Seek Shelter in Healthcare
#Market Strategy — 08.06.2022

Seek Shelter in Healthcare

US Equity Perspectives - June 2022

Alexis Tay, Senior Adviser, Equity Advisory Asia, BNP Paribas

Summary

1Q22 earnings season unveil mixed underlying trends

Cross currents from Russia/Ukraine, rising commodity and energy costs, China’s Covid-related lockdowns, and falling consumer confidence continue to create unwelcomed surprises for the current earnings season.

Amongst selected mass retailers, there were signs of inventory build and demand shifting away from discretionary categories, coupled with signs of consumers trading down. Furthermore, margins were squeezed due to wage, energy and transportation cost inflation, leading to a sharp downward revision on forward earnings.

Muted guidance from a popular social media platform points to macro risks for the digital advertising industry, where companies are concurrently managing challenges from privacy policy changes. Overall, we think large established and diversified platforms that are less reliant on brand advertising will weather any macro headwind better than peers.

Semiconductor results largely remained in the beat and raise category, though there were some instances where supply chain disruptions and China’s Covid lockdowns impacted forward guidance negatively. Our preferred segment remains Compute, where data centre trends remain extremely robust.

All eyes will be on the upcoming software earnings, where investors will scrutinize results for signs of decelerating demand – though we think the drastic compression in software valuations has already partially priced in this expected deceleration. Our preferred segment remains Cybersecurity, where demand will be most resilient in view of a macro slowdown.

Valuation reset and depressed sentiment: early indications of a potential Fed pivot?

While the overall stock market remains extremely volatile, the S&P 500 Index has reset in terms of valuations, now trading at FY22 P/E1 of 17.8x, back to long-term historical average. Long term-oriented investors have been actively adding on equity positions in 1Q22. More reasonable valuations, oversold technicals, and depressed investor sentiment and positioning may set markets up for a short-term bounce.

With risk that inflation may see upward pressure in the next few months due to Covid restrictions in China, the Federal Reserve will likely be on “autopilot” until at least September 2022. However, the central bank  acknowledges that less aggressive tightening or even a pause may be on the table later in the year if the economy starts to slow down dramatically.

In the near term, we maintain a defensive stance, and highlight the Healthcare sector for its defensive attributes, valuation attraction and relative insulation from inflationary pressure. Elsewhere, we think Banks, Defense and Cybersecurity offer pockets of opportunity in a tough market environment.

1Q22 earnings season unveil mixed underlying trends

Cross currents from Russia/Ukraine, rising commodity and energy costs, China’s Covid-related lockdowns, and falling consumer confidence continue to create unwelcomed surprises for the current earnings season.

Recent selected mass retailer results and commentary from a popular social media platform point to some worrying trends.

Amongst mass retailers, there were signs of inventory build and demand shifting away from discretionary categories, coupled with signs of consumers trading down. Furthermore, margins were squeezed due to wage, energy and transportation cost inflation, leading to a sharp downward revision on forward earnings.

A popular social media platform disclosed at its recent investor conference that its forward guidance, given just little over a month ago, has to be revised downwards due to the macro environment deteriorating faster than anticipated.

This is a reminder that digital advertising, despite its structural growth angle, remains a cyclical industry, and companies are concurrently managing challenges from privacy policy changes. Overall, we think large established and diversified platforms that are less reliant on brand advertising will weather macro headwinds better than peers.

Semiconductor results largely remained in the beat and raise category, coupled with resilient demand, pricing power and improving margins, though there were some instances where supply chain disruptions and China’s Covid lockdowns impacted forward guidance negatively. Our preferred segment remains Compute, where data centre trends remain extremely robust.

All eyes will be on the upcoming software earnings reports in early June 2022, where investors will scrutinize results for signs of decelerating demand.  We note an increasing number of sell-side analysts beginning to temper expectations for the sector on macro concerns. Nonetheless, we think the drastic compression in software valuations has already partially priced in this expected deceleration. Our preferred segment remains Cybersecurity, where we view demand will be most resilient in light of a macro slowdown.

Early indications of a potential Fed pivot?

While the overall stock market remains extremely volatile, we would like to highlight that the S&P 500 Index has reset in terms of valuations, now trading at FY22 P/E of 17.8x, back to its long-term historical average (see Chart 1). Long term-oriented investors have been actively adding on equity positions in 1Q22. More reasonable valuations, oversold technicals, and depressed investor sentiment and positioning may set markets up for a short-term bounce.

Read May issue of US Equity Perspectives: Volatile Earnings Season Buffeted by Multiple Cross Currents

s&p 500

While May 2022 FOMC1 meetings showed that most policy makers thought 50bps rate hikes would be appropriate at the “next couple of meetings”, and that policy should move quickly towards the neutral rate, the lack of hawkish surprise is a welcome relief for markets.

With heightened risk that inflation may see upward pressure in the next few months due to Covid restrictions in China, this may keep the Federal Reserve on “autopilot” until at least September 2022 when the neutral rate is reached (according to consensus expectations). However, we note the central bank’s acknowledgement that less aggressive tightening or even a pause may be on the table later in the year if the economy starts to slow down dramatically.

