For the last year, sovereign debt has been the most influential force on the markets. The focus has rightly been on Europe, most notably Greece, but other nations like Spain and Portugal are in precarious situations.
The U.S. debt situation isn’t as critical as Europe’s, but there are plenty of concerns here as well. Remember last summer when the debt ceiling needed to be raised before the U.S. began defaulting on some of its debt? Gridlock in Congress took the situation right up to the deadline. Default was avoided, and part of the agreement included formation of a Congressional “super committee” to figure out ways to reduce the deficit. As you may also recall, they couldn’t agree to a plan, so forced spending cuts are supposed to be coming in many areas.
One of those areas is defense, which is supposed to see $500 billion in cuts over the next 10 years. This is in sharp contrast to the precipitous rise in spending over the last 10 years after the 9/11 terrorist attacks and with the wars in Iraq and Afghanistan. The defense industry is at a critical juncture right now as the wars wind down and deficit concerns increase, yet threats to U.S. security clearly remain.
Total actual defense expenditures in the 2011 budget year, which ended last September, were $687 billion, including $158 billion for the wars in Iraq and Afghanistan. This amount is expected to decline 6% to $645.7 billion in 2012, reflecting a decline in war spending to $115 billion. Spending on the “base” budget remains relatively flat at $530.6 billion, up slightly from $528.2 billion in 2011. The Defense Department has proposed further cuts for 2013, with total spending expected to shrink 5% to $613.9 billion, including further cuts in war spending to $88.5 billion, and we also see projected spending in the base budget fall to $525.4 billion. Current expectations are for further cutbacks in the coming years.
Interestingly, the expected cuts have not yet hit defense-related stocks too hard. One exchange-traded fund (ETF) that tracks the industry is the iShares Dow Jones US Aerospace & Defense (NYSE:ITA). This ETF is up 6% over the past 12 months and 9.7% year-to-date. The one-year numbers are below both the S&P 500 and Dow, but year-to-date, the ITA is right in between the Dow and S&P 500.
Many of the companies in this ETF, such as Boeing (NYSE:BA) and United Technologies (NYSE:UTX), benefit from being diversified in other areas like commercial aerospace. Purer-play defense companies, such as General Dynamics (NYSE:GD), Raytheon (NYSE:RTN), Lockheed Martin (NYSE:LMT) and Northrop Grumman (NYSE:NOC), are on average under performing the ETF, though they have hardly been disasters. I don’t see these stocks getting wiped out with the looming defense cuts, but I would avoid the pure-play defense contractors for the foreseeable future, as I do think upside will be limited.
I think the key point for us as investors is that the defense industry is changing, but it is not going away. We will always have the need to defend our nation and its borders. Trillions of dollars still flow into this sector, and the key in investing is very similar to that of the trend in national defense: a more targeted approach. You have to look in specific segments of the defense industry to find good opportunities — stocks positioned to do well even with pending budget cuts. One of those segments is unmanned aircraft systems (UAS).