Multi-asset allocation views: Emerging themes for portfolio diversification

The macroeconomic environment looks relatively positive at present, which explains why we remain overweight equities and underweight government bonds. However, we are always looking for ways to diversify our portfolios through more thematic ideas.

US healthcare and industrials are two examples. Diversification benefits come in the form of attractive sector-specific characteristics, while holding them together reduces any directional bias to risk appetite or economic growth expectations – healthcare being more defensive and industrials more cyclical.

Healthcare: A defensive sector with growth opportunities

Healthcare is the more interesting of the two, not least because our view on the economy and the natural read-through to corporate earnings does not tally up with the defensive nature of the industry. The sector tends to have quite stable earnings growth - as opposed to cyclical exposure to a pick-up in the economy - but offers two attractive features.

Firstly, while there is currently no shortage of ways to express a positive view on economic growth – for example, being long equities, short government bonds or duration, or taking any one of a number of cyclical positions available in the equity market – there are fewer options for investors to diversify with a position that could outperform if markets entered a risk-off period.

However, healthcare tends to do well when risk appetite reduces. In part, this is because its business drivers do not depend on economic sentiment and the quantity of available discretionary spending, but on factors like government spending programmes and the development pipeline of new drugs. In addition, the earnings profile and earnings growth have been more stable for the sector than the overall market.

Figure 1: Resilient earnings – 3-year trailing earnings growth (healthcare versus S&P 500) (per cent)

For illustrative purposes only. Past performance is not a reliable indicator of future returns.
Source: Refinitiv Datastream, data as of August 15, 2021

The second reason is more profound. Structural changes have been unfolding in the sector recently, creating a potential asymmetry and providing the main reason why healthcare may not underperform even in a positive environment.

For a long time, investors have seen large pharmaceutical companies as being overextended in terms of their in-house research and development (R&D) spending, with returns in the last two decades below historical levels. Several blockbuster drugs from the 1990s and early noughties rolled off without being replaced with similarly successful ones, throwing up challenges around R&D spending. This led to quite a strong push from investors for large pharma companies to outsource R&D and return cash to shareholders.

Interestingly, returns on R&D have started to improve. A good example can be seen in the way COVID-19 led to fast-track approvals for mRNA-based vaccines – those that use small bits of genetic code to convey vaccines.

The technology had been developing in recent years but there was concern around how long it would take regulators to become comfortable with it. When COVID-19 spread around the world, that significantly lowered the hurdle; while mRNA technology is still new, regulators’ willingness to allow a drug to proceed based on the technology has come a long way. This is opening a host of new possibilities for other vaccines where mRNA could be used.

As of February 2021, 44 clinical trials globally were assessing some form of mRNA vaccine, with 23 for infectious diseases. Most are still COVID-19-related, but we are beginning to see applications beyond that.¹

The combination of new technologies and a more open-minded approach from regulators is increasing prospective returns on R&D. This is evident in the share-price performance of some specialist R&D companies, a trend that emerged before the pandemic to some extent, but not in the large pharmaceutical firms. There may be a significant pocket of undervaluation in the latter.

Figure 2: Relative price-to-earnings ratio remains close to all-time lows (healthcare versus S&P 500)

For illustrative purposes only. Past performance is not a reliable indicator of future returns.
Source: Refinitiv Datastream, data as of August 15, 2021

The third structural change is demographics. It has long been known that, with an ageing population, the potential demand for therapeutics should increase, but this is something pharmaceutical companies have struggled to monetise. Revenue growth could have been held back by the lack of progress on technology or regulatory approvals, so recent advances in both areas could present interesting opportunities, while continuing to add defensive characteristics to a portfolio in risk-off scenarios.

These trends are most obvious in US healthcare, which is at the forefront of adopting new technologies and benefits from the speed of regulatory approval compared to other countries. A study comparing decision making by the US Food and Drug Administration and the European Medicines Agency showed the former approved around 20 per cent more drugs in a given time period with a review time that was 70 days shorter.²

Industrials may benefit from capex intentions

US industrials looked attractive at the start of the year thanks to many investors underappreciating the strength of the economic recovery, particularly as Democrats gaining control of the Senate made the approval of a large infrastructure package more likely.³

As the year has progressed, these themes became more mainstream, lessening the appeal of the sector. However, two things have happened subsequently that have made industrials attractive again.

Firstly, market sentiment has moved back from a bullish view to a more neutral one now the likelihood of an infrastructure deal has been priced in and growth sentiment, albeit robust, has peaked. This has led the sector to slightly underperform the broader market since the middle of the first quarter.

Figure 3: US industrials underperformed the broader US market (S&P500 industrials versus S&P500 index)

For illustrative purposes only. Past performance is not a reliable indicator of future returns.
Source: Aviva Investors, Bloomberg, data as of September 15, 2021

In addition, we are starting to see a pick-up in companies’ capital expenditure (capex) intentions, something that has historically been supportive for industrials, against a backdrop of low relative earnings. As Figure 4 shows, the sector’s earnings have increased but are only just returning to pre-COVID-19 levels, whereas earnings in the broader market are well above those.

Figure 4: US industrial earnings versus total business earnings

For illustrative purposes only. Past performance is not a reliable indicator of future returns.
Source: Macrobond, data as of May 31, 2021

We would expect to see some of that feed through into industrials. We also now have the rough outlines of upcoming US infrastructure spending, as well as the pick-up in capex intentions, so forward earnings should start to rise. This would be supportive for the sector, which typically sees a gap from the moment earnings bottom out to when this impacts share prices.

Figure 5: US capital spending plans

For illustrative purposes only. Past performance is not a reliable indicator of future returns.
Source: Aviva Investors, Bloomberg, data as of September 15, 2021

Bringing it together

For style-agnostic investors aiming to achieve diversification within their equity holdings, bringing the healthcare and industrials themes together delivers an even balance, industrials being more driven by a strong economy and healthcare more defensive.

But what makes a difference is both are currently benefitting from positive sector-specific catalysts – the technology and regulatory environment for healthcare and increasing capex plans for industrials. Even if the macroeconomic environment unfolds as we expect, both sectors should benefit.

Put together, this creates a slight asymmetry, delivering some protection in a downturn while retaining upside potential. Almost regardless of the macro environment, this combination is attractive from a multi-asset perspective.