For the quarter ended June 30th, 2023, the major indexes performed as follows:
1. The DJIA rose by 3.4%
2. The S&P 500 rose by 8.3%.
3. the NASDAQ composite advanced by 12.8%.
In comparison, the Gnostic Global portfolio advanced by an unimpressive 5.2% for the quarter. The account started the three month review date with a value of $730.34 USD per share and closed at a value of $768.29 per share.
For the year to date, the Gnostic Portfolio is only outperforming the DJIA major index and the DJIA typically represents the lowest hurdle among indexes.
In the first half of 2023, the DJIA has advanced by 3.8%, the S&P 500 by 15.9% and the NASDAQ by 31.7%. In contrast, the Gnostic account has increased by 13.4%.
I would normally consider a 13.4% six month return to be a major win, but against the returns posted by the S&P and the NASDAQ, it stands out as absolute and relative underperformance. To bystanders, it doesn’t matter that the Gnostic portfolio isn’t still recouping the ground lost during 2022, as are the NASDAQ and the S&P 500 indexes in 2023, but rather, is advancing steadily off of a positive fiscal 2022 and building on that growth. 2022 is now rightfully in the past and investing isn’t about what you achieved yesterday, its entirely about “what are you doing today, and where will things sit tomorrow”. I get that.
Where I have been wrong in the first half of 2023 is due to pressure on two fronts.
1. I hold a relative overweighting in two disparate investment sectors presently under pressure via perceived regulatory threats.
The Gnostic portfolio has, over the years, maintained a policy of letting winners run without active portfolio rebalancing. Accordingly, the account weighting has gradually, but steadily, shifted to some rather notable outsized percentages held in US centered health insurers. for the first half of 2023, ownership of UnitedHealth Group and Cigna held back the overall returns of the portfolio; the two company equities declined by 10.4% and 18.1% respectively.
The reasons for 2023 declines are numerous. Regulated HMO fees for 2024 were set at below normal rates as compared to fees set out during the 2020-2023 cycle and this will impact profit growth in 2024. The markets responded to that negative change in forecast payments appropriately.
Secondly, health insurers have been experiencing a very significant jump in PBM claim requests on weight loss medications sold by Novo Nordisk and Eli Lilly. One unnamed employer has reported that prescription requests for Ozempic, the hotly selling weight loss drug produced by Novo Nordisk, have been running a full 400% higher over the past 12 months with their insurer.
“weight loss company Found’s CEO Sarah Simmer told Yahoo Finance recently that employers have seen Novo Nordisk’s (NVO) Ozempic jump to the No. 1 cost in drugs they are paying for, with one employer confiding that Ozempic prescriptions are up 400% year over year.”
This issue for national health insurance firms, the coverage of a class of drugs known as GLP-1, centers on the fact that current GLP-1 medication prices are obscenely expensive in the USA relative to other markets where the products are sold. US pricing is set at rates typically 9x-11x higher than in Europe, where drug costs are capped. Yet, even in Europe, private health insurers are finding that the demand for GLP-1 is straining the ability of any one insurer to cover the costs without negatively impacting profits in the current fiscal years. The typical cost structure of a hotly selling newer pharmaceutical product tends to have a negative impact on the bottom lines of health insurers for a time until annual fee redeterminations are made, until drug costs are lowered due to competition or a combination of both take place.
In the case of health insurers, this GLP-1 coverage headwind will almost certainly persist until at least 2024. In Denmark, where Novo Nordisk is headquartered, where most of its employees are located, and where the corporation represents the single largest private producer of GDP in the nation, the largest private health care insurer in Denmark has been forced to curtail certain classes of GLP-1 coverage for the coming fiscal 2024 year. For Denmark, a socially liberal nation whose citizenry prides itself on overall health relative to other developed nations, being forced to reduce coverage for pharmaceutical products supplied to the nation, by that nation’s best known pharmaceutical producer, represents not only a point of irony, it suggests that there is significant and growing global pushback against pricing, a repudiation against the cost of the drug class itself.
