Health Care Investors Should Brace For Impact (XLV)

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June 27, 2017 6:10am NYSE:XLV

From Invesco: Commanding much attention last week was the release of the Senate’s version of the American Health Care Act, which was recently passed by the House.

The Senate bill was perceived to be a kinder, gentler version of the House’s bill. However, criticism was almost immediate — and came from both sides of the aisle. The bill has some important commonalities with the House’s version of the bill that would be appealing to conservative legislators.

  • First of all, it increases the costs of premiums for older people versus younger people; the ratio had been 3 to 1 under the Affordable Care Act (also known as Obamacare), while under this version it would be 5 to 1. The objective behind this change is to increase participation among young people. (Think of it as a “carrot” approach rather than a “stick” approach, such as penalties for not signing up.)
  • Importantly, the Senate bill reverses the Medicaid expansion created by the Affordable Care Act for those living above the poverty line. The expansion would be fully reversed by 2024 (to pre-Affordable Care Act levels) and then the bill would actually reduce Medicaid spending even further, below levels it was at before the ACA was enacted.
  • In addition, the Senate’s proposed bill would eliminate a significant amount of taxes currently levied by the Affordable Care Act, repealing them at varying times. For example, the tax on tanning-bed use would be repealed in 2017. The tax on branded prescription drugs and medical devices would be repealed in 2018. The 1.45% Medicare payroll tax surcharge for high-income individuals (those earning more than $200,000 a year or $250,000 for joint returns) would be repealed effective 2023. And the 3.8% tax on investment income (also known as the Medicare unearned income tax) would be repealed in 2017.
  • It is also worth noting that the proposed bill before the Senate would allow states to drop essential medical coverage currently required by the Affordable Care Act, including emergency services, maternity care and mental health care. Some of these elements of the proposed legislation are “hot button” issues that could jeopardize incumbents’ Senate seats in “swing states,” making the stakes very high.

The Senate bill faces opposition from both sides

As of this writing, it appears that the bill may not be passed by the Senate given that five Republican senators oppose it in its current form — as well as all of the Democrats. However, this situation could change quickly. The coming days will undoubtedly be filled with negotiations, which could result in amendments to the bill crafted to win the support of enough senators to grant passage. Then a committee with representatives from both the House and Senate will work to craft a compromise bill, which would be the final version of the bill presented to both the House and Senate for vote; a simple majority in each respective chamber would be needed before the bill is sent to the president for signature into law.

The problem with the above scenario is the return trip to the two chambers — particularly the House. Recall that the first version of the “repeal and replace” health care bill could not win support in the House; hence, a second version was created that was more appealing to the conservative Freedom Caucus. The bill depended upon that conservative support in order to win passage. However, a compromise version could more closely resemble the first iteration of the “repeal and replace” health care bill rather than the second iteration, meaning it could be very difficult to win enough House votes for passage.

More ‘Fedspeak’

Not to be outdone by legislators, a number of Federal Reserve (Fed) officials were vying for some attention last week, out in full force with a variety of speeches. Interestingly, inflation was an important topic for them, with two different factions appearing to emerge on the topic of inflation. One faction — which includes Chair Janet Yellen, Federal Reserve Bank of New York President William Dudley and Federal Reserve Bank of Cleveland President Loretta Mester — indicated that they are of the opinion that the lower inflation we have seen over the past few months is temporary. Conversely, the other faction — which includes Federal Reserve Bank of Dallas President Richard Kaplan and Federal Reserve Bank of Minneapolis President Neel Kashkari — are concerned that the recent phase of lower inflation may be stickier. And that, of course, has implications for monetary policy.

For example, Mr. Kashkari voted against raising rates in March and June, and pointed to low inflation as a reason for his vote to keep rates lower. But we can’t assume Chair Yellen is getting hawkish because she believes lower inflation is transitory. She has also been advocating for an increase in the Fed’s inflation target — which arguably would result in something of the same monetary policy outcome: lower rates for longer. In a speech last week, Chair Yellen argued that the debate over whether central banks should raise inflation targets is “one of the most important questions facing monetary policy.” Some economists have argued that a higher inflation target — such as 3% — could be economically stimulative, giving companies the confidence to raise prices for goods and services — and pay more for labor — without worrying that borrowing costs would be increasing significantly. In other words, this could be something of a game changer, enabling the economy to grow unfettered to a level unseen in years.

What do the Fed’s statements mean for policy?

The recent Fedspeak on inflation suggests the possibility of greater confusion about the Fed’s monetary policy — and the possibility of a policy error — going forward. After all, some economists, including Invesco Chief Economist John Greenwood, argue that the Phillips Curve — the theory that inflation and unemployment have an inverse relationship — does not fully explain inflation. In other words, a tight labor market, and therefore higher wages, doesn’t drive inflation; rather, money and credit drive wages and commodity prices, which then drive inflation. So even though the labor market is tight, there will not necessarily be higher inflation as long as money and credit growth remain low. (This is exactly the situation in Japan.) The Fed therefore needs to be cognizant of the real risks that it will be running while shrinking its balance sheet. Specifically, if Treasury and agency auctions need to increase by up to $50 billion per month by the end of 2018, this could have a serious dampening impact on credit growth. Chair Yellen may find that the runoff of the Fed’s securities cannot simply happen “in the background” and may instead become front and center.

So, what if the Fed slows its rate hike cycle — either because it believes subdued inflation isn’t that transitory or because it has increased its inflation target? It may not matter if the key to boosting inflation is credit expansion. That may require other Fed tools — and business confidence. Keep in mind that if we see further downside in inflation, growth may no longer be the primary driver of markets as investors shift their focus to inflation or Fed error. We will need to watch this closely.

Looking ahead to next steps

On health care, we’ll have to follow the situation closely, as the outcome of this proposed legislation may impact the success of any tax reform legislation, which will presumably follow soon after. This coming week the Congressional Budget Office is expected to release its assessment of the bill and its implications from a budgetary and economic perspective, which will be key. Also, we’ll need to keep an eye on the debates. However, because the bill is being included as part of the larger Budget Reconciliation for 2018, there can only be 20 hours of debate on the bill.

Given the recent Fedspeak, the dollar appears vulnerable to more downside pressure, especially if we get any weak economic data releases. On the docket for the last week in June is more housing data, more Fed officials’ speeches, consumer sentiment and the final reading of gross domestic product growth for the first quarter.

And then there are concerns about the debt ceiling, which will soon loom large. Treasury Secretary Steven Mnuchin has asked that Congress raise it before leaving for its August break, because without doing so the government could run out of money in September. (Secretary Mnuchin said he is only “comfortable saying we can fund the government through the beginning of September.”) However that might be difficult for legislators already working on health care legislation — and then presumably tax reform.

Subscribe to the Invesco US Blog and get Kristina Hooper’s Weekly Market Reviews in your inbox. Simply choose “Market & Economic” when you sign up.

The SPDR Health Care Select Sector Fund (NYSE:XLV) was unchanged in premarket trading Tuesday. Year-to-date, XLV has gained 16.61%, versus a 8.84% rise in the benchmark S&P 500 index during the same period.

XLV currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 36 ETFs in the Health & Biotech ETFs category.

Important information

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The opinions referenced above are those of Kristina Hooper as of June 26, 2017. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

This article is brought to you courtesy of Invesco.

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