Are We Close to a Peak in Interest Rates?

Year to date, the S&P 500 is up an impressive 16% and near an all-time high (as of this writing). Growth continues to underperform. At the furthest end of the risk curve is biotech, with the XBI down about 8.5% on the year, only modestly off this year’s low and down 46% from the all-time highs set in October 2020 and early 2021.

What’s plaguing biotech? Valuations of long dated assets have been crushed as they trade inversely with interest rates, which the FED has been raising at an unusually rapid pace over the past 18 months Biotech stocks are the longest dated of all.

The collapse in biotech valuations threw ice water on their ability to raise capital; only companies with strong data were able to do follow-on offerings.

But there are about 200 companies with less than 12 months of cash, and many are not funded through the next value inflection point. This has resulted in a large number of restructurings to preserve cash and extend runways, we’ve seen companies shut down and liquidate, and there’s been an increase in reverse mergers and substantial consolidation.

That said, things are getting better in the capital markets YTD 2023 vs. YTD 2022.

• There have been 70 follow-ons raising $12 billion, vs. 50 and $8.6 billion last year.
• 47 PIPEs (private investment in public equity), raising $3.1 billion, vs. 37 and $2.4 billion in 2022.
• 23 registered direct offering deals, raising $1.7 billion, vs. 20 and $1.6 billion last year.
• 6 IPOs, vs. none.
• M&A remains strong with 13 deals at over $1 billion each this year, which is on track for a 10-year record.

When will the underperformance end? The economy and inflation have continued to be stronger than expected and while the market was hopeful that the economy would slow and the Fed would halt the rate hikes, this has not happened yet—but it will. The debates are whether ultimately the economy has a soft landing or will it be pulled into a recession. Either way, rates will peak and likely come down over time. When the market anticipates or has a line of sight on rates peaking/falling, we can expect investors to rotate back into biotech stocks.

How did we get here? The rollout of the COVID-19 vaccines literally reopened the economy—and in anticipation of a V-shaped recovery, investors quickly rotated out of expensive biotech stocks and into deep cyclicals—like the depressed airline, hotel, and resort stocks. The reopening trade was “on!” Ultimately, the surging economy fueled inflation and an aggressive FED has had its foot on the gas raising interest rates to levels not seen in over 40 years.

2020 and 2021 were very good years. COVID and work from home virtually shut down the economy beginning in March of 2020, and with it, valuations and earnings for cyclical stocks crashed. Biotech, on the other hand is largely insulated from macro factors such as GDP growth, hence the sector massively outperformed the market during 2020 and much of 2021.

There was a record flow of funds into the sector and biotech stocks were red hot, until, of course, they were not.

In 2020 and 2021 the biotech IPO and follow-on market hit record highs and an unprecedented number of early-stage companies entered the public markets. In 2020, a record 78 biotechs went public, the most ever in a given year and a 77% increase over 2019. IPO gross proceeds also rose sharply—to $12 billion, vs. $5 billion in. 2019.

In 2021, there was even a high number of biotech IPOs; the number jumped to 104, raising nearly $15 billion. But that number dropped to 21 in 2022. There have only been six so far this year.