3 in 3: Swinging at Utilities, Banks Dodge DC Curveballs, Scouting AI’s All-Stars

Baseball playoffs are here, but the fattest pitch in the market right now could be regulated utilities. If you're worried about Washington throwing the bank some curveballs, don't be. And with Earnings Season on deck, we're about to get signals about who's really leading when it comes to AI adoption. 

I'm Jim Lydotes, and these are our three points in three minutes. So let's flip over the timer and let's go. 

Q3 earnings season starts up next week against a backdrop of building inflationary pressures. But one sector we think is setting up incredibly well is US utilities. 

This sector is often seen as sort of a proxy for the bond market. So it's taken a big hit lately from rising treasury yields. In fact, utility stocks have lagged the SP 500 by more than 30 percentage points since the end of March. There's also a concern that utilities could get squeezed if data center demand leads to higher power bills. 

But here's the key point. Utility returns are ultimately set by state regulators. If a utility serves both Connecticut and Massachusetts, and Connecticut, as an example, pushes allowed returns too low, that company can simply prioritize more of its investment spending over the border in Massachusetts, where the regulatory environment is a lot more attractive. And as borrowing costs rise, these businesses are able to recover that expense through regulation over time. 

So we're not calling for the top in bond yields. what we are saying is that some of the most defensive businesses on the planet with growing earnings that should only increase with AI spend just got a whole lot cheaper. And that's a fat pitch, and we've been adding to the group in our value strategies.

Our financials team was just down in DC to take a closer look at banks heading into the midterm elections. And if Congress changes hands, could that raise the risk of unfavorable policies? We think the answer to that is not really. 

So, first, regulators are presidential appointees. So they'll stay in place for now. Second, there's little appetite among Democrats to revive the debate on capping credit card rates, because a cap would ultimately cut off credit for the very borrowers that it's meant to help. And third, capital reform is getting more predictable. Just last week, the Fed finalized its overhaul of the bank stress test process, and a global framework for bank supervision is nearing the finish line. So things are getting a whole lot more predictable in bank land, and markets love that predictability. 

Banks rallied hard through the summer, but have given back about 10 to 12% of that performance since mid-August. That sell-off isn't about Washington. From everything we're seeing and hearing in DC, the policy setup remains supportive, regardless of what happens in November. And finally, we can't leave without talking about artificial intelligence. Back in May, I shared work from our quantitative team that showed that the market wasn't differentiating between companies using AI well and those that weren't. 

Our team developed a proprietary factor that indicates how well a company is leading AI adoption. They found that insurance companies getting more out of AI weren't being rewarded. The same was true in retail, many other industries. So this is all starting to change. Over the last four to five months, our proprietary signal is beginning to line up with individual stock performance, with the leaders in AI adoption generally outperforming their peers since about May. So when you hear about the market broadening out, that's not just about sectors outside of tech. It's also happening within sectors where the market assigns greater value to companies putting AI to work. And it's why this earnings season, we'll be listening closely for signals that AI is showing up in our company's results. 

That's our three points in three minutes with a little sand left in the bottle. Have a great week and we'll see you back here next time. 

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