Federal Reserve interest rate policy to again remain the market focus this year and create a chaotic first half. Biotechnology should be favorably positioned relative to the market if the economy slips into a recession. Biotech fortunes near term are to be determined by the performance of the 10-year yield, which should likely remain anchored or slip due to economic concerns.Biotech Bonanza: 2023 Biotech Outlook As The Fed Remains Hawkish
Sharply rising rates driven by the Federal Reserve hurt the broader market and particularly the higher-risk segments like growth stocks and biotechs. The overall healthcare sector performed relatively better, favored due to its defensive nature during times of economic uncertainty. The S&P Healthcare Index was down 4%, while the S&P 500 declined nearly 20% and the Nasdaq lost 33%. The Prudent Healthcare and the Prudent Biotech portfolios also declined last year after strong performances in prior years.
In the 2022 outlook, we had anticipated the performance of the Nasdaq Biotech Index to be in the range of -5% to +5%, and the S&P Healthcare Index to rise over 5%. The indexes performed worse than our anticipation. However, it was also noted in our last year’s outlook that the projection “assumes the Fed’s inflation targeting strategy will include 3-to-4 quarter-point rate increases during the year… and the return expectation will need to be adjusted if market conditions deviate significantly from current expectations.” Last year, the Fed raised rates by 4.5%, well above the 1% expectation.
Biotech’s Path In 2023
For the financial markets, last year could be called the year of the Fed, as everything revolved around its monetary policy. The Fed shifted rapidly towards a restrictive policy to rein in soaring inflation.
This year is likely going to be the same.
The Fed policy will remain restrictive, at least for the first half. However, the big difference from last year is that most of the distance to an interest rate peak has already been covered by the Fed.
And that bodes well for biotech stocks.
Biotech Performance To Be Driven By The Treasury Yield
Presently, the single most important factor for biotech valuations is the interest rate, particularly the 10-year treasury yield.
Rising yields curb risk appetite and pressures stock valuations while falling yields stoke it and help valuations. This is not always an absolute relationship and stocks can rise even with gradually rising yields, when growth overcomes the yield penalty. But that is not the situation we face presently.
Growing Uncertainty on the Federal Reserve Actions
Market fears are mounting that the economy will slip into a recession as the Fed maintains a monetary policy focus that is heavily weighted on inflation over economic growth.
The minutes of the December Fed meeting released last week conveyed the anxiety of the Fed officials towards inflation proving to be more persistent and that the risk remains tilted to the upside. The officials also remain wary of any unwarranted easing in financial conditions, as in rising stock prices, especially if driven by the market’s misperception of the Fed’s resolve to combat inflation. The minutes stressed that it would take “substantially more evidence of progress to be confident that inflation was on a sustained downward path.”
It is unclear how the 10-year yield will perform due to a mix of market forces. On one hand, the growing recession risk due to a restrictive policy should push the longer-term yields lower. On the other hand, a further sustained period of rate hikes can cause market imbalances and force even the longer-term yield higher. Due to such uncertainty, the first half will be chaotic as market sentiment ebbs and flows on inflation and economic data and how the Fed will interpret it. Unless the Fed clarifies the inflation level that will persuade it to consider a shift in policy, the uncertainty will remain elevated.
Potential Economic Outcomes
There are two obvious potential economic outcomes. One is for the economy to tip into a recession due to a prolonged restrictive policy as smaller-sized rate increases continue in order to bring inflation within the desired range. This is a higher probability outcome at this time and will hurt the broader stock market through at least the first half. However, this scenario will push 10-year yields lower, which can be beneficial for biotech stocks. For the most part, the pure-play biotech industry group is not as tethered to earnings growth as the broader market. Thus, biotechs can outperform in a recessionary environment supported by declining yields, and relatively unpressured from an earnings recession.
Another feasible outcome is for the ongoing economic slowdown to be sufficient to reduce inflation to within the Fed’s desired range, thus avoiding a recession. However, it is a lower probability outcome for now as employment-related metrics remain strong. If this scenario is to materialize, then it will be very positive for the stock market, including biotechs, and expectations will rise for a potential Fed easing in the second half.
A scenario where biotechs can get hurt will be if the 10-year yield rises sharply and makes new highs. That can be envisioned if inflation retreats but only at a slow pace towards the Fed’s desired target range of around 2%. This can force the Fed for continued aggressive monetary policy action, possibly taking the rate beyond the 5.5% Federal Funds rate which is currently the peak expectation. This will cause the 10-year yields to rise. In October, the 10-year yield made a high of 4.33% and thereafter declined to 3.40% in December. It presently rests at around 3.60%. Any rise back to a 4.3% yield or higher can weaken support for biotech stocks until such time the trend changes.
