The stars were perfectly aligned for the financial markets in 2017. Strong and synchronous growth around the globe, no signs of inflation, still accommodative monetary policies, few geopolitical events impacting the economy, and strong corporate earnings all made for a solid year.
The MSCI AC World Index climbed 24.0% for the year. This strong finish was driven by the successful passage of tax reform in the US, naturally economically sensitive sectors turned in the best performances. On the other hand, the first quarter of 2018 was a difficult one for financial markets as the MSCI AC World Index inched down -1.0%. The calm of 2017, which spilled over into January, was broken as volatility spiked to the highest level since August 2015. The euphoric sentiment that helped the MSCI AC World Index advance more than 7% in the first 26 days of the year reversed course as a confluence of potential headwinds came together almost simultaneously. Higher than expected wage data for January in the US triggered inflation fears while speculation increased that the Fed, under new Chair Jerome Powell’s leadership, may take a more hawkish path to normalization. This was compounded in March by the announcement of trade tariffs by the Trump administration and fears of a looming trade war. All this despite, a macro environment that remains the most constructive in a decade.
Looking forward, the broader macro backdrop remains constructive. Concerns that inflation rises faster than expected should subside as structural and cyclical factors, including the deflationary impact of deregulation and supply-side effects of tax reform, holds down inflation. Normalization of monetary policy in the US should continue at a gradual pace while globally, the ECB and BoJ are expected to remain highly accommodative. Additionally, falling geopolitical risks in the Korean Peninsula should reinforce the constructive outlook. Considering this, we continue to favor small/mid-cap exposure over large-cap, expect cyclical strength to resume, and see emerging market healthcare continuing to outperform. Lastly, we expect volatility to stabilize, albeit at more elevated levels than last year’s exceptionally low levels. A more stable and risk-on broader market should help biotech names bounce back given strong industry fundamentals and attractive valuations.
The primary drivers of healthcare demand are the aging population, rising incomes, and ongoing innovation. As these factors intensify further, health expenditures will grow, resulting in an even greater share of GDP for healthcare. In 2015, health expenditures approximated to USD7.4tn and consumed around 9.8% of global GDP. Experts expect to see the fastest growth rates in Asia-Pacific where a confluence of factors are coming together to increase demand and spending. China alone is expected to approach USD900bn in health expenditures annually by 2020-21. Moreover, across most developing and emerging markets, the trend towards universal healthcare and increased coverage will continue, as governments aim to reduce out-of-pocket spending for individuals and expand access. Such efforts likely will encourage further cooperation with the private sector, while increasing public/private investment. For example, in recent years China has been increasingly promoting the use of public-private partnerships (PPPs) to help improve healthcare delivery.
Per the United Nations (UN), the number of people >60 years of age in the world has increased substantially in recent years and is projected to accelerate over the next several decades. A combination of increased longevity and shifting demographics (ie, larger cohorts of older people) means increasingly greater numbers of older people are living even longer. Therefore, the number of individuals globally aged 60 or over is projected to grow by 56% (from 901m to 1.4bn) between 2015 and 2030. Compared with 2000, the >60 yo category grew by 48% through 2015. Based on the UN World Population Prospects: The 2017 Revision, in Germany, the >60 yo group is expected to rise rapidly from 27.3% of the population in 2015 to 34.7% in 2030. The 2015 revision of the UN’s World Population Prospects reports that by 2030, the >60 yo group in developed markets will grow by 26% to reach 375m, while in emerging/developing markets the older population will reach 1bn, a growth rate of 71%. As these groups increase, healthcare demand will mushroom, as older individuals consume on average three-to-four times more healthcare (including prescription drugs) than younger people. In the US, patients aged ?65 yo received 39% of all prescriptions and accounted for 41% of the increase since 2011.
At the same time, the global middle class is burgeoning. The Brooking’s Institute estimates that about two-thirds of the world’s population will be middle class by 2030. The increase will be especially pronounced in Asia-Pacific, which is forecasted to account for 88% of the growth. This dramatic rise of the middle class in the emerging markets will have marked effects on healthcare demand. As incomes rise, especially from low levels (as is the case in most emerging markets), healthcare demand typically expands at a much faster pace than it does at higher income levels. The reason is that healthcare is a “superior good,” which, in economic terms, is one that comprises a larger share of consumption as income rises. In addition, along with a growing middle class, evidence of increasing urbanisation and sedentary lifestyles is apparent. These features of modern life, in turn, are contributing to the rising incidence of obesity and chronic diseases such as heart disease and diabetes.
