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The Federal Reserve looks poised to cut rates later this year – and while the stock market as a whole will likely breathe a sigh of relief, some sectors may feel the effect more than others. Biotech could be one of them – that’s according to Morgan Stanley, at least.

Why biotech in particular?

The biotech sector – those companies on the forefront of medical technology – tends to outperform the rest of the market when interest rates are falling, especially when they’re still high but starting to fall. And that’s the scenario we’re looking at today.

There are a few reasons why that’s the case:

1. Falling interest rates make it cheaper for companies to borrow money. In the biotech industry, that makes it easier to fund new product development.
2. Biotechs tend to be focused on developing products and services over the long term, rather than boosting short-term margins. This long-term focus means they're less concerned with short-term economic fluctuations.
3. Biotech companies often have long-term revenue streams. When interest rates fall, the present value of these future earnings increases significantly, because lower rates reduce the discount applied to future cash flows.

All of that might explain why historically, biotech stocks have outpaced the market by about 17% in the six months following a rate cut, and by about 27% over a year.

As an investor, what’s the takeaway here?

Biotech stocks can make for a defensive addition to your portfolio – demand for healthcare products and services is always present, no matter the economy. But remember, they’re still risky tech companies at heart, with the success of biotech firms often relying on unpredictable factors like regulatory approvals and scientific breakthroughs.

A broader and more diversified approach works well here – and one way to do that is to invest in the entire sector. Our Healthcare Innovation Thematic portfolio does just that, with exposure to a wide range of companies in biotech and other related sectors.

📰 In Other News: Earnings season is in full swing

In case you haven’t noticed, we're in the midst of earnings season, with companies releasing their second-quarter updates one after another.

As of the end of July, more than 40% of the companies in the S&P 500 have provided their latest updates. At first glance, the results seem like a mixed bag. On one hand, only 60% of them have reported revenues that were above estimates. But on the other, 78% have reported earnings-per-share (EPS) figures above the 10-year average. That disparity between revenue and earnings suggests that profit margins are improving.

The current data suggests that firms’ EPS in the second quarter is 9.8% higher than the same time last year. If that number holds at the end of the season, it would mark the fastest pace of earnings expansion since the end of 2021 and the fourth consecutive quarter of positive growth.

That could be enough to convince investors that the S&P 500’s strong rally over the past two years might still have momentum. Although, they’re becoming increasingly harder to please: the market’s reaction to positive surprises has so far been lukewarm.

These articles were written in collaboration with Finimize.

🎓 Simply Finance: Profit margins

Profit margins measure how much of a company's revenue is kept as profit after expenses are paid. Imagine a software company that sells $1 million worth of its products. If its total costs – including salaries, marketing, and overhead – amount to $700,000, its profit would be $300,000. This gives the company a profit margin of 30%.

A higher margin means a company is more efficient at turning sales into profit. It shows how well a business manages its costs, pricing, and efficiency – key factors in long-term financial health.