by Jason Norris, CFA
Principal
Equity Research and Portfolio Management
President Biden held his State of the Union Address this week, and while there was a laundry list of proposals, the two that we believe are on investors’ minds are the debt ceiling and the Medicare drug price negotiation.
The debt ceiling is a statutory debt limit that restricts the funds that can be borrowed to meet the government’s financial obligations. Hence, when the federal government gets close to the limit, Congress must vote to increase the level of borrowing to fund operations. While Washington D.C. has been increasing tax revenues at a healthy rate, spending has surpassed revenues over the last 20 years. Thus, the U.S. must borrow greater amounts to fund operations (see below).
Source: CBO
While there is some discretionary spending that can be cut, one budget item, the cost of debt, is expected to increase meaningfully. The U.S. treasury has been fortunate enough to issue debt at attractive rates the past 10 years, however, this low-interest rate regime is coming to an end. Over the last decade, the 10-year treasury yield averaged roughly 2.0%; currently, the yield is averaging at around 3.7%, with borrowing costs at their highest level since 2010. Interest costs as a percentage of revenue are roughly 10%, which is still low relative to historical performance (see chart). However, with an increase in borrowing and higher rates, that cost is expected to rise, taking up even more of the annual budget.
Source: Federal Reserve and CBO
In response, we believe that there will be a combination of spending cuts and a slowing in the growth rate of discretionary spending, with defense, healthcare and technology being the sectors most likely to be affected. Despite this, we do not believe that the U.S. will default on its debt obligations. This fear came to a head in 2011 and resulted in the U.S. treasury being downgraded from AAA credit to AA. Therefore, if there is an equity market sell-off due to these concerns, we believe it will be short lived and potentially a buying opportunity.
I Want a New Drug
During the State of the Union Address, President Biden also highlighted the recently passed law that will allow Medicare to negotiate drug prices. Clients have been concerned about investing in the pharmaceutical industry due to this legislation. While there is still uncertainty regarding the number of discounts that will be negotiated as well as which drugs are eligible for negotiation, we decided to take an initial look at who may be most impacted. With the help of research from Evercore ISI and Morgan Stanley, we put together a list of drugs with the most exposure, as well which companies may see the largest decline in revenue.
Source: Evercore ISI and Morgan Stanley
Looking at preliminary estimates, the revenue hit to manufacturers looks to be less than 5% and will commence in 2026. Additionally, there still is a lot of uncertainty over how the actual negotiations will work. Therefore, when investing in the pharmaceutical space, we need to be mindful that things can change. However, we expect the impact on the companies to be minimal.
Takeaways for the Week
Markets remained volatile as investors digested corporate earnings and stronger than expected economic data
In response, both stocks and bonds declined