Healthcare gets a shot in the arm

Over the past two years, healthcare stocks underperformed relative to the broader market, despite catalysts such as innovation and progress in weight-loss drugs. This year, the majority of the performance of international equities has been driven by the mega-caps and AI companies. At the same time, healthcare stocks have lagged, mostly due to potential US policy effects on the growth rates for biopharma, healthcare plans, and medical technology firms.

But the tide could be turning. Recently, there has been some clarity on healthcare policies, increased M&A activity, as well as interest from investors who are rotating back into defensive growth and quality earnings due to the volatile macro environment.

One recent example of clarity on policy is Pfizer. Pfizer recently announced a wide-ranging deal with the US government. This resulted in its share price rallying 6.14% on the day of the announcement. The agreement secures tariff exemptions, boosts US government collaboration, and will enhance direct-to-consumer sales.

Furthermore, healthcare companies have been reporting solid results during the latest US earnings season. The Q3 earnings season shows that over 80% of reported healthcare companies have surprised to the upside, and price reactions post earnings are also positive. Looking ahead, the long-term structural growth drivers, including ageing populations, chronic disease management, med-tech adoption, and digital health, remain intact, supporting the structural growth story. 

It has been well noted that equities, more generally, are richly priced, but relative to other sectors, health could be considered a ‘value’ option. The global healthcare sector is trading at around 17 to 18 times forward earnings. This is around its 10-year average, and below the broader market. Healthcare is one of the few sectors that stands out as not being well above its long-term averages in the current market.

Recent developments point to a turnaround for healthcare

Firstly, there has been renewed clarity on US drug pricing policy following the Pfizer–Trump administration agreement, which included exchanging Medicaid cost cuts for tariff relief. This single move has lowered market fears of sweeping “most-favoured-nation” (MFN) mandates that would have pressured pricing across the sector. Investors view this as a framework that could be extended to other large pharma players on favourable terms, and this has improved the policy outlook for the sector. It wasn’t just Pfizer that rallied; Merck, and Johnson & Johnson also experienced price rises after the announcement due to improved sentiment toward the sector.

In addition, after a long period of underperformance due to regulatory and pricing concerns, many large-cap pharma names are now experiencing multiple expansions as sentiment turns more optimistic. As noted above, the sector is trading at a discount to the broader market, yet it has historically offered steady earnings, strong free cash flow, and above-market dividend yields. With macro uncertainty at the forefront of investors' minds, many are rotating toward defensive growth, benefiting healthcare broadly and many investors are targeting those companies with quality characteristics and/or wide moats.

Danaher is a good example. The company develops products including hardware and software, as well as drugs, vaccines and gene editing technologies. Morningstar believes a wide moat surrounds Danaher’s diversified set of businesses, and it sees intangible assets and switching costs as its moat sources. The company has done well recently as sentiment in the sector improved and its strong Q3 results.

Meanwhile, other key pharmaceutical companies are introducing new product cycles and engaging in strong R&D activity, which is usually a driver of returns in the sector. These include:

• Eli Lilly: Continued growth from GLP-1 drugs (Mounjaro and Zepbound) and pipeline expansion in Alzheimer’s.
• Merck: Strength from Keytruda and oncology pipeline diversification.
• Novartis: Positive sentiment following restructuring and innovative therapy launches.
• Broader M&A activity and deal speculation across pharma and biotech have added further upside, as investors anticipate consolidation opportunities.

Rotation into defensive stocks

Amid rising macroeconomic volatility, savvy investors are considering their allocation to defensive sectors like healthcare. Among the concerns investors have are the rising levels of global government debt, labour market weakness and stagflation prompted by tariffs. These could lead to equity market volatility. In that scenario, investors are likely to favour defensive sectors, with predictable earnings and strong cash flows.

If you look at the chart below, it shows the relative performance of the MarketGrader Developed Markets (ex-Australia) Health Care Index (HLTH Index) relative to the MSCI World ex Australia Index and this is charted against the US Government 10-year bond yield, a barometer of the health of the economy. When the grey line is rising, HLTH Index is outperforming. When the blue line, representing the US Government 10-year bond yield is rising, it means that the economy is expected to be stronger, as rates will be higher in the future. 

The chart shows that during past defensive rotations, i.e. weaker labour market/ slow growth and bond yields falling, as they did in 2015/2016 and from the end of November 2018 until the middle of 2020, HLTH Index typically outperformed.

We believe that the healthcare sector is an attractive diversifier in the current environment. Healthcare stocks tend to remain stable during periods of macroeconomic volatility and they have historically experienced relatively strong performance during late-cycle or recessionary periods. The sector's long-term growth is driven by consistent consumer demand for new medications and treatments, which remains relatively steady even during recessions. Other long-term structural trends supporting the sector include:

• The combination of global population growth and ageing demographics.
• Increasing prevalence of chronic diseases, which will continue to drive up the demand for healthcare.
• Increasing expenditures in emerging economies that need to close the gap to match the levels of spending in developed economies, as their growing and increasingly wealthy populations will demand it.

VanEck offers a targeted exposure to healthcare via its VanEck Global Healthcare Leaders ETF ASX: HLTH. 

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