To put it bluntly, while everyone on the planet might want the ability to purchase a proven weight loss drug, very few can afford to do so out of their pocket; even those that can afford to do so would greatly prefer that payment be made with OPM (other people’s money). So, after hearing about the almost miraculous declines in weight reported by social influencers, the public has tried to obtain reimbursement through their HMO on GLP-1 scrips, only to learn that there is growing pushback from health insurers on the class. Public expectation that health insurers will universally cover all classes of GLP-1 drugs, en masse, in the process losing incredible sums, represents a bridge too far. Pharmaceutical companies market to the public that the products are the greatest thing since sliced bread, the public then tries to obtain a scrip, readily written by their physician, only to become irate in learning, more often than not, that the result is an insurance coverage denial.
The typical American household views health care insurance firms as vast treasure troves of profit; investors in health care insurers to some extent may also have that opinion. In reality, the average national health care insurance firm makes a pre-tax profit of about $50 per month US per insured member, some a little more, some a little less. So, when an HMO member pays monthly premiums of about $500-700 and then submits a GLP-1 scrip for reimbursement, expecting to be fully covered for a medication that costs $1,000 monthly, without expecting pushback from the HMO, there is a problem, a cognitive dissonance. We cannot have everything, just because we want it.
Denials of medications by HMOs make for very bad press, particularly going into an election cycle, but to cover everyone submitting a scrip will largely ensure that any currently profitable US health insurer will almost immediately revert to a loss. Investors in health care insurers don’t own a business under the assumption that they are putting up capital for the common good, they own health care companies for the expectation that a profit on members will be had.
Thus, the declines experienced recently in share price for the entire sector have come about as investors tentatively come to understand that while GLP-1 products are good for a health care outcome over the longer term, the expense to an HMO is entirely front loaded, with savings on membership health outcomes only arriving at the back-end of a patient losing sufficient weight over a number of years that other medical conditions arising from excess weight are alleviated. Few investors make back-ended investment decisions, we lack the patience.
In the near to mid-term, the health care insurers will draw more and more media attention as the demand for GLP-1 medication grows, unless they can shift the narrative. It will prove impossible for the industry, given the aggregate level of profitability, to fully absorb the financial hit to their bottom lines via widely expanded coverage, so look for more anecdotal articles on coverage denials or coverage curtailment.
The HMO industry represents the gatekeepers to the bulk of the US employed, retired and unemployed population, so they will do pushing back themselves. HMOs will lobby government officials to increase funding for GLP-1. They will work in concert to limit the number of Americans that will be approved at any one time for GLP-1 scrips. For employer funded plans, look for impressive increases in 2024 premiums to be assessed against the sponsor as well as increased co-pays for members. Finally, the HMOs will be working feverishly with, or against if necessary, the two current producers of GLP-1 drugs to dramatically lower list prices in order to maintain coverage and corporate profit. One company, Eli Lilly, has a noted tendency to playing ball with the health insurers and has achieved a measure of protection as a result. The current #1 producer and the creator of the entire GLP-1 sector, Novo Nordisk, does not work well with health insurers, and as a result, has little cover.
Should HMOs financials pressures increase, they will work to shift the blame. It is almost certain that the narrative chosen for deflection will shift attention off of “greedy health care insurers“, potentially assigning blame and hoping to diffuse public ire by focusing upon “a greedy foreign owned drug firm overcharging deserving Americans by 900%“. Blame games can be vicious.
Finally, federal regulatory oversight of the murky pharmacy benefit manager divisions within many national health insurers, PBMs, have served to diminish investor enthusiasm for the group as a whole. This has most specifically impacted the share price of Cigna, who generates a whopping 69% of total revenues through their PBM division. In truth, the business of a PBM is so opaque, by design, regulators seldom know what holes in the business model to plug. Often, through adroit lobbying by the HHO sector, legislation winds up opening up a loophole, to be exploited, in the very same bill passed that closes another loophole.
