Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Is it time to reduce exposure to health care?
Peter Garnry
Chief Investment Strategist
Summary: In today's equity update we take a deeper look at the health care sector as it has done very well in this low interest environment and recent economic slowdown. We show that the health care sector is not created equal during the contraction and recovery phase which means that investors should be rotating within the health care sector during the next business cycle phase transition. We also highlight the clear sign of a "Warren factor" that potentially has big impact on the sector as the US election approaches in 2020.
Everyday is a new high in global equities as central banks easing and hopes of a US-China trade deal have created a very strong narrative that nobody wants to sell short. But the strong momentum rally sets the equity market up for a potential powerful decline should reality turn out to be that of an even weaker economy with signs of spill over effects into the broader labour market. The next two months are crucial in the assessment of the “soft patch” scenario that equities are basing their price action on.
The global economy according to OECD’s global leading indicators (CLI) the economy is growing below trend growth and slowing down which is what we define as the contraction phase. Historically this phase is not good for equities vs bonds and we also observe across most industries that they underperform relative to the risk-free rate. One of the industries that tend do reasonably well on a relative basis is the Pharmaceuticals, Biotech & Life Sciences industry. Given the rising macro uncertainty we have a lot of clients asking for our view on the general health care sector so in today’s equity update we will provide our view on the sector.
As our business cycle map shows the health care sector consists of two industries; 1) Healthcare Equipment & Services and 2) Pharmaceuticals, Biotech & Life Sciences. They are both defined as defensive industries as they exhibit lower volatility than the general market and provide excellent risk-adjusted returns during the critical Slowdown phase. According to our business cycle map the Pharmaceuticals, Biotech & Life Sciences sector is worth having exposure to in the current business cycle phase but investors have to be prepared to reduce exposure when the economy swings into the Recovery phase where other industries such as Semiconductors, Real Estate and Consumer Durables & Apparel are more high beta plays. One key observation is that the Healthcare Equipment & Services industry tends to do well in the Recovery phase so investors should do a rotation within the health care sector during the phase transition.
One thing is history and while it often rhymes it does not predict the future with any high accuracy. The upcoming US election in 2020 has the potential to be a significant factor for explaining health care returns. The chart below shows the relative performance between the S&P 500 Health Care Index and the S&P 500 Index since mid-April and the PredictIt’s probability of Elizabeth Warren becoming the Democratic presidential nominee. During the month of May when US equities lost 7% the health care sector outperformed the market delivering the promised downside hedge. At this point Elizabeth Warren was a distant possibility in the political race. As her momentum accelerated into early October the “Warren factor” became more and more dominant dragging down health care relative performance. Likewise, the reversal of her probability for being nominated has seen health care stocks surge relative to US equities in general. The key message is that Elizabeth Warren should be on the radar of investors with exposure to health care. It might be that Trump will surpass Warren on changing the health care system, but for now the Warren factor matters to health care stocks.
Another factor to consider if one’s investment horizon spans multiple years is the valuation of health care stocks reaching its highest level since late 2001 and is now flirting with dot-com valuation levels. As we have talked about in multiple equity updates there seem to be a substitution effects from bonds into safe stocks with robust cash flows as rates decline. If US rates go even further from here, it’s plausible that health care sector valuation could reach the dot-com levels. But remember that valuation has a good historical track record of predicting future returns in the sense that the higher the valuation starting point of an investment the lower the future expected return is.
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