Schwab Sector Views: Election, Vaccine News Change the Picture
The dust is still settling after Election Day, but there are signs the outcome may have a significant impact on one sector in particular, Health Care, as well as, to a lesser degree, Utilities. Additionally, we think the recent news of an apparently very effective COVID-19 vaccine bolsters the positive case for Financials, while dampening it for Consumer Staples.
Billed as “extraordinary” by the National Institute of Allergy and Infectious Diseases, the interim results of a late-stage trial for a vaccine produced by drug maker Pfizer and German biotechnology company BioNTech has strengthened the argument for a sustained—and potentially stronger-than-expected—economic recovery. Fully opened economies, renewed business and consumer confidence, and higher inflation expectations would increase the potential for longer-term interest rates to rise, even as the Federal Reserve keeps short-term rates pegged near zero.
While it looked like Democrats had good odds of gaining the majority in the Senate heading into the election, it now appears that control of the Senate will come down to runoff elections for both Georgia seats. The outcome of those Senate races—which will take place Jan. 5, 2021—will determine whether Democrats will have the ability to control the agenda in Washington, or whether projected President-elect Joe Biden will be stymied by a divided Congress. Even with a Democratic win, it’s arguable that a slim majority in the Senate and the smaller Democratic majority already won in the House will make passing the more contentious Biden initiatives much more difficult.
Given both of these developments, we’re making some changes in our sector calls:
- Health Care is upgraded to outperform: With a split or narrow majority in Congress, “Bidencare” likely would be off the table or significantly watered down, reducing uncertainty for the sector and letting its long-term positives shine.
- Financials is maintained at outperform: A split Congress will likely result in a down-sized COVID-19-related fiscal stimulus package, but this combined with a Fed committed to low interest rates and the potential for a very effective vaccine may result in stronger-than-expected economic growth and a steeper yield curve—benefiting the sector’s solid fundamentals.
- Consumer Staples is demoted to underperform: With higher confidence in a sustained economic recovery, this traditionally defensive sector is more likely to underperform.
- Utilities is maintained at underperform: If Congress is split or has a narrow majority, most of proposed $2 trillion in spending on clean energy and infrastructure is called into question, and the sector will be left with high valuations to contend with.
Raising Health Care to outperform
Last month I penned an article about the pre-election proposals and risks facing the Health Care sector. Although vote counting was still continuing in a few states at the time of this writing, and two Senate seats were headed to runoff in January, a number of questions have been answered, which gives us confidence to upgrade the sector to outperform.
While the sector has maintained numerous positive elements, in our view, there was increased uncertainty surrounding the contentious fight for the White House and Senate that raised risks—and indeed the sector had underperformed since peaking in late April, as Biden’s polling numbers improved.
The Democratic Party’s health care proposal seemed to be major source of the angst. Biden’s proposed “public option”—a more affordable, or free, alternative to private health insurance—and enhancements to the Affordable Care Act (ACA) raised questions about the sustainability of profit growth in the health care sector. To some extent, this was similar to 2010, when the ACA was signed into law—although in the end, the ACA turned out to be good for many of the health care industries. If Congress is split, few if any parts of the Bidencare plan are likely to be implemented, reducing a major source of uncertainty. Even in the Democrats’ best-case scenario—a 50/50 split, with projected Vice President-elect Kamala Harris as the tie-breaking vote—the party would have a razor-thin majority, and division between progressive and moderate Democrats could very well result in many of the more contentious health-care initiatives being much tamer or blocked altogether.
This opens the potential for renewed outperformance based on the long-term positives, including an aging global population and a growing middle class in emerging markets, all of whom will demand more extensive drug treatments and medical care over time. Additionally, balance sheets in the sector are solid, increasing the possibility of higher dividend payments, share-enhancing stock buybacks, and mergers and acquisitions (M&A).
The short-term impact from the COVID-19 pandemic has been mixed for the sector. Some companies within the biotech and pharmaceutical industries stand to benefit if they produce tests and vaccines for the novel coronavirus, but at high cost and potential delays of other trials. Job losses and pandemic fears prompted many people to cancel elective procedures and delay routine care, leading to fewer diagnostic tests and drug prescriptions. It was generally a wash for much of the health-care insurance segment, as lower insurance premium revenues were offset by lower claims. As economies reopen, we’re seeing the COVID impact reverse, and indeed, the earnings outlook has improved.
