Why You Should Invest In Defense Stocks Today?

As the first anniversary of Russia's invasion of Ukraine approaches this month, there are few signs that the conflict will end any time soon.

‍

In late December, Ukraine's defense budget was given an even bigger boost as the latest funding bill for the United States government provided an additional $47 billion on top of the $65 billion already appropriated. For 2023, the Defense Department's budget was also increased by 10%.

‍

As of 12 months ago, the three biggest aerospace and defense exchange-traded funds (ETFs) showed positive performance, with the $1.8 billion Invesco Aerospace & DefensePPA +0.07%  ETF (ticker: PPA) up 15.4%, the $5.4 billion iShares U.S Aerospace & DefenseITA +0.22%  ETF (ITA) up 12%, and the $1.5 billion SPDR S&P Aerospace & DefenseXAR +0.06%  ETF (XAR) up 8.7%. 

‍

There is a lot of discussion among investors as to whether or not now is the right time to buy. Is there a major run-up we missed? As Reyna relates conversations the firm has had with financial advisor clients, Rene Reyna is head of thematic and specialty product strategy at Invesco. During the first month of the year, Invesco ETF received about $28 million in inflows.

‍

While Ukraine is the biggest driver of military spending, Jefferies analyst Sheila Kahyaoglu says that space and defense spending is also earmarked for potential conflicts, such as those between China and Taiwan. Despite the economic downturn, the bank remains bullish. According to her, military spending grew 10% in 2023 as inflation increased by 5% or five percentage points. Moreover, military spending will increase by 4% in 2024.

‍

According to Sage Advisory's Bob Smith, this subsector generally has solid balance sheets and cash flow, which can make it reasonable at the moment, but says ETFs aren't cheap enough because of the run-up. Currently, they are on hold.

‍

Hundreds of billions of dollars were invested in aerospace and defense ETFs in 2022, and military contractors made up a large portion of those gains, including Northrop Grumman and Raytheon Technologies. Invesco holds these two names for 13% of its total holdings. iShares holds these two names for 24% of its holdings. One of the biggest holdings in the iShares fund is Raytheon, which represents 20% of the fund.

‍

A more balanced approach to the subsector is taken by the S&P fund, which weighs these two stocks only 6.7% combined. In terms of 12-month performance, the fund lags behind the other two ETFs because of its weighting.

‍

Kahyaoglu says Jefferies is expecting a hard landing, which would be good for the subsector in the short term. The ETFs that hold aerospace and defense stocks offer investors access to the industrial sector without being prone to cyclical fluctuations, but they will underperform cyclical stocks if we don't see a recession in the near future.

‍

Military spending is also unlikely to increase in the near term due to a less supportive House of Representatives, and high-interest rates drag the industry down.

‍

Both Manning and Smith see potential structural changes in global defense spending and space exploration as positives for the subsector in the long run. If the market weakens and if the positive themes persist in the longer term, Smith would be a buyer.

‍

Regardless of the outcome of the Asia-Pacific conflicts, Kahyaoglu believes an increase in the military budget of 4% in 2024 will probably be needed. Military supply chains were also exposed to "massive" shortfalls by shipping ordnance to Ukraine. It is essential for us to strengthen our manufacturing footprint in the years following COVID.