Healthcare Remains Steady As Market Approaches A Key Level

A Resurgent Market

After reaching its lows in mid-June the stock market has stabilized and is rapidly regaining lost ground. It is showing underlying strength in overcoming adverse news. Earnings season has been robust, though second-half estimates are coming down. The market rally appears to have already factored in a slackening of earnings growth in the second half. The near-term market expectation is for an end to a larger chunk of 75 basis point rate increases by the FED as early as at its next meeting in September, shifting lower to a 50-basis point increase, and then stop raising rates by end of the year. At that point, the Fed Funds rate will be in the 3.5% region. The market is looking out into the next year, when it expects the Federal Reserve (FED) to conclude or enter into a long pause mode of its tightening cycle, allowing growth to resume. While the expectation appears reasonable, it is based on a few data points and the Fed will likely need to see a consistent and sharp decline over multiple inflation reports to shift its stance materially.

A Conflicting Market Situation

A key question is are we witnessing the start of a new bull market or a short-term rally within an overarching bear market?

If indeed the bear market lives, then the tenor of the market does not change and the rally will encounter tough resistance likely at the 200-day moving average level, an area of significant importance in technical analysis. If it is the start of a new bull market then it has to be assumed that an economic recession will not materialize and we will witness a decelerating pace of interest rate hikes.

The twin issues of inflation and growth present a conundrum for the market. Commodity prices began a meltdown in June at the time when fears of an upcoming recession spiked. If the US economic growth is looking safe, then there will be upward pressure on the commodities once again, which can keep inflation high and prolong the rate hike cycle. The safe economic growth should push the 10-year yields higher, to reflect growth and inflation, and yields should not decline to reflect a potential recession. Inflation in other major economies like the Eurozone, Canada, and the UK, has surged as well to 8% to 10% and rising. But these economies, particularly the Eurozone, are facing pronounced growth challenges as well. For many, a recession is a higher probability than for the US where unemployment is at historic lows. China’s economic growth has faltered as well. The lower growth outside the US contributes to improving the inflation situation as it reduces demand from major economic blocs, thus reducing commodity inflation.

Healthcare Remains Steady and Biotechs find a Bottom

Healthcare has been a relative outperformer as its decline has been less than the broader market indexes. The sector has been consolidating for the past four weeks. The second quarter earnings season has been strong with many groups like pharmaceuticals, managed care, medical devices, and services, reporting strong growth.

What has been notable is the bottoming of the biotechs, which coincided with the peak in the 10-year yield and has allowed the beaten-down industry group to surge over the past few weeks. The yield has stopped declining for now and biotechs may likely consolidate. The M&A activity surged as well over the past month, boosting the biotech group, as Amgen (AMGN) acquired ChemoCentryx (CCXI) and Pfizer (PFE) acquired Global Blood Therapeutics (GBT).

Conclusion

It is unclear whether we have a new bull market or just a bear market rally. It is also unclear how quickly inflation will decline and what the FED perceives to be an acceptable level of inflation and the slope or trajectory of the decline for it to stop raising rates. The stock market can rise even with rising rates. But a new bull market will likely not begin if an economy is heading towards a recession.

Considering these looming uncertainties, it will be prudent for now to prefer companies that can withstand an economic slowdown relatively better and have more durable earnings growth. In the case of biotechs, companies with promising data readouts and revenue franchises should be preferred over more early-stage ones. In the Prudent Healthcare model portfolio, we have exposure to larger companies like Eli Lilly (LLY), AbbVie (ABBV), Bristol Myers (BMY), McKesson (MCK), and Lantheus (LNTH), due to their more durable growth even if the economic activity shifts lower.