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Thematic ideas | Healthcare as an asset class

Investment outlooks / Q4 2020

The health care sector has long been an outperformer in the US equity market.[1] Returns outpace the broader market over time, while volatility is not especially high. Moreover, health care outperforms substantially in economic downturns, giving it a valuable defensive aspect. These attractive investment characteristics are directly a result of the unique economic aspects of health care, and thus are likely to persist. However, the same idiosyncratic economics of health care also means that politics are a continual source of uncertainty.

Healthcare in the US economy – spending more, getting more, paying more

Since 1960, consumption on health care and medicine in the US has grown steadily as a share of total expenditure on goods and services, nearly quadrupling from 6 per cent to 21 per cent in nominal terms. The rise has been inexorable with the notable exception of this year, when healthcare spending momentarily plunged relative to the rest of the economy (and goods in particular) as the lockdown brought a pause to elective medical procedures.  The growth in the US healthcare sector is of great significance, as the US consumer is by far the largest segment of the US economy, and the US economy remains the largest in the world. Add it all up, and if the US health care sector was a country, it would have a GDP comparable to France[2].

Click chart to expand. Source: US Department of Commerce, 2020.

At one level, the increased spending on healthcare is a failure. Adjusted for inflation, healthcare consumption has stagnated since the early 1980s. This is due to higher health related price inflation. Since 1960, the annualised rate of overall PCE inflation has been 3.30 per cent, while services inflation has been 4.01 per cent and health services inflation has been 5.06 per cent. Most of that excess healthcare price inflation was before the 1990s, and since 2000 healthcare services prices have grown on average by roughly the same amount as overall services – somewhat faster during downturns, somewhat slower during expansions. Moreover, the increased proportion of spending on health is not fully reflected in a comparable improvement in health-related outcomes. Much of the increase in health related spending reflects wasted consumption and unequal distribution of services because of the inefficiencies and distorted incentives.

Click chart to expand. Source: US Department of Commerce, 2020.

However, this increased spending is a success, as productivity gains elsewhere in the economy (in particular, agriculture and manufacturing) have allowed the US to redeploy productive assets away from goods and into services, and thus allow spending on services to increase from about half of total expenditures to two-thirds. Americans can spend more on services like health care, education and entertainment because they don’t have to spend as much on food and consumer goods.

Health care is a “superior” good, in the sense that the demand increases as income increases, much like luxury goods. Health care, however, could be described as “super superior”, as better health care can increase lifespan and thus overall consumption of health care services. This is particularly evident in the final years and month of life, where a disproportionate amount of money is spent.

Thus material abundance allows consumption to be redirected to improving health, and improving health extends the time in which health care can be consumed. The result? Today we have septuagenarian marathon runners[3], while a century ago the average American didn’t make it past 54.

The bottom line is that spending more on services like health care relative to goods reflects American prosperity but spending proportionately more on health relative to other services reflects American inefficiency. Even more damning, the inattention to public health and prevention has led to mediocre overall health quality in the US relative to other developed markets.

Health care in the US market – superior returns yet defensive in nature

The economics of ever-increasing healthcare spending are reflected in the long-term outperformance of the health care sector in the equity markets. Between 1973 and 2019, the healthcare sector has had one of the best risk/reward profiles in the US market. With an annualised return of 12.1 per cent and an annualised volatility of 15.7 per cent providing for a Sharpe ratio of 0.61, health care has had the highest returns and the second-lowest volatility of all the major sectors. Only the consumer staples sector has been comparable, with a slightly lower return and a slightly lower volatility. Over this 46 year period, health care has outperformed the broad market by a cumulative 77 per cent percent, with consumer staples generating an excess return of 61 per cent. Both are defensive sectors, outperforming the broader market during economic downturns and having relatively smaller drawdowns generally.

Healthcare performed exceptionally well under the Obama administration, as the Affordable Care Act greatly expanded access to healthcare. The healthcare sector retraced versus its sister, defensive in 2015 ahead of Trump’s election, as repealing the ACA was a centerpiece of his campaign. However, Trump’s failure to push a repeal of ACA through the Congress provided the impetus for a fresh move higher in the relative performance of healthcare.

Click chart to expand. Source: Datastream, 2020.

Thus, the long-term outlook for the health care sector looks solid. As good health is central to human flourishing, it is reasonable to assume that health related spending will maintain its high share of services spending, that services will continue to rise as a share of total spending, and that consumption generally will continue to grow with the economy. The inefficiencies will likely persist with political gridlock, suggesting that the sector will continue to expand in nominal terms, and that health care providers will have at least as much pricing power as the rest of the services sector.

Next year could see healthcare significantly outperform

The healthcare sector has struggled in 2020 relative to the broader market. Two reasons in particular stand out – the Covid-19 lockdown, and US politics. There is potential for both these headwinds to reverse in 2021, providing a particularly attractive entry point.

While the pandemic has increased demand for healthcare services to deal with the infection, the restrictions on face-to-face interaction has also dramatically reduced demand for all other elective activity. However, this latter effect has likely resulted in substantial pent up demand for the sector, especially as compared to other service-focused industries. The root canal, for example, will still require a trip to the dentist when restrictions end, but the vacations that were cancelled doesn’t get rolled over as additional vacations the following year. Thus, the net impact on sector earnings are probably modestly positive over time.

On the politics side, there is likely a very different outcome for the sector depending upon on the results of the election. President Trump failed to present an alternative to ACA to Congress, but the addition of another conservative justice to the Supreme Court increases the risk of the legal challenge to ACA succeeding. However, a “Blue Wave” with the Democrats winning the White House and the Senate while keeping the House of Representatives makes it likely the Democrats will pass legislation to further entrench and even extend most aspects of ACA. This increase in (subsidized) demand for healthcare would be unambiguously positive for the sector; of course, government regulation could also include caps on profits, particularly for pharmaceuticals.

It is important to pay close attention to the details of the healthcare legislation as it wends through Congress, but a clear Democratic victory and/or the rolling out of a vaccine in 2021 would be important signals to buy in the space.

[1] We focus on the US market in this analysis because it is the deepest and most liquid, and because the private healthcare industry in the US is the exceptionally large and established relative to other developed markets, which generally have a larger public sector role.
[2] In 2019, Americans consumed $2.45 trillion of health care goods and services. In the same year, France had a Gross Domestic Product of $2.71 trillion.

Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.

If not otherwise indicated, all graphs are sourced from Dolfin research, October 2020.

For more information please read our disclaimer.

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