- It appears that while U.S. economic growth has slowed, we are not yet close to a recession.
- The predictive value of the yield curve is dependent on the duration of the inversion, and it remains important to not overreact while diligently monitoring its status going forward.
- ClearBridge is engaging companies in the drug value chain to improve opioid distribution and develop therapeutic alternatives as well as supporting insurers as they prevent dangerous opioid cases before they begin.
Market Overview and Outlook
In the first three months of 2019 the stock market generated a total return of 13.6%, its strongest quarter in almost 10 years. High-yield spreads narrowed by more than 100 basis points, the U.S. dollar rose 2.5% to approach 18-month highs and the U.S. 10-year Treasury yield fell from almost 2.70% to 2.40%. At quarter end, the U.S. Treasury yield curve (as measured by 3-month notes and 10-year bills) hovered around flat after a brief inversion in the preceding week. German 10-year yields turned negative once again.
Stock market internals echoed the divergent moves in financial markets. Stock market breadth was outstanding during January but narrowed in February and March. The strongest sectors in the market — technology, industrials and energy — were among the weakest sectors during the fourth quarter of 2018. Health care lagged in the first quarter as the government continued its effort to reduce drug prices. Financial services companies also trailed the broader market owing to the flattening of the yield curve. Lastly, concerns about international growth hurt materials performance relative to the market.
The positive news underlying the equity market rally was the U.S. Federal Reserve’s pivot away from further interest rate increases, with March’s “dot plot” suggesting no planned rate hikes in 2019. The markets were also pleased that the U.S. and China seem headed for resolution of their trade dispute.
Worldwide economic weakness, especially in manufacturing, drove the strong U.S. dollar and significant declines in sovereign bond yields. European economies were especially soft as evidenced by an Italian recession, sustained UK Brexit-induced disruption and a weak German PMI in late March (which indicated shrinking manufacturing output). Also, while European banks have improved their capital levels, they are still perceived to lag U.S. counterparts and remain fragile. As an example, Deutsche Bank may be forced to merge with a stronger partner.
The industrial side of the economy showed widespread weakness in the first quarter, hurt by headwinds from the U.S. government shutdown, weather, the strong U.S. dollar and Chinese trade war fears. Durable goods slowed to stall speed, just about 0%. In March we saw the weakest ISM Services PMI since August 2017 at 56.1, suggesting slowing — albeit still positive — growth. One area of concern to us is that short-cycle companies we follow — those whose sales respond quickest to near-term economic conditions such as 3M — saw a deceleration in March.
The consumer side of the economy was much better than the industrial side. The auto SAAR bounced to a strong 17.4 million in March after 16.8 million readings in January and February. Early indicators of March housing sales look good as it appears the U.S. consumer is responding positively to lower interest rates. Perhaps most important, employment remains robust. Unemployment claims of 202,000, as reported for the week ended March 30, were the lowest in 49 years. On balance, it appears that while U.S. economic growth has slowed, we are not yet close to a recession. First-quarter 2019 GDP growth looks like it came in at about 1.7%.
An inverted yield curve is one of the best indicators of an incipient recession, although it is not perfect. Seven of the last 10 recessions were preceded by 10-year Treasury yields below 3-month treasury bonds. While the financial press has made a lot of noise about the inversion, the predictive value of this indicator is also dependent on the duration of the inversion. Therefore, it remains important to not overreact while diligently monitoring its status going forward.
The stock market is at the upper end of its valuation range and most of the opportunities that we see right now are repositioning moves to prepare the portfolio for the later stages of a business cycle. For example, property and casualty insurance companies are very defensive in a recession, while banks suffer from a flat or inverted yield curve. The hit specialty chemicals and paint companies take from weaker volumes is overwhelmed by the earnings improvement from lower raw materials prices. That said, there may be some opportunities in technology as new 5G telecommunication standards appear to be coming “online” faster than expected — equipment and tower companies may be attractive plays on this trend. The public cloud companies continue to grow rapidly, driven by the paradigm shift in software to agile designs that run on the cloud, thus enabling semiconductor capital equipment companies to benefit from demand growth.
