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Remember the Sequester? Defense Stocks Don't

11 April 2014 in Trading Ideas

You may remember a bit of anxious hand-wringing a little less than a year ago in reaction to automatic federal spending cuts that eventually went into effect on March 1, 2013.

At the time, the fear was that these sequestration budget cuts would not only destroy jobs but that US-based defense contractors, along with their respective stocks, would feel the pain.

It never happened – in fact, the opposite has taken place, at least in terms of stock performance.

As Oppenheimer analyst John Stoltzfus recently noted, since the March 1, 2013 sequestration cuts, the Dow Jones US Select Aerospace and Defense Total Return Index rose 55.6%, compared to gains of less than half that in the other major US indexes.1

 

During that same time frame, for example, the S&P 500 delivered a total return of 25.7%.

The Modern Warfare motif has seen a similar climb. In the past 12 months, it has gained 54.1%. (In that period, the S&P 500 has risen 20.4%).

Stoltzfus pointed out that while the runup in defense stocks may seem counterintuitive, there is an economic rationale for the rally.

“Realities of instability in the Middle East (Iran, Syria, Egypt), North Korea and most recently in Ukraine remind us that from a super-secular cycle, mankind has been at war or at risk of war for most of history,” he wrote. “The necessity of protecting borders and trade routes as the process of globalization continues likely contributes to the loyalty that investors have shown for this [Aerospace and Defense] specialty index.”

Stoltzfus’ view echoes expert opinions that despite US defense budget cuts, military spending will be necessary in coming years as the government invests in new technologies. As Mike Lewis of defense industry consulting firm The Silverline Group estimates, the annual US defense budget is likely to hover around $500 billion for the next several years.2

Even more importantly perhaps, a pullback in US defense spending doesn’t necessarily mean a dropoff for defense firms when considering the global customer base. As the Financial Times reported recently, Asian military spending is rising rapidly – and more than offsetting shrinking defense budgets in Europe.3

Citing a report by the International Institute for Strategic Studies, the FT said that in 2013 Asia spent $322 billion on military budgets, up from $262 billion in 2012. Meanwhile, European spending dipped slightly to $279 billion from $287 billion in 2010.

According to the report, “Asian states are developing and procuring advanced military equipment of types previously monopolized by the west and Russia.”

This development could bring political headaches, but it also may be a boon for defense contractors.

(To see recent comments on the Modern Warfare motif made by Motif Investing CEO Hardeep Walia in his recent appearance on CNBC, click here.)

1Sam Ro, “Defense Stocks Have Done Spectacularly Well Since the Sequester,” businessinsider.com, April 7, 2014, http://www.businessinsider.com/defense-stocks-stealth-rally-2014-4.

2John Jannarone, “Ukraine crisis: Defense stocks as strong defensive plays,” cnbc.com, March 3, 2014, http://www.cnbc.com/id/101461511, (accessed April 8, 2014).

3Carola Hoyos, “Asian military spending on the rise,” ft.com, Feb. 6, 2014.

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