Ever notice how whenever government subsidizes an area of the economy, cost skyrockets? We have been seeing it with education, funded by government student loans. We saw it (and are seeing it again) with housing, funded by government-sponsored enterprises like Fannie Mae (FNMA, Financial) that bought all mortgages. We see it with health insurance, which even before Obamacare the government tax setup virtually mandated that employers provide their employees.
And we see it with drug prices, as government programs like Medicare and Medicaid cover prescription drug costs. Is it any wonder that when the government pays the bill, costs rise? Seen this way, investing in big pharma stocks, or ETFs like the iShares NASDAQ Biotechnology Index ETF (IBB, Financial), is simply a way of getting some of your taxes back by being on the receiving end of Medicare and Medicaid.
The Congressional Budget Office estimates Medicare spending will top $1 trillion by 2026, though this is quite the conservative estimate, resting on the assumption of low and steady inflation for the next 10 years. What if inflation rises, or even rises quickly as it did in the late 1970s?
The answer is actually worse than simple nominally expanding Medicare costs. Higher inflation would lead to higher interest rates, which would in turn eventually lead to direct cuts in Medicare. This, in turn, could devastate the biotechnology sector. How so?
Biotechnology stocks are heavily dependent on continued government subsidy of drugs. Drug prices can only rise so fast if demand is being artificially subsidized by a government program or two. If ever those subsidies stop, the top-line revenues of even the most stable, strong pharmaceutical companies would plummet. What would happen to their stock prices? Just think of what would happen to the price of college tuition and to the budgets of universities across the country if the federal government simply stopped subsidizing student loans cold turkey.
No need to speculate on the big if, though. We will get a small preview of what could happen to biotech stocks this year as the Independent Payment Advisory Board (IPAB), a bureaucracy set up under Obamacare to advise spending cuts in the event Medicare spending goes above a certain target rate, will likely have to advise spending cuts to Medicare this year. Costs are projected to rise 2.82% with the target rate being 2.62%. The threat of IPAB suggesting cuts in 2016 already caused volatility in biotech stocks last year. The can, though, was kicked down the road because the target spending increase limit was fortuitously not hit last year, by a hair.
If IPAB cuts are triggered this year, Congress will have until April 1, 2018 to implement them, at which point we will have a much better idea of how Medicare cuts will affect the biotech sector as a whole.
As for the bond market, I have already covered in a previous article that interest rates would only have to reach 6.5% across the board for federal debt service costs to eat up the entire discretionary spending budget. That sounds high now, but historically it is considered quite normal. Anything higher than that and interest on the debt would start eating into mandatory spending as well. At that point, Congress would have to start considering more cuts to mandatory spending programs, which includes Medicare.
In other words, if bond yields climb to anywhere near historic norms, the whole biotech sector may start feeling the pinch.
Disclosure: No positions.
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