There are still risks, however. The Supreme Court is expected to rule on the constitutionality of the individual mandate provision of the ACA in 2021, which could—in the most extreme scenario—lead to repeal of the entire ACA. However, in the opening arguments heard on November 10, the majority of the justices indicated that a total repeal is unlikely. Perhaps just as importantly, a poll conducted in October by KFF1 found that 58% of respondents supported the ACA and 79% wanted to maintain pre-existing coverage—so it’s likely that politicians would quickly find a bipartisan solution if a total repeal were to occur.
Additionally, there is broad popular support for prescription drug price controls, which could significantly impact the pharmaceutical industry’s profits. However, the Republican Senate did little to advance this initiative over the past several years, and a split Congress would be even less likely to pass substantive legislation. President Donald Trump did issue some executive orders to reduce drug prices on a limited basis, but none were implemented, amid questions as to the legality of the orders (and high hurdles even if they were legal). It’s unlikely that any future executive orders would be easily implemented without the consent of Congress.
Finally, there was a risk that the 2017 corporate tax cuts—of which the health care sector was a major beneficiary—could be reversed. But this will likely come off the table with a split Congress. Bottom line, we think that the short- and long-term positives for sector outweigh the negatives—particularly with election-related anxieties declining.
Positives for the Health Care sector:
- Strong balance sheets, with ample cash for dividends and M&A;
- Positive long-term demographics trends, including an aging global population and a growing middle class in emerging markets;
- Pent-up demand for elective procedures, drug sales, medical equipment and diagnostics likely will be a positive;
- Valuations are attractive relative to the sector's historical average;
- Positive long-term price momentum.
Negatives for the Health Care sector:
- Hospitals have been squeezed by high COVID-19 preparation expense (although they received some stimulus relief);
- Pharmaceutical and biotechnology companies face a high cost of testing and delays in new trials;
- Higher unemployment reduces health care insurance enrollment;
- Extended-care facilities are likely to see higher costs related to virus mitigation requirements.
Risks for the Health Care sector:
- Supreme Court ruling on constitutionality of the Affordable Care Act (ACA);
- Popular support for prescription drug price controls;
Maintaining Financials at outperform
In general, we believe that the Federal Reserve has much more influence on the economy and markets than the politicians in Washington. Another split Congress would dampen expectations for a large fiscal spending package. However, a moderate fiscal stimulus combined with a Fed that is likely to be very cautious about raising rates and the potential for an effective vaccine could push longer-term interest rates higher—augmenting solid fundamentals in the Financials sector.
Banks’ balance sheets came into the pandemic crisis relatively strong, thanks in part to stringent regulations put in place since the financial crisis of 2008. The recent stress tests conducted by the Federal Reserve confirmed this. Under the most rigorous scenario—a W-shaped double-dip recession—banks’ aggregate capital reduction would leave them with still-adequate capital ratios. Previous fiscal and ongoing monetary stimulus measures, which have contributed to the recovery should soften the expected wave of bankruptcies and defaults.
The Fed’s commitment to keep short-term interest rates low likely opens the possibility for the yield curve (the difference between short-term and long-term interest rates) to steepen, which would help net interest margin revenues. Up until now, investors have remained focused on the interest rate headwinds, resulting in poor stock price momentum. A steepening of the yield curve could reverse that. The sector tends to outperform in the early expansion phase of the business cycle, and we think that quite attractive valuations and strong financial positions are enough to lead to outperformance. Risks would include: the surge in COVID infections could result in renewed stay-at-home orders, stalling the economic recovery, or there could be significant increase in regulations on the sector under the new administration. But stacking up the positives, negatives and risks, we think that the sector is more likely to outperform the overall market in the coming months.
