Kyle Jacobsen

2018 Sectors in Focus: Healthcare and Consumer Discretionary

Healthcare:

2017 Q3 & Q4 Recap

The healthcare sector ended 2017 with the sector up 22.1% YTD (XLV)*. The largest
drivers for 2017 emerged a year prior when the Trump administration targeted high drug prices
and vowed to repeal the Affordable Care Act (ACA). 2017 in healthcare was categorized by
volatility stemming from ACA repeal efforts and drug pricing worries across high-flying biotech
companies. As the sector rebounded last year, healthcare reform, pricing worries, and
overleveraged pharmaceutical companies took the spotlight.

2017-2018 Tax Bill Specific Effects: One of the notable catalysts resulting from the new
tax bill is the removal of an Obamacare individual mandate. The bill removes the private
minimum health insurance mandate starting in 2019. This means that individuals who utilize
private HMO’s and HCSO’s will no longer be required by law to have health insurance at the
minimum age of 26 (non-dependent cutoff age). This is not a near-term catalyst but will likely
cause a rise of premiums and in the number of uninsured individuals. Overall, older citizens in
need will obtain less financing assistance from the healthy and the risk of the insured pool of
consumers will increase.

2018 Outlook

Upside Support:

New Technology Emergence

The largest long-term catalyst for healthcare is now technologies that alleviate extremely high
costs of healthcare and provide care coordination. One of the most organic benefits of the tax cut
to healthcare companies is the freeing of capital that can be allocated to the new age of health
care consumerism. A technology revolution that allows for healthcare providers to execute on
daily operations with more efficiency and at an increasing comfort to patients has already begun
to excite long-term sector bulls.

Favorable Backdrop for M&A and Pipeline Activity

The deal volume we saw in M&A throughout 2017 is expected to grow in 2018. M&A between
health insurers, pharmas, and biotechs can be expected to drastically increase throughout the
year. Most importantly, the non-volatile background will allow for an increased volume of M&A
related to pipeline expansion efforts.

Figure 1

*Stated YTD returns are gross of dividend profits

Kyle Jacobsen

Growth of Generic Offerings

Another notable factor in the 2018 picture for healthcare (specifically pharmaceuticals and
biotechs) is a large amount of similar generics flooding drug markets. This is an upside catalyst
as drug makers will increase buyouts, more biotechs will seek FDA approval, and large
pharmaceutical companies will price their products to remain competitive.

Momentum-driven Sector Rotation

The final driver for growth in the industry in continued earnings expansion and late cycle
momentum. This means that as thematic trends emerge, investors are likely to seek the higher
returns available in healthcare at the expense of a higher risk premium.

Downside Risks:

Healthcare Reform and Drug Pricing Legislation

The tax bill amending the ACA (Affordable Care Act/Obamacare) individual mandate will likely
be the beginning of a full ACA reparation requiring bipartisan support throughout 2018. If this
legislation does not contain the favorable conditions expected for HMOs and HCSOs than a
sector pull back could occur. Also, any execution of drug pricing regulation proposed by Trump
could cause some declines in across big pharmaceuticals.

Broad Rotation Back into Growth Stocks

*Stated YTD returns are gross of dividend profits

Kyle Jacobsen

While many biotechs are overleveraged and healthcare providers are rebounding, the sector
remains undervalued relative to many of the other S&P sectors. Healthcare also stands to lose if
we fail to see a flow back into value and investors overindulge in growth sectors.

Healthcare 2018 Outlook: Outperform and bullish (with a 4 out of 11 sector ranking
projection)

Overall, the 2018 outlook in healthcare became more favorable once top-line growth was
repeated in 2017 and lofty M&A projections were released. While I feel that larger risks exist in
biotech and political headwinds could emerge, relatively reasonable valuations should keep the
sector protected in event of a pullback. Technology investment, piupeline activity increases,
additional generic drug offerings, and momentum-driven sector rotation will allow for a
cautiously optimistic case for healthcare this year.

SPDR XLV ETF 2018 YE PT: $101.75

Consumer Discretionary:

The consumer discretionary sector is composed of five major industry types; automobiles,
consumer durables, consumer services, media (ex. Comcast, Disney), and retail.

2017 Q3 & Q4 Recap

Throughout 2017, consumer discretionary enjoyed marketweight performance (XLY

^22.8%)* on the back of a tightening labor market and solid retail sales. Select industries within
the sector like airlines, restaurants, and specialty apparel contributed to the historical “holiday
bump” in Q4 that many investors speculate upon. Seasonal tourism cycles and increases in
holiday gambling also drove casinos and airline stocks higher in Q4. The largest factor effecting
the sector towards the end of 2017, was the flow into sectors with more attractive returns during
a late bull cycle. Overall, consumer discretionary ranked 6 out of 11 in 2017 with regards to
performance but faces secular headwinds in this goldilocks environment.

2018 Outlook

Upside Support:

High Consumer Confidence

The consumer confidence measures the overall optimism of American buyers and the
ease at which consumers are purchasing non-necessities. The CCI continues to show signs of
holiday peaking and historically-high levels.

*Stated YTD returns are gross of dividend profits

Kyle Jacobsen

Figure 2

Downside Catalysts:

Company Specific Salary Growth: Consumer discretionary companies have a low value
per employee ratio. This means that they rely heavily upon cheap widespread labor. A
competitive rise in wages, especially for employees near minimum-wage levels, will cause lost
revenue on a company-level in the event of wage hikes. This is a headwind is created for
consumer discretionary and consumer staples companies. However, this negative could be
alleviated given widespread wage growth for all consumers which could lead to an uptick in
discretionary spending.

The Emergence of the e-retail consumer:

This threat to consumer discretionary is nothing new, but is slowly shifting flows from
consumer discretionary into technology. AMZN is a primary component of the sector, but is
beginning to become overshadowed by consumer’s making purchasing decisions via social
media. This will continue to be a long-term downside factor for the sector.

Late Bull Cycle Trends:

In the later stage of bull cycles, it is typical for investors to prefer technology, financials,
energy, and industrials. Due to a broad assortment of companies, consumer discretionary stocks

*Stated YTD returns are gross of dividend profits

Kyle Jacobsen

lack the sector-specific upside catalysts that selective investors will look for post-Trump trade.
Instead, it is likely that the sector will underperform until a large pullback pushes flow back
towards value stocks. Overall, the sector’s returns are fairly consistent with the S&P 500 and can
be considered marketweight.

Figure 3

As displayed by the figure, the mountain chart shows that the SPDR XLY ETF (Cons.
Discretionary) is performing in lockstep with the S&P 500 while underperforming the DJIA and
NASDAQ.

Consumer Discretionary 2018 Outlook: Market perform and neutral (personal

ranking 7 out of 11 sectors)

In 2018, the sector will lose attention to other sectors that are considered matured cycle
plays. The labor-intensive sector has resumed normal tightening conditions and has capped
upside due to changes in consumer preferences, all-time low unemployment, and consumer
confidence at unsustainable levels.

SPDR XLY ETF YE 2018 PT: $117.50

*Stated YTD returns are gross of dividend profits