Overall, we maintain a defensive stance, and highlight the Healthcare sector for its defensive attributes,  valuation attraction and relative insulation from inflationary pressure. Elsewhere, we think Banks, Defense and Cybersecurity offer pockets of opportunity in a tough market environment.

Bank stocks see a positive bounce

  • We highlighted the attraction of US banks in our May 2022 issue, and this is a sector we continue to favour.
  • Bank stocks jumped in late May 2022 thanks to a major US bank providing upbeat comments that it would meet or exceed its financial targets earlier than expected because of rising interest rates, increasing demand for loans and the benefits of volatile financial markets.
  • Macro concerns tied to the medium-term health of the US economy are still likely to influence investment decisions and the appetite for bank stocks. However, in light of the recent underperformance and valuation derating, much of the negativity appears to be heavily discounted by sector names.
  • The interest rate cycle remains an important sector driver and we still see value in names best exposed to this.

Cybersecurity benefitting from secular tailwinds

  • We are of the view that cybersecurity budgets would remain resilient and unlikely to be cut despite a macro slowdown.
  • While cybersecurity attacks have increased in velocity and severity over the past years, we think that Russia’s actions in Ukraine serve to further ratchet up cybersecurity risk as groups engage in digital warfare. This is true across government agencies, private organizations and critical infrastructure.
  • Critical infrastructure sectors may be of particular concern, given the lack of cybersecurity sophistication and the potential of wide-spread damage that a critical infrastructure attack can unleash. For example, twice since Russia’s 2014 invasion, hackers have targeted the computer systems underpinning Ukraine’s electrical grid, cutting off power temporarily. 
  • In the current environment, cybersecurity firms could see expedited deployment plans from their customer base. Looking out further, we expect the cybersecurity sector to see robust growth over the next few years. According to Gartner, the cybersecurity market is expected to grow at a 10% CAGR2 through 2025, primarily driven by Zero Trust, Cloud proliferation and digitalisation (Internet of Things).
  • Cybersecurity risk remains high, especially as the network perimeter has dissolved with employees working from anywhere and apps spanning heterogeneous environments (on-premise, hybrid cloud, public cloud).
  • Aside from reputational damage, ransomware has put a dollar value on the cost of cyber attacks, not forgetting cybersecurity regulations have tightened sharply over the years in areas such as privacy, national security and reporting requirements, putting pressure on corporates to increase vigilance and compliance.
  • We expect this heightened threat and tighter regulatory landscape to remain for years to come, which would be supportive of cybersecurity vendors across the group.
  • As a testament to the positive tailwinds the sector is enjoying, cybersecurity stocks under our coverage have reported better-than-expected 1Q22 results, with robust underlying spending and upbeat guidance. Some management commentaries point to greater interest in cyber protection from companies and government agencies across Europe.
  • Overall, cybersecurity software shares have fallen sharply along with the broad market despite robust fundamentals, thus creating opportunity.

Healthcare: shelter in the storm

  • We continue to highlight the defensive merits of the US Healthcare sector at times of market volatility, aided by supportive 1Q22 results. One of the sector’s most attractive characteristics is its ability to play defence during challenging conditions and market weakness, yet also can take part in the price upside during periods of strength.
  • Healthcare has fared significantly better than the overall market during periods of rising volatility and above-average VIX1 levels when examining monthly periods going back to 1990.
  • Moreover, during periods in which the market logged losses of up to 10%, Healthcare managed to post an average gain of 2.4%, compared with the S&P 500 average loss of 3.7% over the same time period (see Chart 2).
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healthcare sector

Defensive merits in the time of Russia and inflation

  • Although not immune to global events, the healthcare sector does offer some defensiveness in relation to two current concerns: Russian exposure and inflation.
  • From a US stock perspective, the sector has limited exposure to Russia, with exposure of large-cap Pharma estimated to be no more than 1-2% of total sales. Some firms run limited clinical trials in Ukraine, but neither Russia nor Ukraine are drug manufacturing hubs, and market exposure is minimal.
  • As for inflation, Pharma and Managed Care in particular may still have some cushion in an inflationary environment. For Pharma, prescription drug prices over the past several years have risen at a faster rate than prevailing rates of inflation, and a clause in the Biden administration’s latest drug pricing plan allows for drug prices to rise at the rate of inflation. For Managed Care, the annual change in health insurance premiums roughly matches the year-on-year rise in wages and inflation. Periods of inflation also come with higher interest rates which is a tailwind to health insurers’ investment income.

Where to position within Healthcare

  • We continue to like the defensive merits of Pharma names. Carrying significant cash levels but facing patent expirations, this space is expected to buy innovation through acquisitions. Supported by the collapse in biotech valuations, Pharma names can be choosier and are better placed to avoid companies where the science is unproven and revenues non-existent.
  • Elsewhere within healthcare, we like Managed Care players such as insurers and healthcare equipment/devices companies for their exposure to long term demographic trends. Animal health is another interesting structural growth story on the back of increasing pet ownership.