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Daily Intelligence Briefing

Thursday, April 22, 2021

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US Military Spending, Russia and China Aggression Could Ramp Up Defense Stocks

Summary: The US has been enveloped in geopolitical turmoil across Europe and Asia over the past couple months. Russia is building up troops along the Ukrainian border and China is making large-scale incursions into Taiwanese airspace. Each of these situations have only become more fraught in recent weeks, coinciding with the Biden Administration’s first military budget proposal – one that was mostly flat from the previous year.

If these tensions continue to ratchet up in coming weeks, defense stocks may become increasingly attractive assets for investors that wish to hedge against the potential for military action across the globe, especially with valuations in the sector relatively cheap when compared to the broader market.

Related ETFs & Stocks: SPDR S&P Aerospace & Defense ETF (XAR), iShares U.S. Aerospace & Defense ETF (ITA), Lockheed Martin Corporation (LMT), Raytheon Technologies Corporation (RTX), Northrop Grumman Corporation (NOC)

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Amid a buildup of Russian soldiers along the country’s border with Ukraine, US defense spending is once again back in focus. Just weeks ago, the Biden administration proposed a fiscal 2022 Pentagon budget of $715 billion. That’s a 1.6% increase from 2021’s $704 billion, but as the Wall Street Journal notes, it’s technically a slight cut in the military’s spending power assuming likely inflation of more than 2%.

Biden’s Defense Budget Seeks Middle Ground, But Objections Abound

The mostly flat budget serves as a middle ground between Republicans and Democrats that have been trying to pull President Biden in different directions. As MRP noted last month, more progressive Democrats in the House of Representatives had been pushing to curb military spending by roughly 10% or more while Republicans in the House Armed Services Committee laid down a new marker urged President Biden to increase the defense budget by 3% to 5%, adjusted for inflation.

Though neither side of the aisle is getting what they want, US defense contractors will probably be happy to continue capitalizing on a budget that has not been significantly cut since 2015.

Still, some Democrats have not totally given up efforts to divert some funding away from weaponry and into other fields, like healthcare and education. The Investing in Cures Before Missiles Act (sharing the acronym ICBM with intercontinental ballistic missiles), recently proposed by Senator Edward Markey (D-MA), and Representative Ro Khanna (D-CA), would prohibit the US government from using fiscal 2022 spending on the Air Force’s Ground Based Strategic Deterrent (GBSD) program. Instead, Defense News reports $1 billion of unobligated funds from the GBSD program would be put toward research on a universal coronavirus vaccine.

That legislation likely faces an insurmountable uphill battle, especially with geopolitical tensions with many of America’s strategic rivals ramping up. GBSD is currently under development by Northrop Grumman, which won a $13.3 billion award in September to build a replacement for the LGM-30G Minuteman III. The Air Force re-upped that commitment, recently awarding Northrop Grumman another contract worth $2.3 billion for sustaining engineering support and program management support services related to ICBMs.

Russia Rallies Troops to East Ukraine Border

Around 120,000 Russian troops will soon be stationed along Ukraine’s eastern border, ratcheting up tensions with North Atlantic Treaty Organization (NATO) member states in Europe. Though Russia was able to unlawfully annex Crimea with little international resistance in 2014, the US, UK and allies in the east like Poland have taken a stiff posture and put pressure on Russian diplomats inside their borders. The Czech Republic, for instance, is now in a political tug of war with the Russian President Vladimir Putin, warning that it will continue to expel Russian state officials if Czech embassy staff in Moscow are not allowed to return to work today.

For its part, Russia has expelled 10 US diplomats in recent days, a reaction to the US’s own expulsion of Russian diplomats and a volley of new sanctions on the nation.

Ukraine is not a member state of NATO, which means a Russian invasion would not trigger the bloc’s Article 5 pact that considers an attack against one Ally as an attack against all Allies. However, Ukraine does maintain normalized relations with NATO and has joined NATO’s enhanced opportunity partner interoperability program.

Along with the buildup of troops, Russia is staging more military exercises in the Black Sea with 20 sea vessels and numerous Su-25SM3 attack aircraft taking part. CBS News reports Russia announced that it was closing the airspace over parts of Crimea and the Black Sea, saying the areas had been “declared temporarily dangerous for aircraft flights”.

Per Politico, the White House is now weighing requests from Kyiv to send additional weaponry to Ukraine – in particular, more shipments of Javelin anti-tank missiles, a joint product developed by Lockheed Martin and Raytheon. Ukraine purchased 210 shoulder-fired Javelin missiles and 37 launchers from the US in 2018 for approximately $47 million, and the State Department approved the sale of a second batch of 150 missiles and 10 launch units in late 2019.

