Fate of the Biotech Industry in an Inflationary Environment

The Biotech industry had a strong push for investments during the pandemic. Several years of financial abundance was followed by bankruptcies and layoffs. What is lying ahead of the biotech industry? What should we expect for the coming years? 

The pandemic reset all the known rules and projections about the global economy. After an initial stall in activity, there was a global rise in inflation due to exploding demand, driven by stimulus payments and ultra-easy monetary policies, accompanied by collapsing supply caused by halted manufacturing and limited labor for services.

Central banks tried to rein in inflation by raising borrowing rates and implementing quantitative tightening. Although initially successful, the effect of these efforts did not last long, and inflation did not return to pre-pandemic levels in most advanced economies. However, high borrowing rates and a contraction in the money supply led to significant transformations across many economies, also affecting the biotechnology sector.

The biotech industry heavily depends on external investment. This is because most start-ups developing new therapies typically do not generate any revenue until they obtain drug approval, which takes several years. Even after approval, building manufacturing and delivery capacity requires significant investment. Without capital injection, most biotech start-ups cannot survive long enough to reach a revenue-generating stage. As a result, they depend on IPOs, acquisitions, or new shareholders. When the money supply contracts, all of these options become scarce.

During the pandemic, unlike sectors such as transportation and energy, the vast majority of biotech companies, especially those in early stages, thrived due to the surge in the money supply. When that money began to dry up, many start-ups felt the pressure and ultimately shut down their operations.

On the opposite end, large pharmaceutical companies did not experience these same waves. These corporations are like gigantic ships; they do not rise and fall much with fluctuations in the money supply. They generate revenue through their operations and are more insulated from such shocks. They also benefited from certain high-demand drugs treating common diseases such as obesity and cancer, which boosted their revenues.

Now, the important question is: What will macroeconomic conditions look like in the near future, and how will they affect the biotech industry? The answer depends on several factors. Let’s go over them briefly.

Will inflation dramatically go down soon? Not highly likely. There are several reasons. Probably the most important is that most developed countries, except for a select few like Germany and Norway, are running gargantuan budget deficits, with little to no intention of reducing them in the foreseeable future. These ever-growing fiscal deficits will continue to fuel inflation.

Perhaps an even more important reason is that the ultra-easy monetary policies during the pandemic permanently changed the psychology of investors and consumers. While the perceived value of currencies has declined, the perceived value of assets, goods, and services has permanently increased. Investors and consumers now place more value on tangible items. Why? Because they have learned that central banks can double the money supply within months, but cannot increase the availability of assets, goods, and services even by 10 percent in the same time frame. Those holding cash during the pandemic saw their wealth erode, while those holding debt tied to assets thrived. This shift has caused a lasting change in behavior. The only force that could reverse this psychology is a sharp, sudden economic shock. But the response to the Silicon Valley Bank (SVB) bailout demonstrated that neither central banks nor fiscal policymakers are willing to tolerate even minor financial shocks. For this reason, I do not expect a reversal in investor or consumer behavior. Few will prefer to stay in cash; consumers will keep spending, and investors will continue buying assets.

Does this mean that venture capitalists will flood biotech start-ups with cash? Not exactly. One important factor is global politics. After the end of the Cold War, Western governments believed that the risk of large-scale land wars was permanently over and significantly reduced defense spending. Military stockpiles and personnel levels were sharply cut in the 1990s and 2000s. Investments shifted toward sophisticated systems rather than large-scale manufacturing. However, the war in Ukraine shattered those assumptions, and many governments realized their weapon and ammunition stockpiles were insufficient for major conflict. Adding to this, NATO allies have recently woken up to the reality that they cannot rely unconditionally on U.S. security guarantees.

How is this related to the biotech industry? It relates to the overall investment environment. Unless central banks dramatically expand their balance sheets, total investment capital in financial markets will be limited, or at least unlikely to grow substantially. In the next decade, a large portion of that capital will flow into the defense industry to meet rising demand. This will reduce the amount of capital available for industries such as biotech.

Defense will not be the only capital-absorbing sector. In recent years, we have witnessed extraordinary growth in AI-related investment across industries. Regardless of whether the value is justified, the current sentiment has created a fear of missing out. As a result, large portions of global capital are flowing into AI. In fact, there is a high risk that much of this investment will be ineffective, focused on hardware rather than human capital or data, but the result will be the same: less investment capital available for other industries.

Another industry that will absorb the global capital is the transportation sector. Due to global warming and other reasons, ground transportation will mostly be electrified. This will require massive investments. For the same reasons, decarbonization of the energy industry will also draw capital from the global financial markets in the upcoming years.  

For all these reasons, the chances of inflation falling in the near future are very low, and investment capital will remain limited. Spending on defense, AI, and growing fiscal deficits will absorb large portions of global capital while fueling demand. The supply side is unlikely to keep up, further increasing inflation.

One important factor is the cost of capital, meaning interest rates. Unless there is a major financial shock, such as a Lehman Brothers-style collapse, interest rates are unlikely to drop quickly. As we saw during the SVB bailout, neither the administrations nor central banks appear willing to allow even minor financial shocks. Another possible scenario is that governments pressure central banks to lower rates, but this has the risk of backfiring. If interest rates fall below inflation, prices will spiral out of control, eventually forcing central banks to raise rates to extremely high levels. Therefore, in either case, interest rates, or the cost of capital, will likely remain high in the near future.

The high costs of capital may continue to put the start-ups and small biotechs under pressure in the upcoming years. This will require these enterprises to act more aggressively for finding investors, providing new opportunities for them. But on the other hand, the investors will need to act more cautiously, as the cost of a dead investment will be high for them.

In summary, the biotech industry is likely to face multiple headwinds in the investment environment: rising inflation, limited and expensive capital, and increasing competition from other sectors. However, this does not mean the entire biotech industry will suffer. Large pharmaceutical companies with steady cash flow and easy access to capital will be well positioned to weather these conditions. In contrast, start-ups with no revenue and limited access to funding may face serious challenges. Start-ups in certain fields like gene and immunotherapy, or those targeting common diseases (diabetes, obesity, heart disease) may be in a better position to weather the winter. Those that survive this difficult period, which may last several years, could reap significant rewards in the future.