I doubt that much will change in any PBM legislation before the congress, but the negative press surrounding the sector is a bit unseemly for even the veteran investors. To those who hold HMO investments, it is times like this, when a duality of pressures, possibly a multiplicity, regarding the business model comes to the fore, that one is reminded there is an element of potential sleaze in the business of private health insurance. However, health insurers have been periodically portrayed as conniving/contriving in the past and got through it after a time. History suggests that this, too, shall pass, but the year ahead will prove me right or possibly wrong and investors must always build in the potential for being wrong.
The other regulatory worry for me in Q2 came about in the Mexican airport operator holdings.
The Mexican congress, in response to concerns from the public about the strength and length of mining concessions in that country, has opted to reduce the term of new concessions by at least half and have also included provisions that could result in the cancellation of mining concessions altogether, should the regulator in Mexico determine cause. I hold no mining equities, least of all Mexican miners, so why would I care?
However, what was initially envisioned as a bill that would cover mining company concessions was worded in a fashion so that it potentially applies to the totality of corporate concessions in all of Mexico, including airport concessions. For Grupo Aeroportuario Del Sureste and Grupo Aeroportuario Del Pacifico, these companies are just halfway through their initial 50 year concession terms, so it would apparently mean little to the present business model. Yet, as news of the legislative changes came to the fore, investor worries increased, due to the fear that a legislature, specifically the president of Mexico, could seek to revoke a concession entirely or change the terms significantly, with little ability of a company to rebut.
The current president of Mexico, Andres Manual Lopez Obrador, or AMLO for short, has a demonstrated distrust of the private business sector in Mexico and has, in the past, specifically targeted private airport concessions for government repatriation. His term ends in 2024. When AMLO leaves, theoretically, so too does the threat overhanging on private operators of Mexican airports, but then again, who knows with any certainty? It could be that the next Mexican president resumes the pro-business approach of prior Mexican governments, but it could also be suggested that Mexico continues to move towards a more leftist national model of governance, which would continue to pressure airport operators.
The negative overhang on airport operators, due to newly identified regulatory risk in Mexico, resulted in ASUR and PAC share prices declining by 9% and 9.1% on the quarter respectively. This, despite record throughput of passengers through the airports. In order for any concession to be revoked, there would need to be cause and ASUR keeps its business model squeaky clean, but Mexico isn’t a first world country. PAC has had a few legal run-ins with Ejido (native tribal communal) landholders in the past, and AMLO considers himself a politician of the common man.
My policy of not actively rebalancing the account periodically results in absolute underperformance such as was experienced in Q2.
The 4 noted underperformers in the portfolio, in an account with 22 equities, were they weighted equally overall, would have represented more than 18% of the account. And because I let equities do what they do without interference, you can be assured that they represented a disproportionately higher percentage of the account than 18%. So, almost 1/4 of the total value of the account actually declined in Q2.
I tend to take these periodic moves in stride, because when any specific equity or sector declines sharply, while other sectors or equities advance strongly, portfolio rebalancing occurs naturally. As of today, UnitedHealth, Cigna, Grupo Aeroportuario del Sureste and Gruop Aeroportuario del Pacifico are far less significant a percentage of the overall portfolio. Therefore, should they continue to stumble along for a pace or, potentially, even fall further, the impacted sectors will, all else being equal, impinge upon the overall results less in the future.
2. I had underestimated the resilience of aggregate consumer spending in 2023. After several consecutive years of price inflation rising far faster than wages, recent wage hikes have been so astronomical, historically speaking, that income growth has almost caught up to CPI moves since 2020.
According to data compiled by the Federal Reserve Bank of Atlanta, aggregate annual wage increases rose by an average that peaked at +6.7% in 2022 and is presently increasing at an annualized run rate of +6% through May 2023. Recent notable outsized pay hikes among most commercial airline pilots have established precedents that look to persist for some time in the foreseeable future. When an entire industry featuring 110,000 pilots, earning an average wage of almost $300,000 per year US obtains annual pay hikes of more than 9% in year one and subsequent mid-single digit raises for several years thereafter, this income replaces a significant chunk of lost wages from the many fired bankers and shrunken fin-techs. Further, it provides a floor for all other employee sectors to negotiate (“if pilots can get a 9% hike, then we plumbers, electricians and other essential trades also deserves a 9% hike“). Virtually all labor groups expect to seek out and receive above inflation rates of compensation but those labor groups with the greatest leverage in this current cycle are the skilled trades and blue collar workers. This is good news for consumers but extremely bad news for inflation fighting policy makers.