Positives for the Financials sector:
- Strong financial position due to stringent post-2008 regulations;
- Economic recovery and fiscal stimulus are tailwinds for loan demand, and likely will limit defaults;
- Cautious Fed along with improving growth prospects has started to steepen the yield curve;
- The sector has attractive valuations relative to its historical average and other sectors;
Negatives for the Financials sector:
- Despite longer-term rates trending higher, interest rates in general are expected to remain low;
- Rising loan defaults are inevitable, but banks have set aside large loss reserves;
- Longer-term price momentum of the sector has been weak.
Risks for the Financials sector:
- A stalled recovery, or renewed economic shutdown due to spike in COVID-19 cases;
- Not enough fiscal stimulus needed to foster a continued recovery;
- Increased banking regulations.
Demoting Consumer Staples to underperform
In recent months, pandemic-related social-distancing behaviors have bolstered grocery, big-box discount retailers, and household goods sales—although some of the food wholesalers that service restaurants have faced headwinds. Retailers within the sector have aggressively cut costs, leaving them in reasonable financial condition.
However, limited pricing power in a low-interest rate environment gives them less–than-exciting top-line growth potential. With the confluence of the above factors, we think that the economic recovery has a better chance of maintaining traction. At this stage of the business cycle, the Consumer Staples sector typically underperforms the overall market. While longer-term price momentum has held up, we think that growing confidence in the economy will weigh on relative performance going forward.
Positives for the Consumer Staples sector:
- It typically has a stable earnings profile;
- Its defensive characteristics tend to be a positive during periods of market volatility;
- Companies have engaged in aggressive cost-cutting;
- It has solid relative valuations.
Negatives for the Consumer Staples sector:
- An improving economy and strong stock market historically has made the sector relatively less attractive to investors;
- Companies tend to have limited pricing power in a low-inflation environment.
Risks for the sector:
- Additional government fiscal stimulus and the future availability of a COVID-19 vaccine could further support the economy and reduce stay-at-home food and staples demand.
Maintaining Utilities at underperform
Despite some recent outperformance amid pre-election expectations for a major clean-energy and infrastructure package under a potential Democratic sweep, we think the sector will resume its underperformance trend that started in early March, assuming that this legislation is much less likely.
The Utilities sector has tended to perform relatively better when concerns about slowing economic growth resurface, and to underperform when those worries fade. That’s partly because of the sector’s traditional defensive nature, given its steady revenues—people need water, gas and electric services during all phases of the business cycle. And low interest rates that typically come with a weak economy provide cheap funding for the large capital expenditures required in this industry.
However, valuations have been driven up to well above their historical average in recent years, as investors reached for yield in this era of low interest rates. We think that these high valuations may decrease the sector’s traditional defensive characteristics in the event of a market downturn.
The lack of a Democratic “blue wave” in Congress significantly decreases the likelihood of a large infrastructure package, which would have meaningfully funded subsidies for building out electrical grids and clean energy infrastructure. Even without major government intervention, the trend toward clean energy will likely continue, as consumers move toward electric cars (increasing demand for electricity) and cost of production declines with new technologies. But without government subsidies, the utility companies will have to fund more of the capital expenditures themselves.
On top of that, while longer-term interest rates are expected to remain generally low, there is the risk that they could edge higher as the economy continues to expand or inflation unexpectedly picks up. Bottom line, we think the Utilities sector will underperform in the coming months as some of the pre-election enthusiasm priced into the sector unwinds, and high valuations depress the sector’s defensive characteristics in the event of an increase in overall market volatility.
Positives for the sector:
- Generally stable revenues;
- Investors often turn to utilities for dividend income when prevailing interest rates are low;
- Low yields provide low funding costs for this capital-intensive sector.
Negatives for the sector:
- Valuations are high relative to the sector’s historical average, potentially reducing defensive characteristics;
- Reduced expectations for a large infrastructure package;
- Economic recovery makes the sector less attractive relative to other sectors.
Risks for the sector:
- Higher interest rates due to an unexpected rise in inflation.
1 Kirzinger, A., et al, “KFF Health Tracking Poll – October 2020: The Future of the ACA and Biden’s Advantage on Health Care,” KFF, October 16, 2020.
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The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market
- Marketperform: likely to track the broader stock market
* As represented by the S&P 500 index
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