During escalating geopolitical tensions, investors betting on the defense sector will receive returns, which is no longer a secret - at least in the short term. But Wall Street indicates that the recent rebound will be even more significant.
The escalating tensions in the Middle East last week led to historic highs in the stock prices of weapon and aircraft manufacturers, with the sector continuing to maintain its historical peak on Monday. Key indicators in this industry are now expected to see the largest annual growth in five years.
However, analysts suggest that the Fed's loose monetary policy, coupled with increased airline fleets, offer aerospace companies the opportunity for lucrative trades. This industry also carries relatively lower risks during the U.S. presidential elections, acting as one of the catalysts driving the stock market up. Global instability is just one of the factors that often favor their sentiments.
David Wagner, portfolio manager at Aptus Capital Advisors, said: "This is not just a geopolitical game." Despite the currently high valuations, he still sees further growth in the defense and aerospace sectors.
The S&P 500 Aerospace & Defense Industrial Index has already risen by 20% this year and is hovering near historic highs. Holding until the end of 2024 would represent the largest growth since 2019. Top performers this year include Howmet Aerospace Inc., General Electric Co., and Axon Enterprise Inc. For this sector, the proportion of revenue from war-related military supplies is relatively small, even though they benefit from defense spending.
This month, $6.3 billion in cash flowed into the iShares U.S. Aerospace & Defense ETF. The fund has already seen the largest inflows since April and has traded significantly from its historical highs.
These stocks are often touted as safe-haven assets, comprising two main subgroups - defense and aerospace - providing investors with a relatively diversified profile.
Ken Herbert, an analyst at RBC Capital Markets, said: "During the last four loose periods, defense has outperformed the S&P 500 index by an average of 23%."
Herbert wrote in a client memo last week that in the six months before the Fed's easing, the performance of commercial aviation and aerospace stocks typically outperforms the broader market by single digits, ranging from low to median, although the relative performance tends to follow after the first year.
However, this time he expects aerospace companies to be cushioned by commercial aircraft order activity from major manufacturers such as Boeing (BA) and Airbus (AIR.PA).
Both companies are experiencing higher backlogs than usual. Airlines operators have been shaken by insufficient demand for air travel during the pandemic and have only recently resumed their usual expansion plans.
Herbert points out that even if the economic slowdown leads to a decrease in aircraft orders for airlines, the current backlogs mean that any impact on production may be negligible.
The rise in value could disrupt some optimism. The average 12-month forward return for aerospace stocks in the S&P 500 index is 28 times, compared to 22 times for the broader benchmark, and the technically heavy Nasdaq 100 index is 27 times.
Keith Lerner, Co-Chief Investment Officer at Truist Advisory Services, said: "Valuations are rich for the group, so this may limit the upside." "If the economic slowdown exceeds expectations, or if we see a short-term easing in the Middle East, this could also put pressure on the group."
If there are any signs of a surge in aerospace stocks due to Iran's plans to launch ballistic missile attacks on Israel, investors largely have not priced in a comprehensive escalation in the Middle East. Another outbreak could stimulate more stock gains. The majority of the rockets fired towards Tel Aviv by Iran-backed Hamas were intercepted, according to the Israeli Defense Forces.
Cole Wilcox, Portfolio Manager at Longboard Asset Management, said: "Unfortunately, we are in an intense and increasingly severe cycle of global conflicts." "This is driving an increase in demand for defense spending, which may last a long time."
