Defense Stocks Outperform Global Market on Expectations of Higher Spending

Defense stocks have outperformed the global market this year by the most in nearly a decade, on expectations of increased military spending by Western governments and as ethically minded investors reappraise the sector.

An MSCI index that tracks aerospace and defense stocks has outperformed a broader gauge of global stocks by 17 percentage points in dollar terms since early January. Such outperformance has occurred only two other times since 1999.

Russia’s invasion of Ukraine on February 24 has fueled expectations of new government orders, higher revenues and stronger profits for companies in the defense sector. Analysts say the war has changed investors’ views of the industry, underscoring its role in facilitating international security.

In turn, shares in companies such as Lockheed Martin and the UK’s BAE Systems have risen strongly, with only FTSE 100-listed BAE up for more than a third year to date. Underpinning those achievements, Vladimir Putin’s foray into his neighboring country has reignited a debate about the extent to which manufacturers of arms and defense machinery should be excluded from portfolios focused on the environment, society and governance.

However, some have warned of premature enthusiasm for defense actions, arguing that it is still too early to say when promises of bigger budgets will translate into better results.

“There seems to be the beginning of an irrational exuberance about the industry. It really is too early to tell,” said Bill Greenwalt, who served as deputy assistant secretary of defense for industrial policy during the George W Bush administration and now works at the American Enterprise Institute.

The United States, the United Kingdom and other allies have pledged significant sums in military assistance to Ukraine and have sent hundreds of anti-tank missiles, drones, ammunition and other weapons to the country. The United States alone has offered more than $3 billion, including a new $800 million aid package announced Thursday that will include heavy artillery and tens of thousands of munitions.

However, most of the weapons so far have come from existing government stocks. “We haven’t yet seen an increase in orders and contracts or a recognition of the need to act quickly,” Greenwalt said.

Doug Harned, an analyst at Bernstein, notes that the increase in share prices is consistent with trends seen in previous regional conflicts. Profits have generally been paid back, often within six months. Investors, he adds, need to think about underlying budget trends. “Do budget trends and relative valuations make defense interesting as a long-term play?”

Others point out that the time scales in the industry mean that any orders, if they arrive, will take time to reach the bottom lines of the companies.

“If you put something in the budget this year, a tank, a plane or a warship, it will not be delivered until 2023, 24, 26 in some cases. You see the movements in these actions and in the sentiment but. . . managements are a bit reticent about framing what this all means for their companies,” said Byron Callan of the research group Capital Alpha Partners.

Jim Taiclet, CEO of US defense giant Lockheed Martin, sounded cautious earlier this week. The head of the company, which together with Raytheon makes the Javelin anti-tank missiles that have been shipped to Ukraine, acknowledged that the more challenging environment suggested “deterrence is a more valuable commodity than ever.” But he stressed that it was “too early” to say if and when this would translate into actual contracts. The company did not improve its outlook for 2022.

You are viewing a snapshot of an interactive chart. This is most likely because you are offline or JavaScript is disabled in your browser.

So for long-term investors, the bigger question is whether promises by Western governments to spend more on defense will result in permanent change. Weapons programs had previously come under pressure from competing demands on government finances, particularly health projects during the Covid-19 pandemic.

Some major investors had even bet against major defense contractors before the invasion.

But defense has moved up the priority list again in 2022, in a scenario epitomized by Germany. Berlin announced a historic change in defense policy and said it would launch a 100 billion euro fund to modernize its armed forces. In turn, shares in Germany’s publicly traded defense contractors have soared. The market value of Rheinmetall, which makes tanks and armored vehicles for NATO countries, has more than doubled this year.

BlackRock, which had a 0.6% short position in BAE Systems at the end of January, quickly trimmed its position by a third in the second half of February, according to data from Breakout Point.

Citadel Europe also cut its short position in Italy’s Leonardo from 0.69% to 0.42% on February 10, while BlackRock UK cut its sizeable 1.13% short position in the Italian arms maker to 0.12%. % the 28th of February. Hedge funds Sandbar and Egerton also cut short positions in Leonardo in the second half of February.

‘Big dilemma’ for ESG investors

While the rise in Western defense budgets has yet to be pinned down after the invasion, some suggest the conflict may yet spark a change in sentiment among ESG investors. In recent months, industry executives had grown increasingly concerned that the widespread trend of sustainability-focused investing would lead to their stock being shunned by institutional investors.

“Perhaps the biggest change that could result from the Ukraine invasion is a reversal of ESG’s lazy view that defense is ‘bad,'” said Robert Stallard, an analyst at Vertical Research Partners.

“The big dilemma is that many sustainable funds would have had exclusions entirely on defense spending. [including] government contracts, all that kind of stuff,” said Gavin Rochussen, CEO of Polar Capital.

Since then, Russia’s invasion of its neighbor has muddied the waters. “How do you try to protect a country from a foreign invader? Is it right that you don’t actually support countries that spend to defend themselves? she added.

SEB Investment Management, the Swedish bank’s fund management arm with SKr831bn under management, is one of the few that has explicitly relaxed its policies on the exclusion of defense stocks. Starting in early April, some of its funds will now be able to invest in the industry.

However, the change is limited: only six of the more than 100 SEB funds will be able to make these investments, and companies that violate international conventions on weapons, such as landmines and cluster bombs, will continue to be excluded, as will than nuclear weapons producers.

“It is important to remember that many of our clients and investors are still unwilling and unable to invest in the defense industry and that, going forward, many of SEB Investment Management’s funds will continue to exclude such investments,” SEB said. .

Other policy changes, if they come, will take time. A recent survey of investors by analysts at Jefferies found that while there seemed to be a call for a looser approach to defense stocks, few investors had implemented policy changes. According to the survey, 44% of respondents were currently reviewing their ESG policies, but only 8% were doing so specifically on defense.

Still, Philip Saunders, fund manager at Ninety One, is confident that change is on the way. “The pendulum is swinging. This is a time when it seemed like the momentum was going in one direction, and now we need to collectively step back, because the reality is that the real world is much nastier than we thought before February 24,” he said. .

Add Comment