"A U.S. recession in the near term seems unlikely given a robust U.S. consumer. "
A U.S. recession in the near term seems unlikely given a robust U.S. consumer. That said, international economies are fragile and the typical excesses that build during an economic recovery are starting to appear. If we were to witness a sustained rebound in Europe and easy credit were to accelerate growth in China, company earnings could surprise to the upside in the second half of 2019 and drive further market gains. The Appreciation ESG strategy of owning large, high-quality stocks is well-suited for today’s market, offering upside participation if the economy continues to grow and preserving capital should a shock appear that causes a market downturn or an economic recession.
The ClearBridge Appreciation ESG Strategy had a positive return during the first quarter of 2019, underperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in all 11 sectors in which it was invested during the quarter. The primary contributors to the Strategy’s performance were the information technology (IT), communication services and consumer staples sectors. The utilities and real estate sectors were the main laggards.
In relative terms, the Strategy underperformed its benchmark due to stock selection and sector allocation. Stock selection in the financials, health care and communication services sectors detracted the most from relative performance. The Strategy’s cash position also weighed on relative results. Conversely, stock selection in the materials sector helped relative returns.
On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Microsoft, Costco, Comcast, Apple and Visa. The greatest detractors from absolute returns were positions in CVS, CME Group, Berkshire Hathaway, Bristol-Myers Squibb and Pfizer.
During the quarter, we established positions in SBA Communications in the real estate sector, American International Group in the financials sector, CBS in the communication services sector and Ciena in the IT sector. We closed positions in Bristol-Myers Squibb in the health care sector and Kimberly-Clark in the consumer staples sector.
Opioid abuse has become such a serious issue that it is included in the UN Sustainable Development Goal #3, Good Health & Well Being, which includes a target to strengthen the prevention and treatment of substance abuse, including narcotic drug abuse. Appropriately used, opioids are an important and effective treatment for chronic and acute pain. They carry, however, the serious risks of misuse, addiction, overdoses and death. There is no profile of a typical user or potential misuser: according to The Hartford, one in three people will be prescribed opioids in their life. Athletes and office workers, teenagers and adults, family members and neighbors — anyone could be involved or affected by opioid misuse.
Since the prescription of opioids began to increase significantly in the 1990s, the number of opioid overdose deaths has likewise risen (Exhibit 1). So has the economic burden: one study estimated the total economic burden of fatal overdoses, abuse and dependence of prescription opioids to be $78.5 billion in 2013 alone.1 The opioid epidemic causes more than 130 overdose deaths per day in the U.S.2 Opioids were responsible for almost two thirds of all drug overdoses in the U.S. in 2015; roughly half of these involved prescription opioids. Yet even while prescribing rates have fallen from peaks in 2010–2012, the amount of opioids prescribed per person is still high — three times higher than in 1999.3
Exhibit 1: Rise in Opioid Overdose Deaths
As an active investor in public equities, ClearBridge pursues a multifaceted approach to support efforts to reduce opioid addiction. ClearBridge is engaging companies in the drug value chain to better control opioid distribution and develop therapeutic alternatives to opioids. We are also supporting portfolio holdings in the insurance industry that identify those most at risk of opioid addiction and prevent dangerous cases before they begin. Helping efforts to reduce opioid addiction also aligns with our efforts to support UN Sustainable Development Goal #3, Good Health & Well Being.
Finding Solutions Across the Drug Value Chain
Patient access to opioids and lack of education on usage risks are primary contributors to the opioid epidemic. As a shareholder of companies across the drug value chain, ClearBridge encourages and supports these companies with the ability and the responsibility to act. Our roles as an active manager include engaging with distributors on their efforts to prevent potentially irresponsible dispensation of opioid drugs and investing in pharmaceutical companies developing therapeutic solutions.
ClearBridge portfolio holdings in the distribution segment of the value chain are working to stop inappropriate diversion of prescribed opioids. The key is that they not be overprescribed, either in cases where one patient’s prescription contains too much opioids at once or for too long a
time, or where too many people are getting prescriptions, some unnecessarily. Distributors are making changes to how they operate to help fight the crisis. CVS Health, for example, has worked with other distributors to build a network of shared records, so one user cannot simply go to a different pharmacy to get a prescription filled. The company has also developed programs for the safe disposal of unused opioids, preventing discarded opioids from finding a market.
In addition, we have a history of engaging health care companies on anesthesiology and the adoption of non-opiate approaches to pain management. We have engaged CVS, Amerisource Bergen and UnitedHealth on how their pain clinic managers ensure appropriate opioid use.