Wage increases surpassed the US rates of core consumer price inflation in February 2023 and have been consistently tracking above CPI.
The inability of central bankers to bring wage inflation in line has supported household balance sheets throughout the rising interest rate cycle.
As impressive as the ascent in interest rate has been, wage increases for the typical American has been equally stellar. Since 2020, the average American employee has experienced a 22.3% average pay hike. That has closed the net negative impacts of consumer price inflation to just 3.4% since 2020, or about 1% annually. Overall, despite stubborn producer price inflation, despite raging consumer price inflation, the typical American household, media pronouncements aside, has proven largely capable of forestalling major negative impacts of inflation and interest rate hikes via internal household changes (substitutions and deferrals) in certain categories of spending. Most households bemoan the cost of groceries, but have almost offset those costs via cutbacks in online discretionary spending, while then going out on a limb with revenge travel.
Going forward, things get very tricky for policy makers, and potentially for investment modelers.
It seems abundantly clear that in isolation, increasing interest rates by the current percentages, has produced relatively limited effect to date upon direction of the overall economy. So, policy makers will have to make choices; do they accept that inflation is now fully baked into the system, which potentially lays the groundwork for a secondary overall move in prices in the coming year? Do they broaden targets via more aggressive reductions in money supply? One thing is certain, with another US electoral cycle coming in 2024, there is little likelihood of federal governments limiting growth in spending; any central bank inflation fighting policy actions will continue to be made largely in isolation, operating at odds with government actions and to a great extent, being defeated by the same. Typically, elections are won or lost, not via broad differences noted in the media, but by the voting public choosing who and whom will most likely disburse the greatest sums of capital to sway the voter base.
Major recessionary inflection points occurred, not when interest rates peaked in isolation, but rather, when interest rates stabilized while employee wage raises declined significantly. In the period of 2001-2004, average wage inflation declined by 2% annually and in the brutal economic recession starting in 2008 and extending through 2010, wage inflation declined from 4.4% annually to a bottom of 1.6% annually.
Wage increases are widely assumed to be a lagging indicator but the multiyear contractual nature of notable wage increases, such as US airline pilots, lead many to deduce that wage inflation will continue to persist well into 2024, potentially making the indicator less of a laggard and more coincident.
And that is where central bankers are losing incredible sleep. I have persistent worry, one that deserves to be mentioned; will consumer price inflation stabilize in the 4%-5% range for a brief time, all the while goods and services continue to be chased by an American populace armed with wage hikes above that for several years, leading to a secondary and equally persistent ascension in price inflation off of the new “normal-permanently higher” assumed base?
Investment markets have responded to the relative stability of consumer spending, to the recent declines in CPI and PPI from the highs and have bid up equities accordingly.
The move has been impressive in Q2 specifically and the market typically looks several quarters out. What equity advances have telegraphed are that the substantial wage hikes for American employees will be largely sufficient to offset inflationary pressures on households, despite far higher interest rates to contend with. Taking the recent wage data into account, there is no reason to dispute such logic. Consumers are adapting, paid for with their abnormal wage hikes received during 2022-2023.
There won’t be any changes made to the Gnostic Portfolio, despite the short term underperformance relative to the two major equity indexes.
The existing composition has carried me an extremely long way. Typically, once every several years, a negative sector bump occurs and in the first half of 2023, I’ve experienced not 1, but 2 , negative sector impacts. It is something certainly to be aware of, but that’s the nature of equities; an expectation of perpetual quarter over quarter outperformance is wholly unrealistic in the long term.
I am aware of the sectors under duress, understand well the current and prospective issues pertaining to the 2023 first half pressure, and choose to tolerate said issues until they either come to a head or wane over time. Occasional regulatory obstacles are the price that must be be paid when one owns regulated businesses.