Biotechs and Pharma Continue to Push the Frontiers of Science
Biotech and pharmaceutical companies continue to deliver some ground-breaking treatments, with oncology and Alzheimer’s disease continuing to garner a major share of R&D spending.
Eisai and Biogen (BIIB) reported positive results late last year in a Phase 3 trial of the anti-amyloid beta treatment of mild cognitive impairment due to Alzheimer’s disease. The drug, Lecanemab with the marketing name Leqembi, slowed the decline in cognitive function and met its primary and secondary endpoints. Last Friday, it was approved by the FDA in an accelerated approval. Another major pharma, Eli Lilly, is seeking accelerated approval for its drug, Donanemab, which works on the same amyloid beta reduction hypothesis. These potential treatments, along with Biogen’s already-approved Alzheimer’s drug, Aduhelm, are amongst the first Alzheimer’s therapies. The treatments are expected to likely slow down Alzheimer’s disease, based on outcome trials still to be completed, but will not stop the disease from advancing and robbing memories. Nonetheless, the approved treatments are real breakthroughs when it comes to Alzheimer’s disease. The FDA’s decision to move forward with approvals, even when benefits are not clearly and firmly established yet, has lit a spark in Alzheimer’s and neurological research for a disease that afflicts nearly 7 million Americans. Alzheimer’s disease remains a focus for numerous companies, big-and-small, like Ionis Pharmaceuticals (IONS), Axsome Therapeutics (AXSM), Prothena (PRTA), Anavex Life Sciences (AVXL), Cassava Sciences (SAVA), and Intra-Cellular Therapies (ITCI), and there will be much-awaited data readouts of multiple promising drugs during the year.
There has also been material progress on drugs for obesity, one of the most challenging disease areas littered with failures over the decades. The field is gaining significant attention on promising breakthroughs since 2021 when Novo Nordisk’s (NVO) drug Wegovy was approved. Its lower-dose drug, Ozempic, has been facing supply shortages. The breakthroughs in the field have come with the discovery that diabetes drugs have the right efficacy and safety profile for tackling obesity. These drugs also have a favorable cardiovascular impact by reducing triglycerides and LDL. Industry giants Eli Lilly and Amgen are also racing to complete trials for obesity drugs. The next major drug up for accelerated approval is Eli Lilly’s (LLY) Tirzepatide as a weight loss treatment, after being already approved for diabetes. The company has another drug Retatrutide, which appears to be even better for obesity than Tirzepatide, and is finishing Phase 2 trials. Amgen is working on an early-stage drug, AMG 133, which last month showed a 15% reduction in body weight for people without diabetes in a Phase 1 trial. Pharma giant Pfizer (PFE) is working on obesity treatments as well. A few promising smaller companies participating in the space include Rhythm Pharmaceuticals (RYTM), which last year received approval for its drug Imcivree in multiple countries, Oramed Pharmaceuticals (ORMP), and Altimmune (ALT).
Oncology remains the largest market opportunity with Merck’s (MRK) drug Keytruda and Bristol-Myers Squibb’s (BMY) drugs Revlimid and Opdivo being the highest revenue drugs for cancer. Last month, Merck and Moderna (MRNA) announced ground-breaking news when an investigational personalized mRNA cancer vaccine in combination with Keytruda treatment demonstrated a significant and clinically meaningful improvement in recurrence-free survival versus Keytruda alone. The vaccine and Keytruda combination reduced the risk of recurrence or death by 44% compared to Keytruda as a monotherapy. The relentless pace of discovery and new approaches bodes well for the biotech sector with many large and small companies disclosing positive data, traction with new approaches, and partnerships. A few such companies are Gilead Sciences (GILD), Incyte (INCY), Arcellx (ACLX), MacroGenics (MGNX), and Kiniksa Pharmaceuticals (KNSA). The CAR-T autologous approach to cancer treatment continues to gain traction with Gilead being one of the leaders through its 2017 acquisition of Kite Pharmaceuticals, along with Novartis (NVS), Bristol Myers, and Johnson & Johnson (JNJ). The allogeneic approach, which holds tremendous promise in expanding the CAR-T treatment, increasing its speed, and lowering the cost, is also building traction, though it presently struggles with response duration. Recently, that has adversely affected companies like Fate Therapeutics (FATE), Allogene Therapeutics (ALLO), Atara Biotherapeutics (ATRA), Nkarta (NKTX), and Adicet Bio (ACET).
