A VIEW FROM THE TOP END

Markets:

In our last note we mentioned that markets were waiting on the Federal Reserve monthly meeting for June to get an indication of when quantitative easing (QE) would be tapered and when interest rates would begin to rise. Some central banks are already moving to reel in dovish policy. As a result, they have seen their currencies rise. The Bank of Canada (BoC) is an example of this as the BoC has tapered their QE program three times in July and has guided to begin hiking interest rates in 2H22. That timeline puts them nearly 2yrs ahead of RBA guidance. Traditionally the loonie trades roughly at par with the Aussie dollar, but the change in policy has seen the Canadian dollar rise where a CAD buys 1.07 AUD at the moment.

At the FOMC meeting the Federal Reserve in the US released their famous dot plot, and the “average dot” is calling for a rate rise in 2023, this is faster than expected, as previous guidance from the Fed was that rates would hold until 2024. If rates are to rise that means asset purchases from the Fed’s QE program would be tapered first. With the money supply set to contract as the central bank shuts off the printing press, inflation expectations fell, and the USD rose. The AUD was off 2.12% after the meeting against the USD, driving Aussie investor returns for the S&P500 (3.04%) and Nasdaq (5.55%) and the ASX was down 0.64% for the period on lower commodity prices. Without the effect of the USD the S&P500 was flat at a 0.01% return. The breakdown for the ASX200 this period was tech (+10.6%) surging off lows, healthcare (+5.3%) and consumer staples (+2.9%) leading, while materials (-4.8%), energy (-4.7%) and financials (-2.2%) dragged the index.

Biotech Spotlight - Patrys (PAB:ASX):

From a market standpoint, when investors think of the ASX, they look at the big banks and they think mining. Over the past decade the ASX has pushed to reinvent itself beyond these traditional sectors. In 2010, the ASX300 was dominated by financials at a 37% weight, and materials at 29%, biotechnology was 3% of the ASX and tech represented 0.74% of the index. Fast forward to 2021 and healthcare and biotechnology is 10% of the index, and tech has swollen 6x to 4.5%. That transformation has made the ASX a place to raise capital if you are a smaller tech or biotech firm and you do not want to get lost in the noise being a small player on the NASDAQ in the US.

In this piece we will highlight biotechnology, a sector that represents $147bn in market cap and $11bn in revenue on the ASX. If we are going to talk biotechnology, we must first start with the approval process. Biotech companies are notorious for being single product, and are essentially binary outcomes, either the drug or technology works, or it does not. A “penny dreadful” that has their drug approved by the FDA, or reaches clinical trial and is acquired, can see their share price rise many multiples, a company that gets knocked back will be virtually worthless. There is almost no middle ground.

The key stages a biotech goes through run in parallel, as there is the approval of the product and then there is the manufacture of the product. For the approval process there are exploratory and preclinical phases that provide a proof of concept and initial safety. Once in vivo tests in animal models are complete, it is time to move to humans. These steps can take years and cost millions, and that is before the budding technology reaches the clinic. Once in the clinic it is a three-phase system, where phase 1 tests toxicity on healthy individuals (20 – 80 people) to determine the highest dosage without serious side effects, this phase has a 70% chance of success to be passed and move to phase 2.

In phase 2 several hundred participants are recruited with the ailment that is to be treated by the new medication. Trial participants are given the dosage from phase 1 and efficacy of the treatment as well as side effects are tracked. The FDA estimates that 33% of medications pass phase 2 and enter phase 3.

The most important phase for a medication’s approval is phase 3, where thousands of participants are recruited for the trial with the condition that is to be treated. Phase 3 compares how the new medication compares to existing treatments, to move forward the new treatment needs to demonstrate it is at least as effective and safe as the incumbent. Phase 3 trials are typically double blind and random, no one knows if they are getting the new drug or the old one, or even a placebo. Phase 3 trials are typically long in duration, and only 25% of pharmaceuticals make it past this stage. In the cases of some conditions, the success rate is even lower. A heartbreaking example is Alzheimer’s that saw a 0% phase 3 success rate from 2008 to 2019. You may have seen Biogen’s Alzheimer’s drug recently got approval in controversial fashion; the graveyard of failed treatments was surely a factor in the FDA’s decision.

While approvals are being sought, a biotech company needs to make commercial quantities of their treatment. There are two main types of treatment, and they can be classified as small molecule and large molecule. Small molecule treatments, like paracetamol, can be easily synthesised in a laboratory through chemical processes. Large molecule treatments, known as biologicals, are many times more complex and are grown inside a living cell. Insulin is the best know biological treatment, and it is grown within the pancreas cells of pigs. Large bioreactors and complicated processes make these types of treatments available in sufficient quantities. Biological solutions are typically more difficult to manufacture, but the trade off is that biological treatments have shown to provide more targeted benefits, with less side effects, so the payoff is evident.

