• July was characterized by rotation and reversal with energy stocks being the clear winners. Healthcare as a sector appreciated slightly, driven by larger companies as small cap names detracted.
• The fund had a negative month, mainly driven by small cap holdings. The services sub-sector was the best performer.
• Healthcare companies have delivered solid Q2 earnings with potential to outperform broader markets heading into midterm elections.

Portfoli Manager, Amennai Beyen

Monthly comment

The stock market (MSCI World Index) continued to broaden out and appreciated by 0.7 percent in July. It was also characterized by frequently shifting market narratives, driving rotation from growth to value and a general reversal from winners to lagging sectors.

Energy stocks were the month’s clear best performers, seeing a strong rebound from the previous month as alternative oil routes gained traction, primarily through Port of Yanbu on Saudi’s Red Sea coast with potential to reduce the importance of the Hormuz Strait.

Tech was the worst performing sector of the month, mostly driven by a rotation out from semiconductors. Healthcare landed in the middle of the pack, slightly increasing during the month. Here, performance was largely driven by large cap companies which aligned well with the companies having announced Q2 financial results.

Strong earnings season so far

At the end of July, 307 of the S&P 500 companies (66 percent of market cap) had reported earnings. It had been a strong showing thus far, with 54 percent of companies’ full-year earnings outlook surpassing consensus estimates and notably, non-tech companies lead the earnings beats.^[1]

Similar encouraging results were seen for healthcare, where companies either reiterated or raised full-year guidance. Although market reactions were net positive, we observed profit taking in some popular names, reflecting higher market expectations given the strong June performance for healthcare.

In addition, price actions at reporting tended to move more with macro sentiment at the given day rather than fundamentals, making immediate interpretations somewhat difficult. Importantly, most healthcare small cap names are yet to release earnings, and their stock performances have taken a back seat in favour of large caps. This was most prominent for biotech stocks which fell back after an extended period of outperformance.

Fed’s direction remains unclear

In late July, the Federal Reserve kept rates unchanged as expected during the month’s meeting, albeit three members calling for a quarter-point increase. Fed Chair Kevin Warsh’s follow-up commentary left markets more uncertain as he vowed to steer inflation to 2 percent without providing clarity on the path towards it.

Coupled with the perceived lack of near-term solutions to the conflict in Iran, inflation concerns continued to drive long-term treasury yields higher. This also contributed to biotech’s stark underperformance last days of July.

Reflections

Second quarter earnings tend to be quite speculative for healthcare names as investors try to gauge full-year trajectories for ongoing launches. For companies having reported earnings, we feel reassured of strong momentum in key products, aligning well with our own feedback from key external stakeholders (physicians, payors and patient organizations). Strong reports have however not immediately been met by increase in share prices but rather slightly delayed reactions, reflecting the larger rotations at play during July. The increased expectations after a strong June showing were logical. Although they may have contributed in some profit taking in healthcare, we saw strong fundamental support for a long-term growth outlook for most larger companies.

M&A appetite did not seem to lessen based on management commentary, indicating it can indeed be a record year for deal making. AstraZeneca’s/Ionis’ negative trial reminded many of the inherent risks even in late-stage programs but also highlights the need for continuous external bolstering of pipelines.

Most of the fund’s holdings are yet to report heading into August, namely the small cap growth-oriented names dominated by biotech. It will be interesting to see how strong reports are met and if markets will again favour growth over value. A paucity in biotech performance was perhaps no big surprise. For instance, the biotech-focused ETF XBI had been up every month of the year heading into July which is unprecedented.

Where does healthcare go from here?

Although the historically large valuation gap in relation to broader market has largely closed (apart from medtech), the sector is by no means overbought. Despite the strong recent run, healthcare has still returned below average returns versus other sectors year-to-date. The improved earnings power seen from this year’s earnings reports suggests there is room for relative outperformance in the second half of the year. On the political front, sporadic healthcare related headlines will catch market’s attention, such as the recent proposal to impose 200 percent tariffs on generics. We see little-to-no political support or likelihood for this to materialize. Rather, companies indicate political clarity is steadily improving. The upcoming midterm elections should provide further momentum to healthcare stocks, if historical patterns are repeated.^[2]

Medtech has been the lagging sub-sector so far, but early signs point to a rebound from current 15-year low valuations. For the services sub-sector, we see attractive pockets of opportunity, for instance in life science tools and among health insurers. For these reasons we are inclined to maintain a relatively balanced exposure across our sub-sectors, each offering potential for idiosyncratic upside.

The war in Iran continues to be the biggest relevant macro factor given its potential impact on inflation. Fed chair Warsh’s unclear stance on curbing inflation is best described as a wait-and-see approach pending more data input. Although the market is unlikely to welcome this uncertainty on future rates, we believe the sector offers opportunities both extreme outcomes – more defensive names should provide a cushion should rates come up steeply and inversely, lowered rates would boost our capital-intensive growth companies.

Ultimately, we believe healthcare’s long-term trajectory will continue upward, driven by greater earnings visibility across all sub-sectors.

^[1] FactSet, data per end of July

^[2] Bloomberg, Rhenman & Partners calculations based on S&P 500 GICS Healthcare index