Health Care
The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.
The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.
While high-beta equity areas have rebounded smartly in recent trading sessions, we remain skeptical that earnings-follow through will be forthcoming. Instead, our portfolio remains defensively-geared, where profit support is strongest. For instance, the latest manufacturing data showed that pharmaceutical shipments continue to boom, underscoring that top-line momentum has started on a strong foot in the first quarter. That bodes well for pharmaceutical relative performance. Elsewhere, beverage shipments have also soared on a growth rate basis, sending a similar upbeat message for the S&P soft drink index. Importantly, pricing power remains solid in both industries, underscoring that the surge in manufacturer shipments likely remains demand-driven. We reiterate our overweight position in both indexes.
Against a backdrop of defensive sector outperformance, our bearish call on the S&P managed care index has reduced odds of playing out. Our thesis was that when overall health care spending is accelerating, as is currently the case, health care services providers win out over the industries that bear the cost of these services. However, if the economy cools, as we expect, then upward cost pressure will be slow to materialize. Our managed care cost proxy, a composite of hospital, drug price and labor cost inflation, alongside several other medical expenses. Cost inflation is easing, despite the surge in prescription drug prices. If upward momentum in the latter cannot substantially raise managed care costs, then there should be little upside risk if drug inflation cools. Meanwhile, consumer spending on health insurance continues to outpace overall spending by a large margin, which is facilitating decent increases in premiums, as gauged by the employment cost index for health care insurance. The implication is that the group is more likely to move laterally than down, despite rising overall health care spending, and we are lifting our underweight position to neutral. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: UNH, AET, CI, ANTM, HUM.
Our cautious outlook on corporate profits amid ongoing deflation pressures is reason enough to favor non-cyclical equity sectors. But the surprise Bank of Japan move to introduce negative deposit rates adds yet another catalyst for defensive and fixed-income proxies. On the margin, capital is likely to seek out high yielding government bond markets. The U.S. still has comparatively juicy yields compared with other developed countries. In fact, a growing swath of the euro area bond market has negative yields. In addition, the U.S. has a strong currency. That could create a self-reinforcing feedback loop, as the exchange rate will sustain imported deflationary pressures over and above the additional pressure on China and the rest of Asia if the yen weakens. When the ECB announced negative deposit rates in the spring of 2014, the U.S. dollar immediately vaulted higher and Treasury yields declined for the rest of the year (see the vertical line). At the same time, long duration sectors such as health care accelerated, while utilities and REITs caught a bid. We expect these sub-surface equity trends to repeat, and broaden, as telecom services should now fit into the mix, because unlike 2014, overall corporate profits are falling and financial conditions are much more restrictive. The implication is that a defensive portfolio structure remains appropriate.
Economic disappointment represents a serious obstacle for stocks. Stay with non-cyclical plays, including telecom services and health care. Upgrade the managed care group, and stay clear of banks, regardless of cheap valuations.
The oversold bounce is not supported by policy or profits, and should be treated as countertrend. Lift machinery to neutral and differentiate between pharmaceuticals and the unwinding of the biotech mania.
The previous Insight showed that S&P pharmaceutical index outperformance is well supported by both endogenous and exogenous forces. The same is not true for the riskier biotech space. As discussed in previous research, biotech stocks have exhibited all of the characteristics of a mania. Now the forces that propelled the group higher are working in reverse. Speculation is rapidly being reined in, warning that the flows into biotech stocks are drying up. Margin debt has crested, reinforcing that the high-octane fuel to support momentum stocks is starting to evaporate. Biotech IPOs are going from feast to famine: if share prices continue to fall, expected returns will follow suit, warning against expecting further capital inflows. Consequently, we expect biotech stocks to remain on the mania track, which has not entered the bubble-bursting phase (top panel).
Pharmaceutical stocks have broken from their correlation with biotech stocks, and we expected this divergence to be sustained. Pharmaceutical profits remain one of the few bright spots within the corporate sector. Drug demand continues to boom, as measured by consumer spending data. Inventories have moved higher at both the wholesale and manufacturing level, but this appears to reflect demand-driven stocking of product, given ongoing strong pricing power gains. In a deflationary world, the ability to significantly lift selling prices warrants a premium valuation. Yet the S&P pharmaceuticals index still trades at a large discount to its historic average relative valuation. If domestic economic disappointment mounts, as we expect, it will provide another catalyst for a relative performance re-rating. Stay overweight the S&P pharmaceuticals index. Importantly, it will be important to differentiate pharma from biotech, please see the next Insight.