A Look at Medicare Drug Price Negotiations and Pharma Stocks

Editors’ note: MarketMinder is nonpartisan, favoring no politician or party. We assess developments’ potential market impact only.

President Biden’s signature Inflation Reduction Act (IRA) hit its two-year anniversary last week to some hoopla, particularly since news on one of its provisions broke: the Medicare Drug Price Negotiation Program. Whether you are for, against or indifferent to it, we think it provides a clear case study of how markets navigate legislative change.

Politicians have long floated Medicare drug negotiation as an antidote to lofty drug prices—and a key vote-getter on both sides of the political aisle. Medicare is the largest buyer of drugs in the country, so many think negotiating down costs would have both direct fiscal benefits and indirect benefits on drug costs economywide.

But the Pharmaceutical industry (which lobbies both parties) and its proponents opposed negotiations, arguing it would limit the incentive (profits) to develop drugs many rely on for their wellbeing. This, the industry says, threatens the innovations that have brought forth drugs improving the quality of life for lots of people. The debate was at an impasse for years and years, and legislation authorizing Medicare to negotiate floundered whenever proposed in Congress—until the IRA passed two Augusts ago.

When the debate over the bill was raging, many figured including drug price negotiation would hit Pharma stocks hard. But since it passed, as Exhibit 1 shows, Pharma stocks are pretty much level with the broader market cumulatively, performing in line with the S&P 500 (albeit with volatility along the way). And if you go back further to when markets likely started pricing in potential legislative change—President Biden’s July 2021 executive order exploring ways to implement Medicare bargaining—Pharma is ahead. If negotiations were going to exact a heavy toll on the industry, shouldn’t it be faring far worse?

Exhibit 1: Pharma Performs in Line With Markets Since Medicare Drug Price Negotiations Tabled

Source: FactSet, as of 8/22/2024. S&P 500 Pharmaceuticals and S&P 500 total returns, 7/9/2021 – 8/22/2024.

Now, we think it is fair to say the bill affected relative returns in the short term. As the IRA was in its home stretch, the S&P 500 rose—a countertrend rally during 2022’s bear market—while Pharma stocks fell. (Exhibit 2) We see a strong case that this was likely due, at least partly, to markets pre-pricing its passage to a large extent. Overall, the final IRA was watered down from what was feared, likely helping stocks feel some relief.

Exhibit 2: Pharma and S&P 500 Total Returns

Source: FactSet, as of 8/22/2024. S&P 500 Pharmaceuticals and S&P 500 total returns, 7/9/2021 – 8/22/2024.

Earlier versions called for a slew of new taxes (including on wealth and unrealized capital gains) and vast social programs (e.g., making the refundable Child Tax Credit permanent and Universal Preschool). As those fell by wayside—with a broadly gridlocked Congress shaving off more radical proposals—so did its cost. The $3 trillion price tag shrank to $369 billion. But the Medicare portion largely skated through intact, untouched by the last-minute haggling as Democratic leadership tried to rally swing-state holdouts. With the Medicare portion not getting watered down, some market disappointment seems natural.

At the same time, markets dealt with it swiftly and moved on. In the two years since, they seem to have realized—rightly—that this wasn’t a massive profit headwind. Rather, its effect turned out to be smaller than anticipated. The first round, which just concluded, affected only 10 drugs, and their average negotiated cut was -22% off list prices versus around -50% originally expected. Analysts estimate the overall sales impact totaling $7.5 billion in 2026—when negotiated prices take effect.^[i] Sound big? Scale it against Pharma’s $312 billion revenue over the last 12 months (and 60%-plus gross profit margins).^[ii]

Now, Exhibit 1 showed Pharma jumping on a relative basis immediately after the IRA passed. Tempting as it might be to call this the market immediately getting over Medicare negotiations, we think it is important to consider the broader context and remember correlation isn’t causation. Stocks endured a bear market from early January 2022 through that October 12. A lot of Pharma’s 2022 outperformance likely stems from the industry’s typically defensive characteristics. After the bull market began, the industry’s—and broader Health Care sector’s—defensive traits began to weigh as more offensive sectors (like Tech) took over leadership as 2023 dawned and recession fears faded. The lesson here for investors, in our view: Markets pre-priced the shift and weighed other cyclical drivers.

For Pharma, though, headwinds haven’t totally abated. Next year, negotiations expand to 15 more drugs. The outcome—which set of drugs and the degree it hits Pharma’s profitability—remains unknown. Markets, as ever, are pricing in a wide array of scenarios. The first round seems to set the precedent for less-onerous-than-feared effects. While there is little clarity surrounding that, as more details emerge, the range of potential outcomes narrows. How the results vary from what markets expect has the potential to further move Pharma stocks. But with one round under the market’s belt, successive rounds’ surprise power diminishes. If they turn out to be as marginal as this year’s, policy uncertainty can fade further.

Overall, it seems clear Medicare drug price negotiations turned out to be a smaller headwind to Pharma profits than feared. Markets mapped out the negatives, priced them in and then continued going about their business. This is how it typically goes with big, widely feared bills. Often, they are sanded down from initial proposals, which can benefit markets overall even as they create winners and losers at a sector and industry level. We saw this with both the Affordable Care Act and Dodd-Frank. Markets got over them quickly, even as the Health Care and Financials sectors registered more of an effect. But even in those instances, sector returns didn’t suffer indefinitely. Rather, companies adapted to the new landscape and found ways to grow, profit and thrive.