Defense stocks beat global markets amid expectations of increased spending

Defense stocks have outperformed the global market this year by the most in nearly a decade, based on expectations of increased military spending by Western governments and as ethical investors reassess the sector.

The MSCI index, which tracks airline and space stocks, has outstripped a broader gauge of global stocks by 17 percentage points in dollar terms since early January. This outperformance has only happened two more times since 1999.

Russia’s invasion of Ukraine on February 24 fueled expectations with new government demands, higher revenues, and stronger profits for companies operating in the defense sector. Analysts say the war changed investors’ view of the industry, underscoring its role in facilitating international security.

In contrast, shares of companies such as Lockheed Martin and Britain’s BAE Systems have risen strongly, with shares of BAE listed in the FTSE 100 index rising for more than a third year so far. In support of these gains, Vladimir Putin’s incursion into his neighboring country has sparked a new debate about the extent to which arms manufacturers and defense machinery should be excluded from portfolios focused on environmental, social, and governance.

However, some have cautioned against premature enthusiasm about defensive stocks, arguing that it is still too early to say when promises of bigger balance sheets will translate into boosted bottom line earnings.

“There seems to be the beginning of some irrational exuberance about the industry. It’s really too early to tell,” said Bill Greenwalt, who served as deputy undersecretary of defense for industrial policy during the George W. Bush administration and now works at the American Enterprise Institute.

The United States, the United Kingdom, and other allies have pledged significant amounts of military assistance to Ukraine and have sent hundreds of anti-tank missiles, drones, ammunition and other weapons into the country. The United States alone has offered more than $3 billion, including a new $800 million aid package announced Thursday that will include heavy artillery and tens of thousands of rounds of ammunition.

However, most of the weapons so far have come from current government stocks. “We have not yet seen an increase in orders and contracts or a recognition of the need to act quickly,” Greenwalt said.

Doug Harand, an analyst at Bernstein, points out that the sudden rise in stock prices is consistent with trends seen in previous regional conflicts. Gains were generally returned, often within six months. He adds that investors need to think about underlying budget trends. “Do budget trends and relative valuations make defense interesting as a long-term game?”

Others point out that industry timelines mean that any orders, if placed, will take time to fuel corporate profits.

If you put something in the budget this year, a tank or a plane or a naval ship, it won’t be delivered until 2023, 24, 26 in some cases. You see the moves in these stocks and in sentiment however. . . “Administrations are a bit conservative in framing what all of this means for their companies,” said Byron Callan of research group Capital Alpha Partners.

Jim Ticklett, CEO of US defense giant Lockheed Martin, was cautious earlier this week. The head of the company – which together with Raytheon manufactures the Javelin anti-tank missiles sent to Ukraine – acknowledged that the more challenging environment indicates that “deterrence is a more valuable product than it has ever been.” But he stressed that it was “too early” to say if and when this would translate into actual contracts. The company has not updated its forecast for 2022.

For long-term investors, the bigger question is whether promises of Western governments to spend more on defense will lead to a lasting transformation. Weapons programs have previously been under pressure from competing demands for government finances, particularly health projects during the COVID-19 pandemic.

Some big investors went so far as to bet against major defense contractors before the invasion.

But defense is back on the priority list in 2022, in a scenario summarized by Germany. Berlin announced a historic shift in defense policy and said it would launch a €100 billion fund to modernize its armed forces. In contrast, the shares of defense contractors registered in Germany rose. The market value of Rheinmetall, which manufactures tanks and armored vehicles for NATO countries, has more than doubled this year.

BlackRock, which held a 0.6 percent short position at BAE Systems at the end of January, rapidly reduced its position by a third in the second half of February, according to data from Breakout Point.

Citadel Europe also reduced its shortfall for Italy’s Leonardo from 0.69 percent to 0.42 percent on February 10, while UK’s BlackRock reduced its large short position by 1.13 percent in the Italian arms manufacturer to 0.12 percent. On February 28. It also trimmed Leonardo’s short positions in the second half of February.

A ‘big dilemma’ for ESG investors

While increasing Western defense budgets have yet to be constrained after the invasion, some suggest the conflict may still spark a shift in sentiment among ESG investors. Industry executives have, in recent months, become increasingly concerned that the sweeping trend of investment focused on sustainability will lead institutional investors to dump their stocks.

“Perhaps the biggest change that could result from the invasion of Ukraine is to reverse the ESG’s lazy view that defense is ‘bad’,” said Robert Stallard, analyst at Vertical Research Partners.

“The big dilemma is that many sustainable funds would have included complete exclusions from defense spending [including] “Government contracts, all of these things,” said Gavin Rochussen, CEO of Polar Capital.

Russia’s invasion of its neighbor has muddied the waters ever since. How do you deal with protecting a country from foreign invaders? Is it true that you don’t actually support countries’ spending on self-defense? ” he added.

SEB Investment Management, the money management arm of the Swedish bank that manages SEK 831 billion, is one of the few that has openly relaxed its policies on excluding defense stocks. As of the beginning of April, some of its funds will now be able to invest in the industry.

However, the change only goes so far – only six of the more than 100 SEBs will be able to make these investments, and companies that violate international agreements on weapons such as landmines and cluster bombs will remain excluded, as will producers of nuclear weapons.

“It is important to remember that many of our clients and unit owners still do not want and cannot invest in the defense industry, and that going forward, many of our SEB Investment Management funds will continue to exclude such investments,” SEB said.

Other policy changes, if they occur, will take time. A recent investor survey by analysts at Jefferies found that while there was a call for a less stringent approach to defensive stocks, few investors actually implemented changes to their policies. According to the survey, 44 percent of respondents are currently reconsidering their ESG policies, but only 8 percent have been doing so specifically in the field of defense.

Philip Saunders, fund manager at Ninety One, remains confident that change is on the way. “The pendulum is swinging. This is a moment when it seemed like the momentum was in one direction, and now we need to pull back en masse, because the reality is that the real world is more sinister than we thought before February 24,” he said.