities are going to have to self-fund this growth," Lydotes said. “The regulators have to keep returns acceptable."

Write to David Uberti at david.uberti@wsj.com