Summary

• Like last month, May was overshadowed by worries over tariffs and trade barriers. The simultaneous debates surrounding the budget, drug prices as well as tariffs resulted in too much uncertainty for many healthcare investors, despite the low valuations. As a result, the healthcare sector underperformed the world index by 9 percent (in US dollar).
• The fund experienced a weak month, also in relation to the sector overall. Medium-sized companies held up somewhat better than small and large caps. The biotech sub-sector, consisting of many small research-intense companies, continued to struggle.
• The Trump administration threatens to implement measures aimed at bringing down drug prices in the US. Furthermore, sector-specific tariffs could, if proposed and implemented, cause further issues.

Monthly comment

During May, worries about tariffs continued. However, it became clear that cuts in demands for permanent tariffs were both desired and seemingly what the Trump administration was aiming for. Trump announced a 90-day break on the Chinese tariffs of 145 percent, and the 50 percent tariffs on goods from EU was halted until July 9^th. Negotiations with several counterparts were initiated during the month but it was not clear which one would come into place first. It seemed likely that deals with certain medium-sized countries would be implemented before agreements with China and the EU. An agreement between the US and the UK did, however, come into place rather quickly.

In these negotiations the US was primarily trying to achieve two things: to remove as many formal and informal trade barriers as possible, and to generate revenue from the tariffs to finance a major part of the tax reform which is currently going through Congress. The main US case for the one-sided tariffs is twofold: firstly, the US exports are subject to value-added tax, while Europe receives tax revenues which the US has no benefit of. This skews the competition between the US and Europe. Secondly, China’s very low levels of public spending on social safety nets to support their population, could be seen as a form of unfair competition (dumping). This, according to the argument, could cause US social structures to crumble in the long term.

Questions around tariffs and the budget closely linked

One estimate, with assumptions regarding future growth and interest rates, is that 200 billion dollars per year (or 2 trillion in 10 years) in tariff revenues are needed to finance the tax reform while also decreasing the budget deficit.

Whether or not Congress can, or may, take these tariffs into account in terms of the budget process in the Senate remains to be seen. The majority’s preference to treat the tax reform as “current policy” (does not require financing) rather than “current law” (does require financing when extended) means that the tariffs will probably not be allowed to be included for the reconciliation budget. Hence, continued budget negotiations seem to feature two parallel routes (officially without tariff revenues but also without demands for financing previous tax reform in 2017 and “unofficially” including these revenues). This, however, could certainly lead to some confusion for the general public, the press and perhaps for some politicians. The official responsible for maintaining the Chamber’s rules for budget reconciliation, the parliamentarian,  would have to accept the basis of this duality.

The House passed the budget

Following several attempts, the House of Representatives passed the new budget. For the healthcare sector, the new budget included both a tax reform and cuts in Medicaid. However, the cuts were smaller than feared, and hence the market gave a sigh of relief. The reform means that a large group of people will lose their insurance but, for many conservatives, the reform also has a “higher” political purpose: Medicaid, they say, is intended for particularly vulnerable groups and should not be part of a lifestyle where individuals pull back from society’s overarching system whereby all adults contribute to their livelihood to the best of their ability.

Reflections

The general sentiment for the healthcare sector is weak, especially for American companies. Reactions to negative news have been sharp while reactions to positive news have been only modest. Risk/rewards have been poor. It is not difficult to foresee further negative developments for the sector. General tariffs as well as potential sector specific tariffs, in accordance with section 232 in the 1962 Trade Expansion Act (imagine steel tariffs but on pharmaceuticals) are troublesome. In the short term we could see some rather strong reactions, specifically on companies with production outside of the US. We focus on companies with low or modest exposure and, here too, it is challenging to get a clear picture as information about production, transfer pricing and profit generation streams is limited. Many affected companies are planning, where reasonable and possible, to relocate their production to the US to produce what is being sold in the US. Hence, one company after another is announcing new or further investments in the US. To the best of our ability, we aim to make risk trade-offs with the objective of mitigating the impact of high sector-specific tariffs on the fund’s volatility.

‘MFN’ discussions enter the political scene… once again

The policy principle ’MFN’ (‘Most Favored Nation’), in other words the Trump administration’s preliminary proposal where American drug prices should reflect the lowest prices in the Western world, is complex. It is sensational from the media’s point of view, but ultimately it is, in our view, not likely to have any major impact.

Our assessment is that the US government cannot implement such a pricing strategy, at least not to a vast degree, without new legislation (meaning 60 votes in the Senate). Medicare could potentially be used as a demonstration project, for instance within a specific therapeutic area, or as a basis for the IRA negotiations which now occur once a year for products which do not face competition from (bio) generics. It is difficult to predict potential market reactions following a tough ‘MFN’ proposal from the Senate within the reconciliation budget. It would mean a lot of noise and headlines, but most probably without much impact on prices, seen as an industry average. There is of course a risk, at least a hypothetical risk, of new bipartisan legislation. However, it would be an extraordinary event and moreover it would mean abandoning the ambition to get other Western countries to increase their drug prices. It would also mean dramatic cuts in the pharmaceutical industry’s R&D budget. A growth industry, with highly qualified jobs, would suffer from a serious strategic setback which we do not believe is what the administration or Congress is after.

Politics is not just wanting, but doing

The new healthcare politics are taking shape, and although there is currently a lot of turbulence, it is not certain that the actual changes will be either major or rapid. The area of vaccination is an interesting example, where biotech company Novavax recently got a completely new Covid vaccine approved, despite US health secretary Robert F Kennedy Jr’s vaccine skepticism. New Covid vaccine recommendations were launched towards the end of May. These were not as strict as first feared. For instance, vaccine is still recommended for children – in consultation between doctors and parents/guardians. Thereby, the administration seems to have stopped state-level enforcement and recommendations of Covid vaccinations for children to be able to participate in school education. Both of these events mean that the healthcare industry is finding ways to adjust to the new environment without coming to a complete halt and starting over from scratch.

Valuations present interesting opportunities

We now have a situation where several well-known companies which we deem to be growth companies are trading at P/E 12, plus/minus a couple of multiples. The sector overall is trading at P/E 16. These levels are closing in on the levels seen after the global financial crisis in 2008-2010. We view this as an interesting opportunity to increase our exposure in some of these companies. However, if the trade agreements do not come into place during the summer, we cannot dismiss the risk of a mild recession, and we may even have to view it as probable. The healthcare sector has historically coped relatively well in such markets. In the current environment where there is a high degree of uncertainty significant risks still remain, but opportunities ought to outweigh them, in particular in the medium term.