• Equity markets had a positive reaction to the announcement regarding tariffs. The White House’s news regarding international drug pricing (MFN) at the end of the month however weighed on the healthcare sector.
• Despite improved clarity around trade, the fund had a weak month, primarily due to the announcement regarding MFN. The details of this have not yet been presented in full.
• Biotechnology was the only subsector that contributed positively to fund’s performance during July. The month’s result came in below expectations and we are not satisfied with the outcome.
• MFN, higher costs and budget cuts continue to create uncertainty in the sector.

Monthly comment

The month began with a slight uptick in risk appetite, supported by market-friendly developments in trade talks between the US, the EU, and Japan. These developments were reflected in positive sentiment toward the healthcare sector. However, healthcare closed the month on a weak note, largely due to President Trump’s proposed reforms to tie US drug prices to international benchmarks, with a particular focus on the Medicaid segment (healthcare for low-income individuals). Despite a generally strong earnings season, healthcare stocks were broadly sold off following Trump’s announcement. The market awaits further clarity on the specifics of the administration’s proposals. Additionally, the Federal Reserve decided against a rate cut, disappointing some investors.

Tariffs remained in focus

After prolonged negotiations, the US reached agreements with both the EU and Japan to impose 15 percent tariffs on select goods and services, including pharmaceuticals, due largely to promised investments in the US. The White House indicated that further measures targeting the global pharmaceutical sector could follow in line with its ambition to repatriate manufacturing and revenue. The EU perceived the agreement as setting a 15 percent cap for general tariffs and sector tariffs combined. The outcome was generally viewed as ‘better than feared’, especially given the one to two-year grace period for pharmaceutical companies to adjust operations. Many large-cap firms reiterated their commitment to expanding or relocating production to the US.

Healthcare sector reacted with sharp swings

The healthcare sector saw sharp swings in response to surprises to earnings, highlighting the continued absence of generalist investors in the space. Most major companies delivered solid earnings, with key products exceeding sales expectations, and resulting in multiple upward revisions to both revenue and earnings guidance. Encouragingly, several large-cap pharmaceutical firms signaled increased optimism through higher R&D investments, also benefiting service providers such as clinical trial and medical device companies. However, health insurers remained under pressure from ongoing congressional budget cuts and regulatory uncertainty, with markets still cautious about the clarity of their future earnings potential.

A volatile end to July

On the final day of the month, the White House announced their demands regarding the “Most Favored Nation” (MFN) pricing model. Seventeen major pharmaceutical companies were issued with a list of demands with a 60-day response window. The proposals included: 1) Applying international reference pricing to Medicaid, which accounts for around 17 percent of US pharmaceutical revenue. 2) Mandating international price levels for all new drugs across all distribution channels. 3) Establishing a new business model enabling direct-to-consumer distribution and thus potentially by-passing insurers and employers. 4) Proposing that all excess revenues must be returned to the US through an agreement with the government, should companies raise prices in other countries to offset lower US prices.

Markets reacted sharply, with healthcare equities declining over 2 percent in the final trading hours, led by pharmaceutical and insurance stocks. Nevertheless, the measures were seen as manageable, as they primarily targeted Medicaid, where prices are already the lowest in the US. A reduction to European levels would only imply an average cut of roughly 20 percent. However, forcing European-level pricing across the board might risk limiting drug access in lower-income countries. While reactions will likely be reassessed in coming weeks, companies with substantial Medicaid exposure saw sharp initial declines.

Reflections

July was a weak month for the healthcare sector in general and for the fund in particular. Most of the negative impact occurred in the final hours of the month following Trump’s announcement about the international reference pricing program, MFN. In addition to MFN, the fund’s holdings in Align and US health insurance companies collectively had a negative impact on the fund in total of around three percent.

MFN is a drug-pricing strategy which has been discussed for a long time in the US. Trump campaigned on this issue, and it has been anticipated since he took office. It has now been communicated, which, in our view, is actually quite positive! The high level of uncertainty about what was to come has weighed on the sentiment for the sector all year and, additionally, the proposed program was not as far reaching as expected. However, the market was caught off guard when it happened at the end of a weak month and, in fact, so far, a weak year, and when sentiment was at its lowest for the healthcare sector.

What MFN could mean for the sector

We view the following areas as positive regarding the various sub-proposals. They apply in the near term and mainly to Medicaid, which affects drugs paid for by the American healthcare program for those with the lowest incomes. Medicaid accounts for less than 10 percent of the global pharmaceutical market and is already characterized by the lowest prices in the US which, on average, are not much more expensive than prices in Europe, estimated at 20 percent on average.

The pharmaceutical industry should have the ability to accept further discounts for this market segment. Also, the sub-proposal to switch to MFN for new drugs for the entire US market can also likely be accepted by the industry, if the details are not overly negative. What is likely to happen is that drugs will become more expensive in other developed countries giving the industry lower sales volumes, but the higher price should largely compensate for this. Countries with low prices today would be particularly impacted by restricted availability as today’s price levels are often (but not always) a result of weaker purchasing power due to lower GDP per capita. The third sub-proposal is to introduce a new type of pricing scheme for the entire US pharmaceutical market, outside the insurance market, where the patient pays directly to the pharmaceutical industry. This would be of great interest for those who are uninsured, and for those products that have a ‘consumer’ character. The pricing would be based on MFN (i.e. the new prices for Medicaid) for all drugs, new and old. We believe this should also be acceptable to the industry. It is unlikely that this would lead to a large number of people opting to become uninsured. The GLP-1 market could certainly gain a new market segment. The long-term effects of having two different price levels for the insured and uninsured may be difficult to predict. The fourth sub-proposal on the recovery of profits due to possible higher prices abroad is difficult to comment on at this stage, it cannot without a more detailed proposal.

A paradoxical situation

The fact that the reporting season has developed better than expected feels like a paradox (given the fund’s development). Nevertheless, there is uncertainty about future drug pricing and there are health insurance companies that will both experience higher costs due to high degree of healthcare utilization along with upcoming revenue losses due to the new US budget. The uncertainty is now well documented, and valuations (P/E around 16.5 on forward-looking earnings) are now at the same low level as in 2016, when Donald Trump, Hillary Clinton, and Bernie Sanders competed with radical proposals to cut pharmaceutical costs. As we know, almost nothing happened following those “threats”, and the sector subsequently performed strongly. This time, conditions should slowly change and possibly for the better we believe, particularly considering that access to drugs is now expanding in the US. We are now most focused on finding out how the details will pan out.

To summarize, this month’s results are below our expectations, and we are not satisfied with the outcome. However, the reports in July have generally come in above. We believe that the market is somewhat exaggerating the potential effects of tariffs, MFN, and budget cuts, all of which can be managed without too much impact on the results for most of the sector’s companies. The tariffs are to large extent temporary, until production is relocated to the USA. The proposal for international reference pricing is significantly better than feared and will have relatively limited impact on the companies’ results, as it appears from Trump’s letter. The budget cuts mostly impact insurance companies and hospitals with a large proportion of Medicaid patients. Therefore, our long-term strategy remains intact, despite the current high level of uncertainty. Our assessment is that we have passed the peak of uncertainty from this year’s political maneuvers and that the fundamental business conditions for our sector should become increasingly clear.