What is going on in the healthcare sector?

Author: Andy Budden, Investment director at Capital Group

In relative terms, 2023 was the worst year for healthcare stocks since 1999, underperforming the global equity market as a whole by 20%.

Excluding Novo Nordisk and Eli Lilly - two large and notable outliers whose successful diabetes/obesity drug franchises drove outperformance in their share prices last year - the sector would have underperformed even more, by 24%.

Relative performance of MSCI World Health Care versus MSCI World Index (USD)

There is no single reason for the relative weakness of the health sector in recent times. Instead, several factors may be at play:

Risk environment

After a difficult 2022, global equities, as represented by the MSCI World index, rebounded strongly in 2023 (+24% in USD) driven by enthusiasm around artificial intelligence and the expectation that central banks will pause rate hikes or even consider cutting rates. As a traditionally defensive sector - demand for healthcare products and services is less correlated to the economy and equity markets - healthcare lagged this risk market.

Inflation Reduction Act (IRA)

Signed into law in 2022, the IRA is a key US federal government law that aims to curb inflation by investing in infrastructure, clean energy and reducing healthcare costs, among other goals. The law gives Medicare - the US federal health insurance programme for people over 65 - the power to negotiate directly with biopharmaceutical and biotech companies on the prices of their most commonly used drugs (in terms of spending). By 2030, 60 drugs will be selected for price negotiation.

Clearly, Medicare uses a range of on-patent and off-patent drugs and generally pays more for those with patents. As patent duration is shortened by the IRA, Medicare is in a stronger position to negotiate drug prices when drugs go off patent and face increased competition. New drugs can take years - sometimes more than a decade - to develop, test and approve; to generate a sufficiently attractive return on investment, a sufficiently long period is required during which the cost of that development can be recouped through effective pricing.

Prior to this new legislation, new drugs could benefit from up to 15 years of patent protection before "loss of exclusivity", which legally opens the door for competitors to market biosimilars/generics, often at significantly lower prices. In practice, the IRA reduces from 15 years to 9 (for small molecule drugs) or 13 (for large molecule drugs) the period during which pharmaceutical companies can benefit from favourable prices.

Relative valuation of the health sector under previous political systems

MSCI USA Health Care Index relative to the MSCI USA Index, trailing 12-month forward P/E

M&A risk

2023 was a quiet year for M&A in the healthcare sector, affected by sharply rising financing costs and economic uncertainty. However, this is likely to mean a pick-up in M&A activity in 2024, as budgets are realigned and large-cap biopharma companies look to bolster their portfolios. According to a Goldman Sachs estimate, M&A capacity in the healthcare sector could increase by 34% year-on-year by 2024. The market fears that buyers will have to pay large premiums, as there are relatively few companies left to acquire in the biotech sector.