Gene editing treatments are building momentum, achieving significant milestones last year with approvals for the most expensive treatments, including two from bluebird Bio (BLUE). Such treatments are high-priced due to the rare nature of the diseases and the potential to treat or cure in one course, rather than through life-long treatment. Bluebird’s Skysona therapy costs over $3 million and its Zynteglo therapy is priced at a little under $3 million. Novartis’s therapy Zolgensma for muscle-wasting conditions costs a little over $2 million. Therapies targeting larger patient populations are also moving through the pipeline. Gene therapy is a promising area that has experienced its share of setbacks and is now beginning to deliver treatments. Management consulting firm McKinsey estimates that 30 new gene therapies can come to market in 2024.
The cornucopia of platform-driven approaches from gene editing to RNA to CAR-T cell therapies underscore the transformational nature of the treatments and the relentless quest for new drug discoveries.
M&A and Partnerships
Last year was a difficult year for M&A with volumes touching multi-year lows and down nearly 50% from the prior year. The two largest deals were Pfizer’s (PFE) acquisition of Biohaven for $12 billion and Amgen’s (AMGN) acquisition of biopharma Horizon (HZNP) for $28 billion. Both Pfizer and Amgen accounted for four of the top 5 highest-valued biotech deals in 2022.
After a challenging last year with soaring inflation, an aggressive Fed, and doubts about economic growth, such challenges will persist in 2023 though at a far more diminished level. Greater economic clarity as the year unfolds and ample balance sheet cash at large biopharmas should spark a more intense M&A year, with oncology, immunology, and neurology as some areas that can witness significant transaction activity.
R&D returns at big pharma can only be boosted through clever and multiple acquisitions that can broaden the pipeline and improve its success rate. Many pharmaceuticals are facing patent and pipeline cliffs over the next few years, a key rationale for Amgen’s purchase of Horizon Pharma last year. M&A remains a strategic tool for driving pharma revenue growth. Consulting firm PwC projects M&A to rebound sharply to match levels before 2022.
Nearly 90% of the biotech industry group has a valuation of up to $5 billion. Thus, the sweet spot for deals will remain from $500 million to around $5 billion as bolt-on acquisitions. Biotechs with pipeline assets in Phase 3 and late Phase 2 will likely be preferred for acquisitions, while companies in early Phase 2 and post-Phase 1 are likely to be preferred for backend loaded milestone-driven partnerships.
Deal activity is hard to predict, but it is an important driver of industry valuations. Indications suggest that 2023 will be a busy year for transactions.
This can be the year of biotechs after two consecutive years of negative or barely positive returns. While the broader market will likely have to overcome worries of a potential recession and a prolonged period of the restrictive policy, the biotech group should be able to find support and outperform. The market worries about recession should normally put pressure on the 10-year yield to slip or remain anchored around 4%. The direction of this yield will determine the path that the high-risk biotech group takes.
Under the assumption that the 10-year yield will not make new highs this year, we anticipate the biotech group to deliver returns of 15% to 20% and perhaps higher during 2023. The first half can get chaotic for the market and even biotechs, with the immediate outsized risk being that the market is underestimating the potential for the Fed to raise rates by 50 basis points at the February 1 meeting, instead of a 25 basis point move that is being presently priced-in.
The Prudent Biotech model portfolio remains fully invested at the moment. Many promising companies in biotechs can perform well in the 2023 market environment. A few of them, besides the ones mentioned above, are Gilead Sciences (GILD), Vertex Pharmaceuticals (VRTX), Moderna (MRNA), BioNTech (BNTX), BioMarin (BMRN), Arrowhead Pharmaceuticals (ARWR), Sarepta Therapeutics (SRPT), Karuna Therapeutics (KRTX), Axsome Therapeutics (AXSM), Xenon Pharmaceuticals (XENE), Madrigal Pharmaceuticals (MDGL), Akero Therapeutics (AKRO), Arcellx (ACLX), Rhythm Pharmaceuticals (RYTM), Verona Pharma (VRNA), DICE Therapeutics (DICE), and Prometheus Biosciences (RXDX).
A major industry event this month is the J.P. Morgan Healthcare Conference from January 9-12, which is an active time for corporate news releases and often positive sentiment.
This outlook expectation is simply a general framework to guide investors and will need to be adjusted if market conditions deviate materially from current expectations.