Ready for Fed Rate Cuts? Biotech's Potential to Watch

The Federal Reserve appears poised to cut interest rates later this year. While the broader stock market might breathe a sigh of relief, certain sectors could be more significantly impacted than others. Biotechnology could be one of those sectors - at least, that's what Morgan Stanley believes.

In 2024, biotech stocks had a slow start, with the S&P Biotechnology Select Industry Index returning just under 4% in the first six months, compared to a 15% return for the S&P 500 Index.

However, optimism may be returning as inflation continues to decline and the likelihood of a Fed rate cut in September increases. In fact, since July 11, when the U.S. Consumer Price Index fell to a 3% annual rate for the first time in a year, the S&P Biotechnology Index has outperformed the broader market.

This difference in returns has a precedent. The biotech sector we posted gains in the one-month and six-month periods following the first rate cut in seven out of the last eight rate-cut cycles, according to an analysis by Redburn Atlantic. Twelve months later, the sector outperformed the S&P 500 by an average of 16%.

When interest rates decrease, the biotech sector - comprising companies at the forefront of medical technology - tends to outperform the broader market, especially when rates are still high but starting to decline. This is the scenario we're witnessing today.

Low valuations have helped support positive returns. Biotech valuations were depressed due to a three-year downturn that ended in late 2023. As a result, by mid-July, nearly 130 biotech companies had negative enterprise values - indicating that the pricing of these companies suggested any research and development (R&D) would only reduce, rather than add to, their value. While this number is down from a peak of 232 last year, it remains significantly higher than pre-recession levels.

1. Since biotech companies typically focus on developing complex concepts and products that generate revenue over the long term, their cash flows are often far in the future. Remember, to calculate the present value of these future earnings, you discount them over time using the interest rate as the discount rate. The further into the future these cash flows are, the more significant the impact of the discount rate. Therefore, when interest rates decrease, the present value of these cash flows can increase substantially.

2. Lower interest rates reduce companies' borrowing costs. In the biotech industry, this makes it easier to finance the development of new products. For large companies looking to make acquisitions, this also means they are more likely to afford smaller biotech firms, even at higher prices.

3. Biotech companies tend to focus on the long-term development of unique, high-value treatments and therapies rather than on boosting short-term sales or profit margins. This means they are less affected by the typical reasons for interest rate cuts, such as reduced pricing power.