Investment In The Pharmaceutical Market During The Recession: New Reality Of Market

• The pharmaceutical market is least affected by negative events in the world economy
• Specialized strategies which take into account peculiarities of different markets are efficient
• The actual return in pharma has already reached 24.85% and a YTD return is currently 7.35%.

In 2022 the crisis occurred not only in the world economy but also in asset management. Credit Suisse lost   1.59 billion Swiss francs, or about $1.65 billion, in the second quarter of this year. A net loss of $1.2 billion   was driven by slower issuance of bonds and loans for companies and a decline in trading revenue of the   investment bank. Norway's sovereign wealth fund, a benchmark for diversification and reliability, lost $174   billion, or 14.4% of the value of its investments, during the same period. The fund lost 17.1% on equity   investments, mostly due to the sagging technology sector. And losses of BlackRock, one of the largest investment companies in the world, reached an «impressive» figure of $1.7 trillion.

Reliability is first and foremost stability in a crisis. Traditionally recognized as highly reliable, strategies for investing in stocks and bonds showed their ineffectiveness in the first half of the year. One of the main reasons for the colossal losses of investors is that «generals are preparing to fight their last war,» not fully aware of the complex set of problems in the global economy.

What is going on in the global markets?

The world economy is going through a difficult time, with central banks and governments struggling with skyrocketing inflation, the prospect of an economic crisis due to the war in Ukraine, and the risks of a recession.

Some of these processes, among them high inflation, began in 2020. At this time governments of various countries, including the US, handed out vast amounts of helicopter money to citizens. The US authorities allocated about $7 trillion to people and companies affected by the pandemic. The US Federal Reserve began a quantitative easing policy (QE) in 2020 by buying government securities from the market. The program ended only in the spring of 2022.

Most of the funds allocated by the government were expected to go into investments. The prediction was partly justified, and stock markets performed well at the end of 2021. For example, the S&P 500 increased by nearly 27% (the third consecutive positive year for the index). However, mostly the money went to current consumption. Ultimately, this translated into record inflation in the US and Europe.

In July, the European Central Bank raised its key rate to 0.5% for the first time in 11 years amid annual inflation in the eurozone, which reached an all-time high of 8.6% against a target of 2%. The US Federal Reserve raised the rate by 0.75 p.p. for two sessions in a row (the last time the regulator took such a step was 30 years ago) — it reached 2.25-2.5%. And although annual inflation in the US in July slowed for the first time since April — to 8.5% compared with 9.1% in June — it still remains at a forty-year high with a target of 2%, according to the latest US Bureau of Statistics data.

 

Such high inflation has led markets and investors to expect decisive actions from the Fed. As a result, the first half of 2022 was the worst in 50 years: the S&P 500 dropped 23.5% from its highs in January to mid-June, the NASDAQ Composite, composed mostly of high-tech stocks, plunged 33.4% (from its highs in the fall) and the Dow Jones Industrial Average fell by 19%. In a volatile environment, investors always stop targeting growth companies and invest in treasuries and value companies that already have established businesses.

Hostages of the situation

Global central banks were a little late to react and have created the impression of losing control of the situation. By raising the rate, they were trying to curb inflation, but it had turned out to be complicated. It is even worse in Europe as several countries have high foreign debt. Those are Italy, Spain, Portugal, and Greece. Investors remember the crisis when Greece could not pay its debts. But Greece is just 2% of the EU economy, and Italy is the third largest economy after Germany and France. And if Italy cannot service its foreign debt, the problems will be significant, to say the least, both economically and politically. That is why the ECB is very limited in what it can do — if it raises the rate, the interest on government debt will go up.

So far, there is no recession in Europe, and in the US the recession can be called technical. The American GDP has been declining for only two quarters in a row: by 1.6% in the first quarter and by 0.9% in the second. At the same time, another factor significant for determining recession — the US labor market — is at its best in 20 years. In July alone, the economy added over half a million jobs, and the unemployment rate fell to 3.5%, the lowest level since 1969. There are no signs of a recession in the quarterly reports of large companies.

