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Strategy Update

Ozempic and a Market of Megatrends

There has been growing adoption of new weight-loss drugs throughout this year, driving enthusiasm for the two manufacturers of these drugs, Eli Lilly and Novo Nordisk. After a year of strong gains, these two companies are now the first- and third-largest healthcare companies in the world as measured by market capitalization. Novo Nordisk’s success is so significant that it has single-handedly raised the economic outlook for the entire country of Denmark, which is where Novo is based.

The success of the weight loss drugs has set in motion a counter-trend for many other medical companies. On July 20th of this year, a seemingly innocuous comment from Intuitive Surgical, the leading manufacturer of robotic surgical equipment, triggered a widespread move in dozens of leading medical companies when the company announced it had seen a slight softening in demand for bariatric surgeries. The language was measured, but the stock market was swift in its reaction. Shares of Intuitive Surgical, and many medical equipment peers, began to fall in July.

Investors have now started to map out a new megatrend within the economy and stock market. Their assumption is that the world is going to be reshaped by widespread adoption of weight-loss drugs. Eli Lilly and Novo Nordisk have continued to gain momentum since the summer, while the list of medical companies losing value has grown longer and longer. Shares of medical companies treating sleep apnea, diabetes, heart disease, and kidney failure have all plummeted, some by as much as 50% in just a few months. Makers of knee and hip replacements have lost a quarter of their value, as investors contemplate a population putting less wear and tear on their joints. The entire medical equipment sector within the S&P 500 has declined by roughly 30% since the end of July. More recently, makers of packaged foods and restaurants have joined the decline. Shake Shack, Pepsi, Utz Brands, and Kellogg are just a small sampling of food companies that have lost nearly a quarter of their value or more in recent months. Food packaging companies are declining, as are companies that sell equipment to restaurants.

Much like the enthusiasm around artificial intelligence (AI) that we wrote about in the summer, the excitement over weight-loss drugs has a legitimate foundation. The clinical effects of these drugs are significant. A follow-up trial by Novo has shown that Wegovy, its leading weight loss drug, can reduce heart attacks and strokes in certain populations. Widespread adoption certainly has the potential to alter medical care and, to a smaller degree, food consumption. But as with AI, the impact within the stock market seems overly swift and exaggerated. Is society on the brink of seismic change that will alter everything? Or is there a reason why investors might be too willing to buy into that narrative and overextend themselves?

In our view, the macroeconomic backdrop matters tremendously in helping explain the emergence of two market megatrends in the same year. At the moment, the average stock is beset by two problems. First, interest rates continue to climb, which then pressures valuations for most companies. With investors able to get 5% in a money market fund or Treasury Bonds, many stocks simply have to get cheaper to remain mathematically compelling. And second, the economic outlook is atypically cloudy, with conflicting signs of strength and weakness throughout many pockets of the economy. The average stock in the market is on pace for another negative year at the moment, given the interest rate headwind and economic uncertainty.

Faced with these inferior returns, it’s understandable that investors would latch onto any narrative that seems simple and compelling. Whether that narrative concerns AI or weight-loss drugs, at a minimum an investor can say confidently that these trends will have some impact in the future. Of course, “impactful” is not the same thing as “transformative,” but in an environment where it has become quite hard to build confidence around most investment themes, it is not surprising to see investors potentially overplaying their hands when it comes to these two trends.

Current Strategy

The third quarter was challenging for stocks. The enthusiasm for AI stocks began to fade; most medical stocks were weak; and consumer staples companies fell sharply. The slide in most stocks has continued into October, as rising interest rates have exerted more pressure on stock valuations. Economic data continues to offer a mixed view on the economy, with the labor market remaining healthy even as consumer spending is under some pressure from rising interest rates. To illustrate the conundrum presented in the data, it seems most people are still able to find a good job, but more of their salary may be going towards 8% mortgages, higher rents or burdensome auto loans.

The set-up for many stocks and industries has not felt very compelling through the summer and early fall. For most clients, we were selling stocks in equal measure with any new buys. That is beginning to change, as the stock market churns lower and approaches a modest correction. More companies are showing the economic impact of higher rates, and earnings are starting to suffer, with share prices following them lower. In our view, the table is being set for a more prolonged, durable and widespread recovery in stocks in the future. For many clients, we have a lot of cash on hand, setting us up to begin stepping back into the stock market. But as always, we will invest in stocks judiciously, especially recognizing the current value of cash that yields above 5%.

The bond market may be nearer an inflection point. The shorter-term end of the bond market has not moved materially now for several months. There are growing expectations that the Federal Reserve is near the end of its rate hiking cycle, and the primary question now is how long they may keep rates at current levels. Inflation is declining, although the Federal Reserve would like to see it decline more significantly. The long-term end of the yield curve (typically bonds that mature in 10-30 years) is struggling, and yields are rising. Investors can now get reasonably good rates of interest for the next decade. Committing money for that long can be scary, and cash, at the moment, is just as rewarding. But it is not likely that cash yields will stay this high forever, and fixed income investors must plot years into the future. With some bonds maturing very soon, we are looking to extend the maturity of the fixed income portfolio for clients to ensure that we can earn a good rate of interest for years to come.