A Secular Growth RevivalASecularGrowthRevival

The healthcare sector of the S&P 500 Index declined -4.3%, trailing the overall Index’s 7.5% return. Additionally, the Nasdaq Biotechnology Index declined -1.8%. Over the trailing 12 months, the healthcare sector of the S&P 500 Index fared much better than the broad market, returning -1.8% compared to the Index’s -7.8% decline.  

While the healthcare sector has broadly outperformed over the prior year, it has primarily been driven by larger market cap pharmaceutical and managed care companies that are able to fund their businesses with cash generated from operations. With that being said, medical device as well as smaller capitalized, earlier stage companies have trailed index returns for three of the past four quarters. In Q4, some macro trends that pressured many industries began to reverse as supply-chain constraints, chip shortages, nurse shortages, and the strong U.S. dollar headwinds became tailwinds that are leading to attractive growth prospects for select pharmaceutical, healthcare equipment & supplies, and biotech companies.  

As we look towards the remainder of 2023, we believe that the sector has begun to show signs of leadership again as investors place more emphasis on stable company fundamentals and the significant alpha-generating opportunity that broad innovation can provide. As a result, we believe that the strong relative performance the sector achieved in 2022 is sustainable as an acceleration in investment and innovation is not yet reflected in the price of many stocks. 

Ongoing Fed tightening (over a very short period of time) as well as geopolitical and inflationary concerns continue to impact market returns and volatility. This market backdrop has resulted in increased expectations that we may be headed toward a hard-landing recession. The financial sector would be negatively impacted if this would occur, specifically around higher credit losses and slowing consumer/business lending activity. This dynamic has showed up across all risk assets. For example, high yield spreads remained at elevated levels throughout the quarter. The financials sector of the S&P 500 Index returned -3.4% in Q1 versus the 7.5% return of the broad S&P 500 Index, thus reflecting the vulnerability of the sector to a severe economic recession.  

This situation was further complicated in March when the entire sector became stressed due to significant uncertainty around funding quality and credit dynamics. Of course, this was driven by the SVB default, the Credit Suisse government-mandated takeover by UBS, along with major questions about the liquidity profile of several regional and community banks. At this point, the concern and fear around banking-sector health seems to be centered on liquidity and duration differences between a given bank’s assets (i.e., loans and securities) and liabilities (i.e., deposits and term funding). The government’s actions continue to address these concerns. In addition to liquidity, we believe another key risk to banking health is the status of loan quality. Banks carry significant exposure to commercial real estate (CRE), which is experiencing significant secular (post-Covid) and cyclical challenges. As this economic cycle potentially turns, asset quality will need to be watched closely. 

Further income statement pressure will come from continued labor cost pressures, but this is being offset by improved tech-driven efficiencies and generally better overall operation of the businesses by management. Nevertheless, the market is less concerned with these dynamics and is solely focused on the expectation of a future economic slowdown and the course of Fed tightening. For the quarter within the sector, consumer finance did the best (bouncing back in price return after a very difficult 2022), with the banks performing the worst (as expected) with low-teens negative returns.  

Property and casualty insurance remains a safe haven given its defensive nature and strong pricing dynamics. Additionally, it has an attractive valuation and a reasonable earnings floor to support the industry under a more difficult macro environment.

Despite lagging the return of the S&P 500 Index during the first quarter, midstream energy continued to gain ground to start the year. While energy broadly staged a strong rally in the last two weeks of March -- and remains the best-performing sector since late 2020 by a wide margin -- it was one of the worst-performing sectors during the quarter. Weak oil and gas prices, coupled with recessionary fears stoked by regional and global bank failures, weighed on the broader group. Midstream was one of the best-performing segments of energy over the period, lagging only the refiners, and outperformed the broader market during January and February. For the full three-month period, the Alerian MLP Index gained 4.0%, underperforming the S&P 500 Index.  

Midstream energy has successfully transformed itself over the past few years, and we believe the group is well positioned both near and long term. Actions taken before and during the pandemic resulted in behavioral changes that are still in place today. Fourth-quarter 2022 earnings results were mostly above expectations and highlighted that the fundamental outlook remains favorable. Dividends and cash flow rose year-over-year and share buybacks continued to play an important role in capital allocation and stock valuation support. While some of the strong tailwinds from 2022 (e.g., extreme commodity price dislocation due in part to Russia’s invasion of Ukraine) will likely dissipate this year, we expect that tremendous balance sheet strength and attractive valuations should buoy the sector. Capital discipline continues to drive management decisions and we believe the sector will continue to operate judiciously, remaining free cash flow positive and returning capital to shareholders.  

Over the longer term, we expect midstream energy companies will play an important role in our energy future. The global energy transition will require multiple sources of energy to be successful and hydrocarbons – especially natural gas -- is expected to continue to have a role, driving future demand not just for the commodities but for the essential logistical systems that move them. With physical steel in the ground, midstream energy infrastructure companies have difficult-to-replicate asset networks with high barriers to entry, and whose adaptability to transport other energy sources is underappreciated. Management teams are increasingly aware of the role they will play in our energy future, focusing not just on the environmental impact of their operations but also on how their asset bases can and will be part of a greener future.

Volatility in bond yields and falling power prices weighed on utilities during the quarter and the group was one of the worst-performing sectors of the market. The utilities sector of the S&P 500 Index underperformed the broader S&P 500 Index by more than 10%. The group gained back a bit of ground in March as defensive sectors benefitted from a flight to safety due to increased recessionary fears around regional and global bank failures. The utilities sector of the S&P 500 Index finished 1Q23 with a -3.2% return versus the +7.5% return of the S&P 500 Index.  

Despite giving back more than half of the relative performance gains from last year, utilities still outperformed the S&P 500 Index significantly on a trailing 24-month basis, driven predominantly by a meaningful recovery in 2022. The group had been the worst-performing sector on a trailing two-year basis prior to 2Q22, despite strong fundamentals. Even during this period of economic volatility, the companies continued to execute operationally and deliver strong earnings, while also de-risking their portfolios. We believe continued solid execution, along with the potential growth opportunities from renewable energy investments, should help to drive the sector’s earnings going forward. In addition, continued geopolitical concerns and a flattening yield curve remain tailwinds. Strong fundamentals and macro factors underscore the opportunity in the sector, especially given what remains a lower-than-average interest rate environment.