The US 10-year bond yield climbed almost one quarter of a percent to 1.83% amid increasing expectations that the Fed was on the cusp of a second interest rate hike in the US this cycle and that problems arising from negative interest rates marked a low point for yields-pressured bond markets. This expectation undermined equity markets, with the MSCI World falling 2%. The Canadian Dollar weakened against its US counterpart.

Historically, the healthcare sector has been popular with growth investors, and for good reason.  Positive long-term demand trends due to an aging population, combined with significant barriers to entry underpinning the ability to raise prices combine to offer the prospect of above average earnings growth, largely independent from the economic cycle. This combination should have particular appeal in the current environment of moribund growth and weak pricing power, however the sector has been underperforming the broad market significantly. What are the issues frightening investors, and what can we expect going forward?

Two main factors are causing investors to question assumptions around the historical business model of pharmaceutical companies, particularly their ability to raise prices at will: political pressure from government, and commercial pressure from large scale drug purchasers.

The US Government is the largest payer for prescription drugs, so it has a vested interest in the trajectory of drug prices. However, elections create the potential for a change in the balance between the various competing interests. The Republican platform is largely focussed on replacing the Affordable Care Act with some alternative offering patients greater choice and reducing the burden on employers. Hilary Clinton’s goals include improving the Affordable Care Act, and improving Drug Affordability. Proposals to increase affordability include  making it easier for generic/biosimilar drugs to get to market, creating a watchdog to ‘respond’ to excessive price hikes in older drugs, and allowing Medicare to directly negotiate for drug prices. While both platforms could result in changes, the ability to pass legislation obviously depends largely on who controls Congress, so if gridlock persists, any radical overhaul is ultimately unlikely. However, due to pre-election uncertainty, it’s no surprise that investors are avoiding the sector until the outcome is known.

Additionally, there are state-level initiatives which create uncertainty in future earnings potential for the pharma sector. Most prominently, Proposition 61 in California proposes mandated best pricing for state employees/retirees. While it seems likely to pass, how drug companies will respond remains to be seen. In our view, any proposal to impose direct Medicare price controls are the most concerning for investors, although the current system has already resulted in concentrated buyers negotiating with drug companies, demanding and receiving considerable economies of scale.

This increasing pressure by drug purchasers (insurance companies and their Pharmacy Benefit Management agents) to reduce net drug prices is the second serious source of pushback to pharma earning potential, and it seems to be intensifying and affecting additional areas. For example in diabetes treatment, Novo Nordisk (a former portfolio holding) recently revealed that an inability to get sufficient pricing on its new drugs to offset negative pricing on older treatments, caused a 50% cut in its medium term growth target. In our opinion, this ongoing pressure from purchasers is a bigger fundamental concern than political headlines.

So where next? The consensus from a recent healthcare conference we attended is that the sector should perform better post-election, although the pricing environment will likely remain tougher for some time. Given that price increases more or less fall 100% to the bottom line, valuations will likely adjust downwards, and it’s not clear that this process is complete. However, while price pressure is a challenge for the industry, the inexorable increase in healthcare costs is a real longer term challenge for government finances, and any ability to reign them in without hampering innovation would be a welcome ‘big picture’ development.  In any case, change always creates opportunities, so Cidel – and investors – will be on the lookout.