Insights & Advice


A new defense stock cycle

Photo of a fighter jet flying through blue skies and puffy clouds

Defense stocks have soared since the outset of the Ukraine-Russia conflict. That is a typical reaction to geopolitical strife. Frequently, investors bid up the sector only to sell these stocks once peace returns. This time may be different.

Vladimir Putin has put the world, and specifically Europe, on notice that he is bound and determined to resurrect the formal might of the USSR, no matter how long it takes. His actions have caused a sea of change in Europe’s decades-long freeze on defense spending. Germany is a prime example of what analysts believe will be the beginning of a new era of inflated European defense budgets.

In February 2022, Chancellor Olaf Scholz argued before the German Parliament that the invasion “was a turning point in the continent’s history.” In order to prepare his country for this new reality, he immediately doubled Germany’s defense budget from 47 billion euros to 100 billion.  Several European Union (EU) members are planning the same thing. Finland, Sweden, the Netherlands and the UK have been first to declare their intent to beef up defense spending and more countries are expected to follow. The intent is to raise defense spending by NATO members to more than 2% of GDP.

And while the Ukraine War is serious enough to goose spending for planes, tanks, drone, rockets and such, the shooting war simply adds to a long list of mounting hostilities in an increasingly dangerous world. The threat of China and its ambitions to annex Taiwan, North Korean missiles, incessant warfare in the Middle East, rebel movements in Africa, and regular instances of cyberwarfare have kept defense spending high throughout the last several years, at least in the U.S.

The U.S. defense budget has been stable and rising given the quantity of perceived threats. As a result, the defense and aerospace sector have been quietly outperforming the market’s returns for the past eight years or more. Thanks to the pandemic, and resulting supply chain issues last year, the industry experienced reduced production, but with the down swing in coronavirus cases (at least in the U.S.) production is getting back to normal. Most Wall Street analysts are expecting government defense expenditures to rise from about 2.8% to a range of 3.5-4% in the next few years.

From an investment point of view, the defense stocks move in cycles; roughly gaining for 7-8 years, underperforming for 2-3 years, and then growing again for another 8 years or so. From 2020 to 2022, the industry underperformed, thus setting investors up for what could be a spate of outsized gains.

If we look back during the last 20 years of U.S. involvement in the Middle East, defense stocks such as L3Harris Technologies, Northrop, Lockheed Martin and Raytheon gained respectively 1,399%, 866%, 800% and 509% compared to the S&P 500 Index advance of 297% from 2001 to August 2021. I am not cherry-picking results either; most defense stocks have had similar returns.

Obviously, government spending is the largest customer of defense companies.  At least 19 members of Congress (or their families) are personally invested in defense contractors, and some of them sit on congressional committees that regulate defense policies. I will avoid the obvious conflict of interest issues that this might raise and just remind readers that politicians on both sides of the aisle have good track records in investing in stocks that they can influence.

All indications are that the war in Ukraine is moving to another phase. Military experts expect the war will continue and may evolve into a protracted war of attrition. The China threat is not going away, and now that most western nations are rethinking their defense spending, it appears that we may be starting on a new multi-year cycle for defense stocks.

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