Solskin
The Health Care Select Sector SPDR (NYSEARCA:XLV) is an exchange-traded fund (“ETF”) performing rather well in this inflationary environment thanks to its pricing power and high margins.
The FED’s rate hikes are slowing down the economy, but the healthcare sector is traditionally one of the best sectors when the economy is in a slowdown or even in a recession.
The healthcare sector is, together with the energy sector, the only equity sector in a long-term uptrend.
We expect XLV to perform well against a backdrop of high inflation and a slowing economy. Buy!
Sector performance
The energy sector remains the best-performing equity sector. Until recently, it was the only sector with a positive 12-month return. Recently, it was joined by Utilities, Healthcare, and Consumer Staples.
Figure 1: Total return chart (Yahoo! Finance, Author)
For quite some time, Energy was also the only green sector in the LT trend column of our Trends table. Now it’s joined by Healthcare.
Figure 2: Trends (Yahoo! Finance, Author)
Both Energy and Healthcare have inflation hedging capabilities, albeit that Energy is considered to be the better inflation hedge.
On the other hand, Energy has a higher economic sensitivity. As the economy slows down, this should play more in favor of Healthcare than Energy.
We expect both sectors to perform well against a backdrop of high inflation and a slowing economy.
Slowdown and recession
Research by State Street Global Advisors shows that Healthcare is among the best-performing sectors in both a slowdown and a recession.
Figure 3: Sector Roadmap for Business Cycles (SPDR)
While other equity sectors may experience sharp declines in business activity, healthcare stocks are often more resilient to economic downturns. Many people rely on healthcare services regardless of the economic situation. They don’t stop taking their medicine when the economy slows down or enters a recession.
The Fed’s rate hikes will slow down the economy, and that should be ok for healthcare stocks. It might even lead to a recession. An inverted yield curve is often used as an indicator of an imminent recession, and the yield curve is certainly inverted now.
Figure 4: Inverted yield curve (Bloomberg)
It was economist Campbell Harvey’s dissertation at the University of Chicago (in 1986) that showed that the shape of the yield curve was linked to the path of the U.S. economy.
The same Campbell Harvey is now doubting if the inverted yield curve will cause a recession this time. He thinks that the fact the yield curve-growth relation has become so well-known and widely covered in popular media that it now impacts behavior. This awareness induces companies and consumers to take risk-mitigating actions, such as, e.g., boosting savings.
In Campbell Harvey’s own words:
“It suggests we could dodge the bullet: avoiding the hard-landing – recession – and realizing slow growth or minor negative growth. If a recession arrives, it will be mild.”
For healthcare stocks, it doesn’t matter that much: they are usually among the best-performing sectors in both a slowdown and a recession.
Figure 5: Healthcare sector and recessions (Janus Henderson)
Inflation hedge
We already told that the healthcare sector has quite some inflation-hedging capabilities. For years, uncertainty about drug pricing legislation weighed down healthcare stocks.
Last year, the Inflation Reduction Act finally removed that overhang of uncertainty. According to Janus Henderson, the legislation was largely what the market expected. The Inflation Reduction Act aims to lower healthcare costs for patients.
Beginning in 2023, drug price increases in Medicare will be limited to the rate of inflation. This implies that healthcare companies can raise their prices in line with inflation.
The sector will hence remain an inflation hedge.
XLV
The Health Care Select Sector SPDR ETF gives investor exposure to all the healthcare companies in the S&P 500 (SP500) and includes companies from the following industries:
- pharmaceuticals;
- health care equipment and supplies;
- health care providers and services;
- biotechnology;
- life sciences tools and services; and
- health care technology.
Figure 6: Top holdings (SPDR)
XLV has an expense ratio of only 0.10% and a 30-day SEC yield of 1.5%.
State Street Global Advisors gives every sector a valuation, momentum, and earnings sentiment score. There are only three sectors with no red bar: Energy, Healthcare, and Utilities.
Figure 7: Sector dashboard (SPDR)
The energy sector scores best, with three times a green score. Runner-up is Healthcare, with two green scores (for momentum and earnings sentiment). Only on valuation, Healthcare has a neutral score. This seems a fair assessment to us. Healthcare stocks are valued more or less in line with the broader market and slightly undervalued compared to their own history.
Figure 8: Healthcare valuation (Janus Henderson)
Figure 9 gives an overview of the evolution of both XLV’s short- and long-term trends over the past years.
Figure 9: Total return chart (Yahoo! Finance, Author)
Conclusion
The Inflation Reduction Act finally removed the overhang of uncertainty about drug pricing legislation for the healthcare sector and allows healthcare companies to increase prices in line with inflation. The sector will hence remain an inflation hedge.
The energy sector is also an inflation hedge, but compared to the energy sector, the healthcare sector is less sensitive to the business cycle and this comes in handy when the FED slows down the economy by rising interest rates. Both sectors are the only equity sectors in a clear long-term uptrend.
The Health Care Select Sector SPDR ETF offers investors access to a sector with both defensive and growth characteristics. Given the sector’s pricing power and high margins, the valuation remains attractive.
The healthcare sector joins the energy sector on our list of favorite sectors that we expect to perform well against a backdrop of high inflation and a slowing economy. Buy XLV.
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