Rate cuts are on the horizon, and it's the moment biotech companies and their investors have been eagerly anticipating.
Biotech stocks have struggled to deliver the kind of returns typically associated with the "tech" in their name. The SPDR S&P Biotech ETF (XBI) has only achieved a 4.6% annualised return over the past five years, significantly lagging behind the S&P 500's 16% return. The last time the biotech sector outperformed the broader market was in 2020. A major factor behind this underperformance is that over 80% of the companies in the biotech ETF are losing money, making it difficult for them to raise the necessary funds for research and trials—especially with interest rates exceeding 5%.
However, relief appears imminent. The Federal Reserve is expected to cut rates for the first time since 2020, with the futures market indicating a 65.5% probability of a quarter-point cut and a 34.5% chance of a half-point cut when the Fed makes its announcement on September 18. This is significant for biotech stocks, which have historically moved inversely to interest rates.
According to Jefferies analyst Michael Yee, the SPDR S&P Biotech ETF has a strong negative correlation with interest rates, meaning that when rates rise, biotech stocks tend to fall, and when rates fall, the stocks generally rise. "With rates at a 20-year high, the potential for the first rate cut in years may create a more favorable environment for biotech, supporting our view that 2024-2025 will be better years for performance," Yee explains.
The landscape for biotech stocks has also shown signs of improvement. In the second quarter of 2024, 693 small- and mid-cap biotechs were cash-flow negative, a decrease from 949 in the same quarter of 2022, and the same number as in the first quarter of this year. This suggests that the most financially troubled companies have either delisted, been acquired, or simply faded away, which could stabilise and consolidate the sector, according to Mizuho analyst Uy Ear. Additionally, these companies now have an average of seven quarters' worth of cash on hand, a figure that has held steady over the past three quarters, up from 5.9 quarters in the first quarter of 2023.
The positive momentum is already evident in biotech stocks. The SPDR S&P Biotech ETF has risen 12% over the past three months, nearly double the S&P 500's 6.7% gain. Mark Newton, global head of technical strategy at Fundstrat, believes the gains are likely to continue, citing "very attractive basing patterns" in the SPDR S&P Biotech ETF, the iShares Biotechnology ETF (IBB), and other healthcare sector areas.
"Expect continued outperformance at a time when many are focused solely on technology," Newton writes. "Given that healthcare is the second-highest weighted sector within the S&P 500, behind technology, strength in this sector is very constructive for the broader market and provides a subtle but meaningful tailwind."
