Assistant Portfolio Manager David Chung shares his outlook for the defense industry amid political change and the nascent global economic recovery.

Key Takeaways

• Investors should consider the impact on the defense industry from potential changes to government spending under a new presidential administration and the lingering economic effects of COVID.
• At the same time, ongoing geopolitical tensions and a growing reliance on defense technologies have solidified the industry’s long-term importance.
• As the economy recovers, select defense companies continue to report good financial results.

As we’ve witnessed across most industries, COVID-19 had a significant impact on the defense industry, both directly and indirectly. Early in the crisis, at the height of initial lockdowns over a year ago, the industry was not immune to disruptions in factory production and industrial manufacturing or broken supply chains. With the help of favorable progress payments from the government to aid its industrial supply base and a nascent economic recovery, select stocks within the defense industry appear to be turning the corner, as companies report encouraging quarterly results. Investors must now assess both the current factors that could impact defense stocks and the longer-term outlook for the industry.

Defense Spending in a New Administration

The U.S. government is the primary source of revenue for many defense companies; hence, the nation’s defense budget has a significant impact on the industry. A presidential administration change and shift in congressional power have thus raised questions about the size of the defense budget as the new government prioritizes its spending. One indirect impact from the pandemic was the sheer magnitude of recent COVID-related fiscal stimulus, which could affect future spending decisions if the government is eventually forced to make budget cuts under the burden of increased federal debt.

For now, the Biden administration has proposed to increase defense spending in 2022 to U.S. $715 billion. This represents a modest 1.6% increase from 2021’s U.S. $704 billion budget. While allocations for areas outside of defense are expected to rise more dramatically, for the time being there seems to be no desire to cut defense spending in order to gain budget savings. In fact, while priorities may change from administration to administration, defense spending is generally considered an essential part of the fiscal budget and has tended to remain stable despite the political environment over the past several decades.

Government also typically awards defense programs under a multiyear cycle, cementing outlays for projects years in advance. So, while the industry shut down during the initial wave of COVID, defense stocks in general were somewhat insulated from shorter-term economic impacts due to the relative stability of these cash flows.

Technology and Geopolitics Provide Tailwinds

We have written previously about how technological innovation is affecting companies across the economy, including less obvious areas like manufacturing. The defense industry is another example of how this proliferation of technology can help drive long-term growth. Because while defense companies are typically known for their relative stability, their product and capability focus should qualify them as innovators, investing heavily in research and development.

The military is constantly developing and deploying new technologies as national security threats evolve. For instance, hypersonic missiles are significantly faster, less detectable and harder to intercept than traditional long-range ballistic missiles. Space will be a new frontier as a warfighting domain and requires advanced capabilities in satellite, communications and resilience. Cybersecurity, electronic warfare, nuclear deterrence and autonomous/unmanned systems are other areas that will continue to be prioritized and modernized in a rapidly changing environment.

Countries are in a continual race to stay ahead of their rivals and counteract perceived threats. Global peace remains shaky, which means ongoing geopolitical tensions should create a long-term tailwind for defense. Military spending ‒ including steady defense investments by China and Russia and the pursuit of nuclear weapons in North Korea and Iran ‒ show no signs of abating and are likely to necessitate continued defense spending from the U.S. and its allies.

Focus on Fundamentals

With the nascent economic recovery, which has begun to broaden outside of the technology sector, select stocks within the defense industry are gaining momentum as firms report encouraging quarterly results. For the time being, the U.S. defense budget looks to be stable while longer-term forces in geopolitics and technological innovation could create tailwinds in the industry. That said, we believe it will be important for investors to focus on defense companies that possess solid balance sheets to return capital to shareholders and make acquisitions, as well as stable cash flows and consistent dividends. We think this focus on fundamentals, along with the backdrop for the industry, can create long-term opportunities in defense stocks.