But there are negative trends, one of which is a drop in savings. According to the Bureau of Economic Analysis, personal savings as a share of disposable income in the US dropped to 4.4% in April, the lowest since September 2008. Combined with an expected key rate hike (at least once before the end of the year), this trend will lead to a decline in aggregate consumption. This process, in turn, will cause the labor market, wages and spendings to shrink — which could already lead to an actual recession.

Interestingly, the worse the economy gets, the softer the Fed's policy will become. Since investors believe in a recession and think that the Fed will not aggressively raise rates. This paradoxically has a good effect on stock markets. All three indices started rising in July: the S&P 500 has already rebounded 14% from its bottom in June, the NASDAQ has gained 20% and the Dow Jones has added 11.3%. The rebound of the markets in July is temporary — they will be declining shortly on fears of stagflation and continuing geopolitical tensions.

Bucking the trends: pharma market

Even though the global market is on the verge of recession, free money is still in it — as well as relatively stable industries. The pharmaceutical market is a prime example. At the end of 2021, its global volume was estimated at $1.42 trillion. 20% of the S&P index is in healthcare and pharmaceuticals. This is a significant part of the worldwide economy that has its own laws.

Unlike other commodity markets, the pharmaceutical industry is virtually unaffected by inflation, recession, crisis, war, and logistics chain breaking as it has inelastic demand. This means that a government of a democratic country cannot fail to fund drugs for patients with diabetes, cancer, and other serious illnesses, regardless of the state of the budget. Demand is constant — a diabetic patient needs insulin injections all the time.

In the US, which is the mainstream pharmaceutical market, companies have free pricing for originator drugs. On average, they raise their prices by 5-7% annually. This provides about 4-5% annual growth of the global pharmaceutical market. And it will continue growing at the same rate in 2022 despite the crisis, although the SPDR S&P Pharmaceuticals index dropped by about 10% in the first half of the year.

The average annual growth rate for the global economy in 30 years is about 2%. The fact that the growth rate of the pharmaceutical market is more than double that figure speaks in its favor. In recent years, the business-friendly policy of the FDA (the US regulator) has contributed to the gap. The Center for Drug Evaluation and Research (CDER) approved 50 new drugs in 2021, compared with just over 20 new molecules in 2016.

This friendly policy explains, among other things, the ineffectiveness of Donald Trump's 2020 measures to limit drug prices in the US. These measures were not aimed at originator drug manufacturers who protect themselves securely from government regulation. Their ironclad argument is: «If you want us to release new drugs and improve the quality of life for patients, you have to allow free pricing to invest in their development.» And to create new drugs, one must spend an average of $1.5 billion per molecule (this amount includes preclinical studies, all phases of clinical trials, and procedures to bring a drug to market). So the pharmaceutical market, unlike many others, is relatively stable.

Investing in times of crisis

If the pharmaceutical market is growing 5% a year, a fund investing in companies in the industry should grow even faster. For example, there can be an ambitious goal to achieve a target return of 15% per year. But there is a real example, that the actual return can reach 24.85% since October 2020, and a YTD return for 7.35%.

There are two main reasons for the solid results:

• Try not to take unreasonable risks. We carefully forecast trends and invest when a company has a significant advantage over its competitors — or there is no competition at all. It is possible in the rare disease market, which is not broad enough to develop additional drugs to treat orphan diseases.
• Consider buying blue chip companies only when the market undervalues them, and focus on diversified companies with various areas and drugs in the portfolio. For example, Moderna. Its shares have fallen about 2.5 times in the last year. The company offers only one significant product and is not diversified enough. Taking closer look at the results of clinical trials and predict how the FDA might interpret them. The scientific background of the fund's top managers helps in the analysis.
• Use of financial engineering techniques. Do not buy stocks but invest in structured products based on a basket of stocks and include the assets of companies that funds like ours predict will not decline in price by more than 35% over the next three years. Due to this, it’s possible to get an average coupon yield of more than 20%.

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The crisis of 2022 showed that management companies need to reconsider their approach to investing. The times when people could invest in ETFs and buy bonds and stocks without understanding specific industries is over. In my opinion, the most effective strategies today are specialized ones that are tailored to particular markets by professionals with relevant industry experience along with financial engineering specialists.