The defence sector may be something investors tend to overlook because it seems distant and unfamiliar. Besides, most of us don’t expect a WW3 to break out anytime soon. But Credit Suisse pointed out in a recent report that defence stocks is a “clear overweight”. Here are three reasons it gave.
1. Defence Spending Low by Historical Standards; Spending Expected To Rise
EU and US defence spending is 18 percent and 10 percent of GDP respectively, which is below the 20-year norm. In particular, for the US, it is around 40 percent lower than the 40-year average. In Europe, none of the major EU nations (with the exception of the UK and Poland) meet the North Atlantic Treaty Organisation (NATO) requirement of spending two percent of their GDP on defence. However, many European countries have committed to increase their spending on defence.
In the Asia Pacific region, Japan has called for a debate to amend its pacifist constitution, which would enable it to increase defence expenditure beyond one percent of its GDP. China is expected to continue to pick up its defence spending, increasing by around 10 percent.
Post-Cold War Tension
Increased political tension is another reason that could lead to an increase in defence spending. Against the backdrop of heightened political tension, Russian defence spending is up nearly 50 percent as a proportion of GDP since 2011. It currently stands at around 5 percent, which is more than double of that required by NATO.
2. Hedge against Trump Being Elected As President
More Spending on Military, Claims Trump
Donald Trump has explicitly said that he would lift the caps imposed on military spending by the Budget Control Act of 2011. He vowed to grow the active-duty army from 475,000 to 540,000 soldiers, increase the number of Navy ships from 280 (planned) to 350 and add dozens of additional fighter aircraft. This would result in about US$80-90 billion of additional defence spending compared to Obama’s 2017 budget.
Moreover, Trump has suggested that US support for NATO members would be conditional upon them raising defence spending to two percent of GDP. Credit Suisse opines that defence stocks could act as a hedge in the event of a Trump victory in the upcoming presidential election. Credit Suisse also highlighted that there is a high correlation between the relative performance of defence stocks and Trump’s popularity levels in polls.
3. Defence Sector Immune to Foreign Competition; Diversification into Cyber Security
Heavy Barrier to Entry
As it concerns national security, the defence sector is heavily regulated and protected from foreign competition. This creates large barriers to entry and limits disruption from either Chinese competition or new technologies.
Diversification into Cyber Security
Furthermore, defence companies are increasingly involved in cyber security, which is becoming an important focus for governments and businesses. According to the Centre for Strategic and International Studies, cybercrime costs the global economy US$575 billion a year, thus explaining the trend that companies and governments are increasingly investing in cyber security.
The UK government announced that it would increase spending on cyber security by £1.9 billion by 2020 while in the US, a Federal Chief Information Security Officer (CISO) has been appointed for the first time. The CISO will be tasked with driving “cybersecurity policy, planning, and implementation across the Federal Government”. President Obama has also made a budget proposal asking for US$19 billion for cyber security across the US government.
Investors Takeaway: Northrop Grumman & Lockheed Martin
Northrop Grumman Corporation is a global security company that specializes in aerospace systems, mission systems, and technology services. Northrop Gumman is the fifth-largest defense contractor in the world. In Feb 2016, Northrop Grumman won a contract to build a long-range strike bomber, which was valued at US$80 billion.
Lockheed Martin Corporation is another global security and aerospace company. It is currently the largest US defence contractor with over 10 years of consecutive dividend increases, and it is also positioned to benefit from expansion in US military spending.