How Investors View the Healthcare Sector

by Helen O’Donnell

The first quarter of 2018 is off to a dramatic start, as the stock market’s sharp gains in January were handed back in a hurry in February and any investor who wished that volatility would return to the market saw that wish granted. With the dip the week of Feb. 5, the market formally entered a correction phase, as it marked a 10% decline from its former peak. That decline didn’t last very long, however, as the market began to recover by Feb. 9. But after a couple of weeks of gains, the selloff began again. 

So what are the issues investors are weighing and how will they affect the healthcare sector? Here are a few of the items high on the list:

Higher interest rates – the yield on the 10-year Treasury traded as high as 2.94% in late February before easing slightly, up from 2.41% at year-end 2017. The move reflects data that the economy is improving, as well as the reality that the federal government deficit will approach $1 trillion this year due to tax cuts and new spending. 

Meanwhile, new Federal Reserve Chairman Jerome Powell in his first testimony to Congress suggested that the economic outlook remains strong and that further gradual increases in the federal funds would be likely. The expectation of additional rate increases this year is prompting investors to ask more questions about debt exposure, particularly around issuers’ exposure to floating rate debt vs. fixed rate.

Labor market tightening – The January jobs report from the U.S. Labor Department was released on Feb. 2 and showed healthy employment. While the unemployment rate remained at 4.1% for the fourth month in a row, wages grew 2.9% vs. January 2017. This was the strongest gain since June 2009, and investors weigh whether this figure marks the beginning of a period of higher wage gains, which in turn, could pressure margins unless the employer has pricing power or productivity gains to offset such increases. However, the February report released on March 9 provided some comfort, as it showed strong job gains – 313,000 jobs added – but the jobless rate remained at 4.1%, reflecting more entrants into the job market, and wage growth moderated vs. January’s gains. February’s average hourly earnings grew 2.6% on an annualized basis.

A Federal Budget agreement – A last-minute agreement allowed the President to sign into law a proposal that prevented another government shutdown and allocated new spending to defense and certain domestic programs. 

Among the healthcare programs that will see some of this domestic spending are initiatives to fight the opioid crisis and address mental health. $4 billion is allocated over two years to improve veterans’ hospitals and clinics; $2 billion over two years for the National Institutes of Health and changing the reauthorization of the Children’s Health Insurance program to 10 years from six. The package also has a two-year delay to payment cuts to Medicaid Disproportionate Shares Hospital payments, which was welcomed by the industry. 

Lower tax rates – The new tax bill was a clear positive to investors this year as it should lower tax rates for most for-profit businesses, particularly those that are primarily focused on the United States. For the healthcare industry, however, there may be some offset to this benefit as the bill also eliminated the individual mandate from the ACA, so there will be no penalty for not enrolling in healthcare coverage.

The potential for more M&A – The tax bill also gave multinational companies an incentive to repatriate overseas cash at more favorable tax rates. For some companies, particularly the larger pharmaceutical companies, investors expect that this cash windfall may be used for acquisitions, either for other pharmaceutical companies or for biotech companies. In 2017, approximately $200 billion in life sciences deals were announced, with the largest transaction accounting for $30 billion. During the first week of 2018, transactions totaling $11 billion were announced.

Healthcare spending outlook and investors’ views

On Valentine’s Day, CMS Office of the Actuary released its 2017-26 projections for national health expenditures. The office estimates that national healthcare spending will average 5.5% growth annually during this period, an acceleration after more moderate estimated 4.6% growth in 2017 and 4.3% growth in 2016. For 2018, spending is expected to grow by 5.3% driven partly by higher prescription drug prices. For the 2017-26 period, spending is again expected to outpace GDP growth, which means that healthcare is expected to rise to 19.6% of GDP by 2026 from 17.9% in 2016.

Part of the accelerated spending reflects demographics – more Baby Boomers will age into the Medicare program, which is expected to grow at an average of 7.4%. By 2026, individuals age 65 and older are expected to account for 18.8% of the total U.S. population, up from an estimated 15.5% in 2018. Medicaid spending is expected to increase an average of 5.8% per year, also influenced by a rising number of aged and disabled enrollees. Meanwhile, private health insurance spending is expected to average 4.7% due to low enrollment growth and downward pressure on utilization. The latter reflects slower growth in income and wider use of high deductible health plans. 

Over the 2017-26 period, hospital spending is expected to increase from $1.13 trillion to $1.85 trillion, with acceleration from an estimated 4.6% increase in 2017 to 5.1% in 2018 and 5.6% in 2019. 

For investors, the healthcare industry’s secular growth rate is appealing, but the profitability outlook isn’t as clear. During 2017, a key question for investors was the sluggish pace of commercial patient utilization, a trend that resulted in generally softer than expected hospital admissions and a less favorable payor mix. This trend was generally attributed to consumers delaying discretionary procedures because of high costs, and some disruption in the usual seasonal pattern by storms and severe weather in many parts of the country in the last few months of the year. However, some analysts also noted that the industry could be experiencing a softer spell after a couple of strong years boosted by new coverage under the ACA. 

The widespread severe flu season this year is expected to drive higher healthcare utilization in early 2018, but the broader question remains of how and where consumers will receive healthcare in the future and how will they pay for it. In a move that echoes how some companies used to manage employee health, Apple is expected to launch primary care clinics for its employees this spring. The new clinics, called AC Wellness, will “offer a unique concierge-like healthcare experience for employees and their dependents,” according to the website, www.acwellness.com. While still in the early stages, the clinics hope to integrate “best clinical practices and technology in a manner that drives patient engagement.” While the Apple experiment is expected to initially involve just a couple of California markets, investors are looking to see how healthcare delivery evolves and whether steps by large employers will slow the growth rate of healthcare spending and result in some dislocation of services.

Helen O’Donnell
Managing Director
Solebury Trout

hodonnell@soleburyjr.com

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