NEW YORK, April 10 (Reuters) - U.S. utility stocks marked their strongest start to the year since 2019, benefiting from an investor retreat from riskier assets during the Iran war and strong electricity demand from firms building out artificial intelligence infrastructure.

The S&P 500 Utilities Index gained 7.5% in the first quarter, notching its strongest opening stretch since the first quarter of 2019, according to LSEG data.

The S&P 500 index fell 4.6% in the same period - its worst quarter since 2022 - dragged down by inflation worries as energy prices spiked. The index has since recovered some ground, approaching a one-month high this week after the U.S. and Iran agreed to a two-week ceasefire.

The first-quarter gains in utilities stem from their traditional role as a defensive sector, offering investors opportunities for steady dividend payouts and lower volatility during market swings.

Other so-called "bond proxies" including stocks in the S&P 500 Real Estate and the S&P 500 Consumer Staples also gained during the first quarter.

"When volatility really ramps up and there are questions about where the market is going in the short term, it's natural for investors to rotate into defensive type equities and utilities tend to be a prime recipient of along with healthcare," said Matt Stucky, chief equities portfolio manager at Northwestern Mutual.

AI DEMAND

Utility stocks benefited from increasing electricity demand from large technology companies that are building massive data centers in their drive to dominate artificial intelligence.

Electricity demand from data centers could more than quadruple by the ⁠end of the decade to consume as much as 17% of U.S. power supplies, according to research by the Electric Power Research Institute, EPRI.

"I read a few recent quarterly calls from some of the utility companies and the big drivers are the data centers and the increased electricity demand, which is crowding out other interests," said Gerry Sparrow, president at Sparrow Capital Management.

"The data center demand is coming from technology companies -- in particular Alphabet, Meta Platforms ( META ) and Oracle, with their capital budgets that include data center buildout for AI. So that's some of the stuff that's moving the market around, especially around individual utility companies."

RISK-ON TRADE

With the U.S.-Iran ceasefire now offering markets a window of relative calm, fund managers will likely begin to rotate out of defensive positioning and back into more cyclical and growth oriented names.

This might result in the utilities sector paring some of its recent gains. However, utility companies with direct exposure to the AI buildout - particularly those serving commercial customers in data center corridors in Virginia, Texas, Florida and the Midwest - are expected to retain investor interest, Sparrow said.

Those companies include American Electric, Dominion Energy ( D ), Nextera Energy ( NEE ), Xcel Energy ( XEL ) and Duke Energy ( DUK ).

"A lot of the performance is likely going to be tied to how much they're serving industrial customers versus residential customers closer to the larger cities," Sparrow said.