Policy Headwinds and Manufacturing Reshoring

Our U.S. Biotech and Biopharma analysts Sean Laaman and Terence Flynn discuss the latest developments that could be positioning the healthcare sector for strong outperformance.

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Sean Laaman: Welcome to Thoughts on the Market. I'm Sean Laaman, Morgan Stanley's U.S. Small and Mid-Cap Biotech Analyst. 

Terence Flynn: And I'm Terence Flynn, Morgan Stanley's U.S. Biopharma Analyst. 

Sean Laaman: Today, we'll discuss how a rally in the healthcare sector is being driven by more favorable macro conditions. 

It's Tuesday, October 28th at 10am in New York. 

So, Terence, healthcare has lagged the broader market year-to-date, and valuations have been near historical lows. But recent weeks show strengthening performance. Policy headwinds have been front and center.

What's changed in the regulatory environment and how is the biopharma sector adapting to these pricing and tariff dynamics? 

Terence Flynn: Sean, as you know, with many other sectors, tariffs were initially a focus earlier this year. But a number of companies in our space have subsequently announced significant U.S. manufacturing investments to reshore supply chains. And hence, the market's less focused on tariffs in our space right now. 

But the other policy dynamic and focus is what's called Most Favored Nation or MFN drug pricing. Now, this is where the President's been focused on aligning U.S. drug prices with those in other developed countries. And recently we've seen several companies announce agreements with the administration along these lines, which importantly has provided investors with more visibility here. And we're watching to see if additional agreements get announced. 

Sean Laaman: Got it. Another hurdle for Large-cap biopharma is a looming expiration of patents with [$]177 billion exposed by 2030. How is this shaping M&A trends and strategic priorities? 

Terence Flynn: For sure. I mean, as you know, Sean, patent expiry is our normal part of the life cycle of drug development. Every company goes through this at some point, but this does put the focus on company's internal pipelines to continue to progress while also being able to access external innovation via M&A. Recently we have started to see a pickup in deal activity, which could bode well for performance in SMID-cap biotech. 

Sean Laaman: At the same time, you believe relative valuations look compelling for Large-cap biopharma. Where are valuations versus where they've been historically? What's driving this and how should investors think about positioning? 

Terence Flynn: Absolutely. Look, on a price to earnings multiple, the sector's trading at about a 30 percent discount to the S&P 500 right now. Now that's in line with prior periods of policy uncertainty. But as policy visibility improves, we expect the focus will shift back to fundamentals. Now, positioning to me still feels light here, given some of the patent cliff dynamics we just discussed. 

Now, Sean, with the Fed moving toward rate cuts, how do you see this impacting your sector on the biotech side? 

Sean Laaman: Well, Terence, particularly in my space, which is Small- and Mid-cap biotech companies, they're typically capital consumers are not capital producers. They're particularly sensitive to the current rate environment.

Therefore, they're sensitive to spending on pipeline. They're sensitive to M&A. So, as rates come down, we expect more spending on pipeline and more M&A activity, which is generally positive for the sector. Looking forward, biotech sector is generally the best performing sector on a six-to-12-month timeframe post the first rate cut. 

Terence Flynn: Great. You've also talked about this SMID to Big thesis on the biotech side. Can you explain what's driving that? 

Sean Laaman: Sure Terence. There’s three pieces to the SMID to Big thematic. So, we in SMID-cap biotech, we cover 80 to 90 companies. About a third of those are newly, kind of profitable companies. Those companies are turning from being capital consumers to capital producers. We see about $15 billion of cash on balance sheets for 2025, going to north of 130 billion by 2030. That's the first piece. 

The second piece is due to regulatory uncertainty at the USFDA. We're seeing more attractive valuations amongst clinical stage names. That's the second piece. And third piece relates to your coverage, Terence. I refer back to that [$]177 billion of LOE. So, we expect generally that M&A activity will be quite high amongst our sector. 

Terence Flynn: And let's not forget about AI, which has implications across the healthcare space. How much is this changing the dynamic in biotech, Sean? 

Sean Laaman: It is changing, but we're really at the beginning. I think there's three things to think about. The first one is faster trial recruitment. The second one is faster regulatory submissions. And the third one, which is the most interesting, but we're really at the beginning of, is faster time to appropriately targeted molecules. 

Terence Flynn: Great. And maybe lastly, what are the key risks and catalysts for SMID-cap biotech in the current environment? 

Sean Laaman: As always, we're focused on pipeline failures in terms of risk. Secondly, in terms of risk, we're looking at regulatory risk at the FDA. And thirdly, we're looking at the rise in China biotech and the competitive dynamic there.

Whether you're watching large cap biopharma, M&A moves, or the rise of cash-rich, SMID-cap biotechs, the healthcare sector setup is unlike anything we've seen in years.

Terence, thanks for speaking with me. 

Terence Flynn: Always a pleasure to be on the show. Thanks for having me, Sean. 

Sean Laaman: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.