Industrials

Chris Bryant is a Bloomberg Gadfly columnist covering industrial companies. He previously worked for the Financial Times.

Defense manufacturers gathering at a sweltering Paris Air Show this week are feeling pretty chipper about business. Even if that's a sign for the rest of us to bunker down.

Amid terror in Europe, conflict in the Middle East and a rise in state-sponsored cyber-attacks, several nations had already begun to ratchet up defense spending again after a period of tighter budgets. And now, of course, there’s President Donald Trump, whose seemingly fragile ego and ignorance of geopolitics doesn't exactly lessen the chances of international conflagration.

Defense Recovery
Germany is among countries set to lift military spending this year
Source: AWIN, Kepler Cheuvreux

Though the commander-in-chief of the world’s most spendthrift military (annual budget, roughly $600 billion) has castigated the likes of Lockheed Martin Corp and Boeing Co over inflated costs, he clearly enjoys the idea of having a big military at his disposal. Building more planes and ships would also create the kind of industrial jobs that Trump likes.

Indeed, his first overseas tour was a fruitful occasion for the weapons industry. Trump secured $110 billion in arms deals in Saudi Arabia and appeared to back claims that Qatar is sponsoring terrorism, thus ratcheting up tensions in the region.

And while Europe’s leaders didn’t appreciate being lectured by Trump on their Nato spending commitments, it’s possible some have concluded that they should lift military budgets -- if only because America is no longer seen as a partner to depend on. If all European governments spent the Nato-required 2 percent of GDP on defense, this would add about 100 billion euros yearly to defense spending, Kepler Cheuvreux analysts calculate.

So while some scientists think the world is closer to cataclysmic disaster than at any time since 1953, investors don't seem to mind too much. A Bloomberg Intelligence index of large western defense stocks has gained about 27 percent since Trump’s election, double the increase of the S&P500.

Doomsday Nears
Nuclear weapons and climate change increased the risk of disaster and now there's Trump...
Source: Bulletin of the Atomic Scientists

In fairness, defense shares were riding high before Trump’s victory. The sector has trebled in value since mid-2009, despite tepid top-line growth. Cost-cutting, competition-reducing consolidation and share buybacks (especially in the U.S.) have boosted earnings per share.

Defense on the Attack
Western defense group share prices have soared, despite moderate defense budgets
Source: Bloomberg Intelligence
Peer group mostly comprised of U.S. and European defense groups.

However, investors must now pay a lot more to own that stream of earnings. Valuations are at their highest since the aftermath of the 2003 invasion of Iraq.  

Multiple Expansion
Investors are having to pay up for defense company earnings
Source: Bloomberg

Are investors getting ahead of themselves? There's an argument that aging military platforms make higher spending inevitable in coming years. Many of the U.S. military's most important aircraft are at least 20 years old, Bloomberg Intelligence notes. Yet Trump’s ability to get Congress to turn on the Pentagon budget taps is open to considerable doubt. His 2018 budget left some hawks disappointed.

Protectionism is also a worry. If Trump champions "Buy America" policies, other countries will be tempted to do the same, potentially harming military contractors on both sides of the Atlantic. Non-domestic customers make up one-quarter of Lockheed Martin sales. At BAE Systems Plc, Europe's biggest arms manufacturer, the percentage is almost four-fifths.  

Of course, the one thing that would really bolster those defense company valuations is another major global conflict, as this piece by Bloomberg's Julie Johnson and Roxana Tiron notes. It would be a stretch to say the market is pricing in the likelihood of this. But as an indicator, it's not a happy one.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Chris Bryant in Berlin at cbryant32@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net