2023-03-06 18:27:59 ET
Summary
- Russia's invasion into Ukraine has led to massively increased (European) defense budgets.
- The war has been a wake-up call that conflict can emerge out of nowhere.
- Even if the Ukraine war is resolved, there are other salient geopolitical threats to justify continued elevated budgets.
- The defense spending is likely to decouple from the economy to an extent.
The iShares U.S. Aerospace & Defense ETF ( ITA ) is an interesting long going into 2023 and beyond. It will also work as a pair trade with general stock market exposure offset through a broader offering like the S&P 500 (SP500 ) or the S&P 500 industrials sub-sector. Russia invaded Ukraine, for the second time in the last ten years, on February 24th of, 2022. Initially, the iShares U.S. Aerospace & Defense ETF kept tracking the S&P 500, but since October 22nd it has started to outperform the S&P 500 massively:
No doubt the exchange-traded fund ("ETF") is benefitting from increased defense spending as a direct result of countries replacing equipment or suddenly realizing underspending on defense is risky after all. But it's not just the direct conflict that I believe will be a tailwind for many of the constituents of this ETF. The conflict also illustrates that wars in Europe are nothing of the past, and autocracies can suddenly, with little warning, force others into highly undesirable conflicts.
Meanwhile, the tension between the U.S and China has been building for some time. Over the past few years, there are increasing signs of unhappiness of the regimes with each other. A recent example is how the U.S. restricts semiconductor access by China. There are even voices in the U.S. navy that warn of a Taiwan invasion as soon as 2024. Most recently, China is further ramping up military spending: China's military budget outpaces other spending in shift to security
Although China’s military spending is only one-third of the US level, it has grown fivefold over the past two decades according to the US think-tank CSIS, and now exceeds that of the 13 next-largest military spenders in the Indo-Pacific combined. Beijing has spooked its neighbors with increasingly assertive use of its military, holding unprecedented exercises last August to punish Taiwan for hosting Nancy Pelosi, the US House Speaker, and to assert its claims in the South China Sea against the Philippines and Vietnam. China’s proposed rise in 2023 defense expenditure is 2.2 percentage points above the government’s 5 per cent growth target, a larger gap than in the draft budget a year ago, when Beijing first proposed a military spending increase higher than its growth target. Proposed defense spending also significantly outpaces development-related budget items such as education, social security and scientific research
I expect that as hostilities continue, Chinese spending will be met by increased spending in the West. The U.S. has been spending very high but seems unlikely to take a breather anytime soon. There are few, if any issues, where I'd say there is as much bipartisan support as on the need to take China and Russia seriously as threats.
Most countries have been falling short of NATO defense spending targets in Europe for many years. Here's some data to put the potential into context out of the U.K. House of Commons library. Take note that NATO has 30 member countries:
Defense budgets NATO countries (U.K. library of commonwealth)
Russia's invasion into Ukraine changed things in a big way. Sure, spending has not immediately increased but these are all democratic governments. The process takes time and back-and-forth in parliaments. Meanwhile, it takes time for capacity to ramp up as well. Already defense firms are struggling to meet demands directly driven by the war in Ukraine. Let alone, the indirect demand and driven by the increased attention that's being paid to other, suddenly salient, global threats.
Here's an overview of global defense spending pledges that have been made since February 2022:
Timelines differ, but the general direction is very clear: defense budgets are expanding in big ways.
Ideally, investors take advantage of this trend by investing in the most attractive and best-positioned defense companies. However, it takes a lot of time to get a deep understanding of an industry and why company A is a superior proposition to company B. There's also a bit of luck involved and a broad basket of defense companies ensures one doesn't miss just the right company.
I thought the iShares U.S. Aerospace & Defense ETF was an interesting enough proxy for this trade. I pulled up its portfolio through Morningstar, and it contains all the big U.S. defense firms like Raytheon (RTX) Lockheed Martin ( LMT ), Boeing ( BA ), Northrop Grumman ( NOC ), General Dynamics ( GD ), etc.
There are many other smaller positions with a lot of aerospace and defense suppliers that have generally less recognizable brand names. The downside of obtaining this exposure through an ETF is that there's a 0.4% total expense ratio involved. If you bought a basket of select defense companies, you would be less diversified but at least avoid that headwind to performance.
Another downside of this approach is that I expect the greatest increase in spending to come from Europe. I think a fair bit of that spending will be directed at U.S.-designed technology, but ideally, some of the large European companies that are likely beneficiaries would be included as well.
Another segment of the defense industry that isn't captured within this ETF is to cyber-defense. I think companies like Palantir ( PLTR ), Science Applications International Corporation ( SAIC ), and CACI International ( CACI ) are very interesting as well. Unfortunately, they fall outside of the scope of this ETF.
Morningstar allows you to compare ETF-level data on the companies within and I thought that was fairly interesting.
These companies currently generally trade at higher valuation ratios compared to an index (they used "industrials" as an index):
ITA valuation data (Morningstar)
If you compare it to the S&P 500, the basket is still fairly expensive:
SPY valuation data ( Morningstar)
To get the purest exposure to the tailwind of increased defense budgets, an investor could go long the iShares U.S. Aerospace & Defense ETF and short the S&P 500 or the Vanguard Industrials ETF ( VIS ) against it. Or even short a mix of the two against ITA. What I particularly like about this trade (although I think it will capture a multi-year trend) is that it is potentially not as economically sensitive. If you think about some of the more dire economic scenarios for the decade ahead, these likely involve an increase in geopolitical tensions. I don't believe geopolitical tension, friend-shoring, etc., are generally beneficial in too many sectors. However, the more tension, the higher the odds we'll see countries delivering on the defense budget goals they're currently setting.
For further details see:
ITA: Major Tailwind As Increased Defense Spending Likely To Persist