The conflict in Eastern Ukraine is a complicated one, given the large population of ethnic Russians and Russian-speaking people in the Donbass region who formed militias around armed and equipped Russian mercenaries, volunteers, and unmarked soldiers back in 2014. Since then, small-scale civil wars have resulted in multiple self-proclaimed republics springing up in the impoverished region, including the Donetsk People’s Republic and Lushank People’s Republic – each aligned with Russia. Any incursion by Russian forces into these areas, would likely receive some level of support among the local population.

China Charging Up Military Spending Amid Taiwan Tensions

Chinese aggression toward Taiwan is also on the rise, following President Biden sending an “unofficial” delegation to the island nation that China insists is still under their jurisdiction. In response, Beijing launched 25 warplanes into Taiwan’s air defense identification zone (ADIZ) earlier this month, including 14 J-16 fighter jets, four J-10 fighter jets, four H-6K bombers, two Y-8 anti-submarine warfare planes and one KJ-500 airborne early warning and control aircraft. The South China Morning Post reports that it was the biggest ever incursion by People’s Liberation Army warplanes into Taiwan’s ADIZ.

While US Defense Dept. spokesman John Kirby recently affirmed that “[the US remains] committed, as we have for multiple administrations, to aiding Taiwan in its self-defense, to providing material for them to defend themselves”, NBC news notes that China’s massive arms buildup has raised doubts about America’s ability to defend Taiwan if a war broke out. In simulated combat in which China attempts to invade Taiwan, the results are sobering and the United States often loses, said David Ochmanek, a former senior Defense Department official who helps run war games for the Pentagon at the RAND Corp. think tank.

As MRP noted last month, US allies in the region are feeling that heat and ratcheting up their own budgets. According to The Diplomat, Japan has approved a “record” defense expenditure of 5.34 trillion yen ($51.7 billion) for 2021. India too has increased its defense spending for 2021-22, allocating a marginal hike of 1.4% to 4.78 rupees ($65.3 billion) in 2021-22.

Indeed, the Pentagon has said “the need to counter the pacing threat from China” is a top priority and as a result, mentions hypersonics, missiles that travel faster than the speed of sound, as an area of focus.

China’s Military expenditure will increase to 1.35 trillion yuan ($208 billion) in the coming year up 6.8% YoY, the largest gain since 2019. Bloomberg reports that is a much bigger increase in spending than the projected rise of 1.8% across budgeted fiscal spending.

Per the Motley Fool, a number of defense contractors, with Lockheed Martin and Raytheon Technologies leading the way, have identified hypersonics as a potential area of growth as the US is seen to be lagging China in their development. The US currently has 70 different hypersonic weapon programs costing $15 billion from 2015 and 2024.

For Investors

Speaking of Lockheed, the most recent major defense contractor to report earnings, EPS edged up 8% to $6.56, topping views for $6.34. Revenue climbed 4% to $16.26 billion but missed the expected $16.4 billion mark. However, IBD notes the company upgraded guidance to a full-year EPS of $26.40-$26.70, up from a prior estimate of $26.00-$26.30. Revenue expectations were raised to a range of $67.3 billion-$68.7 billion, up from prior guidance of $67.1 billion-$68.5 billion.

The earnings call came in the wake of Lockheed clinching a modification contract worth $447.2 million earlier this month, focused on the production and delivery of 12 MH-60R aircraft, which will be supplied to the government of the Republic of Korea.

As Barron’s notes, defense stocks are chronically cheap, partly because of budgetary fears. In the 1990s, when defense contractors saw solid returns despite President Clinton’s cuts to the budget, the sector traded at about a 20% discount to the S&P 500, based on price-to-earnings ratios. Today the discount is closer to 30%.

For investors, a cut to US military spending would have likely meant less money for key US defense contractors like The Boeing Company (BA), Lockheed Martin Corporation (LMT), Raytheon Technologies Corporation (RTX), Northrop Grumman Corporation (NOC), etc. However, the flat budget is probably a positive outcome for aerospace and defense shares.

Additionally, a ramping up in geopolitical turmoil around the globe will undoubtedly bring heightened attention to the sector.

To gain broader exposure to those firms, investors could look to the iShares U.S. Aerospace & Defense ETF (ITA). However, it is worth noting that Boeing represents 20% of the weighting in the ITA, despite the majority of its business being commercial aviation. For those seeking a more straightforward approach toward the defense industry, the SPDR S&P Aerospace & Defense ETF (XAR) is a viable alternative.


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