Healthcare Markets Continuing to Expand
Another important aspect to consider is the role that innovation plays in the creation of healthcare markets. For example, in the last two decades, notable healthcare markets have been created in the treatment of Pulmonary Arterial Hypertension (PAH), Multiple Sclerosis (MS), Lysosomal Storage Disease (LSD) & Hepatitis C. These four new markets can be credited for generating over USD42bn. There are several other markets being developed such as: Idiopathic Pulmonary Fibrosis, Myelofibrosis, Cystic Fibrosis, Duchene Muscular Dystrophy & Transcatheter Aortic-Valve implantation. In 2017, there were over 46 new molecular entities were approved by the FDA for the treatment of conditions ranging from multiple sclerosis to chorea associated with Huntington’s Disease. As of March 31, 2018, there have been 6 new molecular entities that have been approved by the FDA this year which likely puts the industry on track for a decent year.
The spine market is a good example of a market related to healthcare that has experienced significant growth in the past years due to the reasons mentioned above. The spinal fusion segment has been the tailwind of the growth in that segment of the market. The spine market comprises three broad groups of device manufacturers: the large-cap diversified medtech/orthopaedic, the mid-cap pure-play spine portfolio, and the small-cap (or private) pure-play companies.
A notable US market trend has been the increase in outpatient surgeries. Between 2005 and 2015, the share of US spine surgery done in the outpatient setting rose from 5% to 45%. This growth was enabled by innovations in minimally-invasive-surgery (MIS) implants and techniques. The available navigation and robotics systems to support MIS surgeries increased concurrently.
MIS presents obvious benefits in limiting damage to the structures surrounding the treatment site. Depending on the approach (i.e., posterior, anterior, or lateral), accessing the spine can be complicated by the array of tissues, organs, vessels, nerves, and other structures in the region. Traditional open surgery either significantly damages or risks damaging these structures to access the target site of the spine. MIS promises less traumatic treatments, shorter stays in healthcare facilities, and lower risks of complications. However, the physician must be able to navigate through the body to reach the spine, and then, with limited access, proceed with the surgery. This type of procedure requires technological innovation in imaging, navigation, neuromonitoring, procedure and access instruments, implants, and interbody device designs.
For example, expandable devices enable the implantation of vertebral interbody fusion cages via a much smaller access than the traditional monobloc devices. Some players have led the development of these innovative devices. However, the required US FDA 510(k) clearance for most devices is a lower barrier to entry than a premarket approval (PMA), and therefore most companies have, or are soon launching, expandable cages as part of their portfolio.
Spine is the largest market in orthopedics and patients with spine problems account for the second most physician visits after the common cold. Five companies generate approximately 70% of the market’s sales. The spinal-surgery market is showing low, but stable, growth. However, there are important shifts within the market, including the increased use of MIS and its enabling technologies.
Headwinds to the adoption of MIS include both the limited sub-segment of cases that can be treated and the need for surgeons to be trained in new advanced techniques. However, when appropriate, MIS promises benefits to the patient. It also serves as a great marketing tool and is a key factor in driving patient volumes. As patients are increasingly educating themselves, they are further driving adoption among surgeons by asking for these innovative surgical approaches.
The healthcare sector continues to be attractively valued, trading generally in line with the broad markets at about 15.5x ntm P/E estimates. The valuation picture of healthcare’s key industries has not radically changed, with medtech (21.3x) continuing to trade at a significant premium to the broad markets and healthcare. The other three major healthcare industries continue to trade at a discount: biotechs at 14.4x, services at 14.0x, and pharmas at 14.5x. The key area of focus for healthcare investors, particularly in the lead-up to the US mid-term elections, will likely be the US political environment. In the months before the 2018 vote, both Democrats and Republicans appear to be using healthcare to help fill the debate vacuum created by last year’s passage of the tax reform bill. Through the administration’s steadfast support for innovation, the current political environment appears to favor biotechs, medtechs, and, to a lesser extent, pharmas, while creating some political headwinds for generics and the supply-chain (through competition and transparency promotion). At Sectoral, we believe that investment portfolios must be built upon the same principles of balance, quality and durability. As such, our successful investment approach is grounded in primary research of company fundamentals and meticulous due diligence. We believe our rigorous investment philosophy allows us to offer unparalleled products and services to our global client base.