Patients are also prescribed opioids for dental health care; dental health care professionals write 12% of all opioid prescriptions, almost half of which are for adolescents. A recent Stanford study found that routine painkillers prescribed to teens after wisdom teeth removal could contribute to opioid addiction in young adults.4
UnitedHealth has launched oral health programs and policies to reduce opioid access in a number of ways, such as limiting the level of the prescription through the UnitedHealth oral pharmacy policy, as well as mailing information about the risks and proper use of opioid prescriptions to patients with dependents from the ages of 16 to 22 years. In addition, UnitedHealth will track the dental professionals who are among the top 10% opioid prescribers in their network and notify them of their status. After being contacted, these professionals have reduced prescriptions by 17%. The program has been updated to flag the top 20% oral health prescribers.
"Long-acting local anesthetics can work just as effectively as systemic versions and might even prevent initial opioid use. "
While opioids are the most prevalent and cost-effective form of pain management for many use cases, we are also investing in companies developing alternative therapeutic solutions. Portfolio companies Pacira Pharmaceuticals, Alkermes and Heron Therapeutics are developing opioid substitutes which would allow use of non-systemic pain relief in surgeries – long-acting local anesthetics that work just as effectively as systemic versions might even prevent initial opioid use.
Pacira Pharmaceuticals manufactures and markets Exparel, a treatment that can serve as an alternative to alleviate post-surgical pain, a primary introduction point for opioid use. The current standard of care to manage post-surgical pain is oral or intravenous opioids and there are few alternatives that offer pain relief as effectively. Exparel is a long-acting formulation of a well-known local anesthetic injected directly into the surgical site during a procedure to block pain locally, rather than systemically. By being given Exparel during surgery, patients can either avoid the use of post-surgical opioids or significantly reduce their dose and duration of use.
We have also discussed efforts to address the opioid crisis with pharmaceutical maker Alkermes. The company sells Vivitrol, a long-acting injectable drug that reduces the effect and craving for opioids. The drug is used as part of rehabilitation protocols, along with detoxification and therapy/counseling, and is clinically proven to decrease abuse relapse rates. Vivitrol is used instead of opioid replacement therapies like methadone. In addition to traditional drug marketing, Alkermes has engaged at all levels of government and the justice system to broaden the use of Vivitrol to combat the growing opioid addiction problem in the U.S, including in federal prisons.
Heron Therapeutics is a pharmaceutical maker with two commercial anti-nausea treatments for patients going through chemotherapy. We are excited about the prospects for a next-generation non-opioid painkiller in Heron’s pipeline (HTX-011) for post-operative pain that is expected to receive FDA approval around the middle of 2019. Heron is benefiting from fast-track approval procedures that have been established by the FDA to encourage innovation and that we believe can bring non-opioid treatments to market in a timelier manner.
Insuring a Better Approach to Use of Painkillers
As the opioid epidemic has begun to have a more and more tangible impact on employers, property & casualty insurance companies, such as ClearBridge holdings The Hartford and Travelers Insurance, have been proactively working to detect addiction and tailor rehabilitation. Due to in-house triage personnel, insurers have a unique perspective on the crisis in that they often have the first look at treatment and prescription trends that might involve opioid use. Both The Hartford and Travelers are fighting the opioid crisis by holistically working with doctors on diagnosis and treatment for employees in filing workers’ compensation claims.
Both The Hartford and Travelers are pursuing innovative programs to combat opioid addiction by using predictive analytics to identify drug-seeking behavior. The Hartford uses an analytics model that incorporates nonmedical psychosocial factors, such as subtle verbal cues, to identify claimants at higher risk of addiction. Using this model, The Hartford has seen opioid use on its claims drop by 25% from January 2015 to July 2016; the average morphine equivalent dose per claim decreased by 9% over that time frame as well.
Travelers has developed an Early Severity Predictor® to identify when an injured employee develops chronic pain, so it can work with employees and their doctors to eliminate or reduce the need for painkillers.
These programs help monitor and reduce the risks of addiction, which not only saves livelihoods and lives, but also benefits employers in terms of reduced lost work time, lost productivity and lower insurance costs. Since 2015, The Hartford has been able to help workers’ compensation claimants reduce opioid use by 43%.
ClearBridge supports and encourages these practices and makes them part of our long-standing conversations with Travelers and The Hartford. Our ownership of these companies is an example of cases where smart ESG practices serve the interest of both shareholders and society.