Defense Stock Rally Runs Out of SteamBy and
Pentagon’s budget will be constrained without deficit spending
Market sees political dysfunction and curbs its enthusiasm
These should be lush times for those who profit from conflict. Global tensions are rising while President Donald Trump promises the most spending on U.S. troops and military hardware since Ronald Reagan’s buildup of the 1980s.
Instead, a post-election defense-stock rally is sputtering as concerns grow that dysfunction and division in the Republican-controlled government could thwart that plan. It’s another Trump trade at risk of being undone by congressional leaders ill-schooled in the art of compromise and by fiscal conservatives, who may insist on maintaining spending caps set under President Barack Obama.
Lawmakers still haven’t approved a fiscal 2017 budget as a government shutdown looms this month. The easiest solution would be to extend for the full year a temporary measure known as a continuing resolution that holds funding at 2016 levels. Doing so would starve spending for new ships, bombers, missiles and helicopters built by companies like Lockheed Martin Corp., Boeing Co., General Dynamics Corp., Raytheon Co. and Northrop Grumman Corp.
Analyst Douglas Harned offers a blunt assessment: During the next six months to a year, the news for defense investors “is more likely to be bad than good, as it becomes clear that the president and Congress will be unable to bring a budget together that significantly increases defense spending.”
The S&P 500’s defense group has notched a 15 percent gain since Trump’s Nov. 8 victory, outpacing the broader market. But half that run-up came in the first week after the election, when big Pentagon spending increases seemed like a slam dunk. The group has been a middling performer on the broader index, which is led by a 34 percent gain for casinos and gambling companies.
“Irrational exuberance has waned after year-end 2016 euphoria,” Robert Stallard, a defense analyst with Vertical Research Partners, said in a report to clients Monday. “A combination of conservative guidance for this year and the Trump agenda hitting the reality of Congress appear to have flushed out some investors.”
Companies that benefit from Trump administration policies that don’t rely on Congress have fared better. Attorney General Jeff Sessions rescinded an Obama administration order directing the Federal Bureau of Prisons to phase out its use of private lockups. Prison operators CoreCivic Inc. and Geo Group Inc. have risen 126 percent and 97 percent, respectively, since the election.
The U.S. spends about $600 billion a year on its military, about as much as the next 14 nations combined. Trump would have to pull off a remarkable political feat for military spending to reach Reaganesque levels without increasing revenue, persuading conservatives to accede to higher deficits.
Another, less palatable option: Geopolitical tensions would need to “escalate into an all-out war,” Harned, senior aerospace and defense analyst with Sanford C. Bernstein & Co. Inc., wrote in a note to clients Monday. “We would not predict either of those events in the near term.”
Doubts About Leadership
Trump, who ran as a blunt talker with an arsenal of simple-if-vague solutions, has been frequently stymied as he encounters the complexities of governance. Despite his promises to stanch the flow of companies to Mexico, relocations have resumed after a post-election pause. Last month, a plan pushed by Trump and House Speaker Paul Ryan to end the Affordable Care Act fizzled without a floor vote after seven years of Republican promises.
“It raises the question about how strong Speaker Ryan in fact is, or how capable he is of finding an appropriate middle ground,” said Howard Rubel, managing director with Jefferies LLC. “The health-care vote could be a precursor to other embarrassments to the Republican party if they aren’t careful.”
Republicans are splintered ahead of the budget showdown. Members of Congress, now on a two-week recess, will have about four days to approve a catch-all omnibus spending bill covering the remainder of fiscal 2017 -- or extend a temporary measure due to expire on April 28 to keep government open. The Trump administration has requested a supplemental spending bill that includes $30 billion for defense and $3 billion for a border wall, at a price of significant non-defense cuts.
A compromise defense-spending measure already approved by the House may carry funding for all the other government agencies. Most of the bill is already agreed on, according to Senator Richard Shelby, an Alabama Republican and veteran member of the Appropriations Committee. Democrats, like Senators Jack Reed of Rhode Island and Dick Durbin of Illinois, the ranking member on the defense spending panel, indicated they would back it.
The budget drama should be in full swing as defense company CEOs present first-quarter results -- and try to temper expectations, according to Ken Herbert, an analyst with Canaccord Genuity.
“Considering the hype around defense spending under the Trump administration, we see some risk,” Herbert wrote in a report Monday. “The defense fundamentals will take a few quarters to catch up with expectations.”
Military-service chiefs warned Congress last week of dire scenarios should lawmakers resort to another continuing resolution. They range from the Navy canceling deployment of ships, to the Air Force cutting non-war related aircraft refueling missions.
Then there’s the prospect of adding to the wear-and-tear on equipment and weapons due to spending constraints and years of war. The average age of the U.S. Air Force aircraft fleet is 27 years, according to data compiled by Jefferies. That’s why analysts think defense stocks have good growth prospects -- eventually.
“There’s not a question that we need to boost defense spending because we’re using up our material faster than we should,” Rubel said. “It’s appropriate to bump up the budget.”