Will Trump spark a global defence spending spree?

With the US and NATO set to raise military spending, are defence sector stocks set for further gains?

US flag
Source: Bloomberg

US President Donald Trump recently confirmed he plans to raise defence spending by 10% from current levels, seeking to cut costs across the civil service to pay for it. This has driven a substantial rally for US defence sector stocks. Trump’s also pressuring NATO nations into raising their expenditure to reach the target of spending 2% of gross domestic product (GDP) on defence. Given this, could the rally in the defense sector extend to European stocks?

The 10% rise in US defense spending is something of a contentious issue. It comes alongside Trump’s announcement of $1 trillion in infrastructure spending. Funding for both of these massive commitments is unclear. Quite frankly, unless Congress is going to accept adding to the country’s huge debt piles, something has to give. With that in mind, there is no guarantee we will actually see these plans come to fruition. The rise in defence spending is actually not as unprecedented as it might seem, coming off the back of a circa 20% cut in defence spending under Barack Obama. Given the pressure Trump placed upon Lockheed Martin over the rising costs of the renewal of the F35 aircraft fleet, there is also reason to believe profit margins could continue to suffer irrespectively of the amount of new orders.

With Trump pushing NATO members into raising military spending towards the 2% of GDP target, it is clear European firms could also benefit from a rise in orders. Looking at the chart below (Source: The Economist), it is easy to see that while a handful of nations currently fulfil their 2% mandate, most spend somewhere between 1% and 2%. With a 10% rise in US spending equating to around $66 billion, the 0.5%-1% rise across the majority of the ‘others’ section plus Germany would equate to around $142-72 billion of additional spending. 

The Economist NATO chart

However, there’s a problem as despite Trump’s claim that money is ‘pouring in’ to NATO, we have a number of European nations whose austerity policies make it difficult to justify a sudden shift into military expenditure. That being said, should we see the Europeans raise defence spending, it could spark a surge for the big names in the industry.

US providers are likely to get any of the business associated with the US rise in spending, but picking the winners and losers could be tricky and there’s always the risk that firms may not even retain current contracts when they are up for renewal. With that in mind, it makes sense to look at the iShares U.S. Aerospace & Defense ETF as means to gain access to firms across the spectrum. The chart below highlights the incredible trend it has been enjoying, which looks likely to continue for some time. Going by the continued creation of higher highs and higher lows, any retracements or pullbacks look like interesting buying opportunities. 

Top holdings 

Holding name Percentage
Boeing Co 10.11
United Technologies Corp 8.53
Lockheed Martin Corp 7.47
General Dynamics Corp 6.87
Raytheon Co 6.17
Northrop Grumman Corp 5.86
Arconic Inc 3.62
L3 Technologies Inc 3.27
Textron Inc 3.20
Rockwell Collins Inc 3.20

 

ITA EFT chart

It is a little more difficult in Europe, with no similar ETF to buy into. The main names to look out for in Europe include BAE Systems, Rolls-Royce, Airbus and Thales. Unlike the US, European governments would be less loyal to EU providers, and the European firms could see competition from the US sector if NATO countries do raise spending. Looking at the chart of Rolls-Royce, we have seen a rally into a crucial trendline resistance, which must be overcome if we are to see the 2016 recovery persist. A break through trendline resistance and through 875 would point towards a push into 1060 and 1300. However, there is obviously a chance we could see this trendline undermine the recent gains, with a push back below 635 particularly worrying if it occurred.

Rolls-Royce chart

The BAE systems chart shows a market which has less challenges ahead, with price continuing to break into new highs over the past year. We are currently within another one of those legs higher, and with few signs of this trend coming to an end, we are likely to see further gains. A clear support level of 580 must remain intact for the bullish outlook to stay valid.

BAE Systems chart

Overall, there appears to be a shift back towards military spending rather than cuts, which can only be positive for some of the firms in the industry. Whether to invest in Europe or the US remains a bone of contention, with arguments for both sides. However, diversification amongst the sector appears to be a sensible option given the future prospects.

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