To give a real-life example, our whole sale fund has held a position in a company called Patrys (PAB:ASX). Patrys is a biotech company traded on the ASX. Their key offering is PAT-DX1 ("DX1"), a large molecule biological (as opposed to small molecule synthesised pharmaceutical), with the unique ability to both cross the blood brain barrier and penetrate cells without killing them. DX1 is attracted to the damaged DNA of tumour cells and has the property that it can disrupt the production of DNA, this binding and disruption in animal models has shown promise in reducing tumour size as it slows the tumour's ability to replicate itself.

PAB:ASX is currently finishing preclinical trials for toxicology and is working with manufacturers to move to the first stage of the clinic in H2FY22. The first stage of the clinical trial requires a commercial quantity of the drug and will test toxicology in a human model. The biological DX1 will be produced in bacteria or other living cells, unlike a small molecule, so the manufacturing process requires more trial and error to get the selected cell line into production. For this reason, there is production risk associated with DX1 to get to the clinic, despite sufficient funding. The key milestone further to toxicology in the animal model to reach the clinic will be the announcement of manufacturer scale up (expected this calendar year).

Despite the positive news flow in the past month, PAB’s DX1 still has a way to go on their biotech journey and will likely partner or be acquired by a large pharmaceutical that would like to enter DX1’s space. In oncology, 60% of deals are done in the preclinical stage. The expense and time taking a drug to the clinic is a big pharma game.

If you would like to learn more about PAB:ASX, and specifically DX1, there was a recent article in The Australian, that can be read through the company webpage, click here.

Updating our checklist:

• Valuation: Valuations between the ASX200 and S&P500 diverged the past two weeks. The S&P forward P/E ratio rose to 22.64x while the ASX200 dropped to 19.34x. Institutional investors exposed to the American markets are increasing their downside protection and the number of short sellers on the leading US index has risen from 2% to 5% short interest. Backstopping any drops in valuation is the sheer volume of funds flowing into the equity markets. With no better investment return in other asset classes Goldman Sachs raised their US funds flow from $350bn to $400bn to go into equities over the remainder of the calendar year. Not all markets are at such lofty valuations, as European markets are closer to 10yr valuation averages.


• Global PMIs: PMIs are not out until next week, but we are seeing a trend in the US where household spending is shifting from goods to services. This makes sense as the reopening efforts in the US accelerate, folks are starting to move out and about again, instead of purchasing items. In China steel output has nearly doubled, with no inventory build. China’s efforts to curb commodity prices in the iron ore market appear that they are up against high demand, but Beijing has its sights set on speculators, and are trying to flush them out of the market in the near term to prevent supercharging of key commodity markets.


• Downgrades on guidance: It has been relatively quiet on the guidance front in both the US and Australia. One of the biotech reflation plays that we follow did have an upgrade based on reduced restrictions in the US, and the baby formula market got a boost with China announcing that they would allow couples to have up to three children moving forward. While the latest two child policy and now three child policy has failed to raise birth rates, the announcement did put positive momentum into the beaten-up formula names such as A2 Milk and Bubs.


• Infection rates to slow globally: Another two weeks has passed, Melbourne has arisen from lockdown, but Sydney has now fallen. The country’s largest city succumbed to the spread of the delta variant of the Covid virus this week. The latest lockdown emphasises that while Australia has fared well during the pandemic, we will remain vulnerable until vaccination rates climb and our population achieves herd immunity. Elsewhere over seas vaccination efforts are accelerating in mainland Europe and Canada. The US and UK are seeing their rates fall, but both populations still have high uptakes and vaccination percentages in their populations.

  You can follow Australia’s vaccination journey with our live vaccine tracker at the link below:

  
  TFM Vaccine Tracker


• Monetary and Fiscal stimulus announcements globally: Australia’s central bank held rates again with their announcement this month and are continuing their asset purchase program. The RBA has little desire to see the AUD skyrocket, so they will lag policy in the US and continue to be dovish in comparison to the Fed. An AUD in the high 70’s to low 80’s is more desirable to reach employment targets locally than seeing an AUD at par with the USD that would hurt exporters. As mentioned above, the Fed has shown an indication to the market that they will start raising rates and reducing asset purchases sooner than expected. While inflation is still at a 29yr high in the US, expectations in the bond market showed that if money stops being printed inflation will be transitory as the central bank has said. On the infrastructure front, Biden’s team is now working on a bipartisan solution that is significantly smaller than the $1 trillion plus proposal a few months ago. Still, no one knows how to pay for the smaller legislation, as tax hikes or a gasoline tax are wildly unpopular. The printing presses seem like the logical next resort.
  

The past two weeks have been interesting, it started with a waiting game as markets anticipated the Federal Reserve actions, then after the meeting things began to reshuffle and time flew by. We mentioned that some markets are beginning to look frothy like the US, we are currently holding more cash in our models than usual for this reason. Pullbacks happen but at this stage of the economic cycle a price retreat would be more of a buying opportunity than an imminent crash. Although, as always, it remains a good time to visit one of our financial advisors if you do feel you have extra resources at hand. There is never a better time than today to sort your finances and set or review your financial goals, and sound financial advice is the best way to do that. Take care and we will be in touch again in two weeks’ time.

Regards,