Defense Stocks Are Killing It, but for How Long?

Martial talk has been in the air of late, in connection with Iran and the US’s drone killing of its top commander, General Qassim Suleiman. And despite lowered tension at the moment, questions are stirring about the level of Pentagon spending, which under President Donald Trump has burgeoned.

The current military buildup smells like victory for investors. Defense stocks have bested the market during the Trump Administration. Just compare the S&P 500 to the largest military-oriented exchange-traded fund (5.7 billion in assets), the iShares US Aerospace & Defense. In price terms, the defense ETF is up 54% versus the broad-market index’s 44.8% in the three years Trump has been president.

Whether that Wall Street trend continues depends on who the next Oval Office occupant is, Republican Trump or a Democrat. Among the leading Democratic presidential candidates are Senators Bernie Sanders and Elizabeth Warren, who are on the left side of the party. They think a lot of military spending is wasteful.

In a campaign statement, Sanders complained that “we should not be spending more on the military than the next ten nations combined.” Warren has decried “our bloated defense budget.” The more moderate Joseph Biden told the Washington Post that “we can maintain a strong defense and protect our safety and security for less,” by trimming wasteful outlays.

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Regardless, 2020 should be good for military contractors’ stocks. While the Trump presidency has been a golden time for investors in military-oriented equities, election years in general seem good for them, regardless of who wins. Defense shares have outperformed the market in nine of the last 10 election cycles, by 16 percentage points on average, according to UBS analyst Myles Walton.

Big winners nowadays are stocks in corporations like Northrup Grumman, Lockheed Martin, and Raytheon. Although their prices have run up, these contractors aren’t that expensive: Northrup has a price/earnings ratio of 16, Lockheed 17, and Raytheon 18—less than the S&P 500’s. One reason for the tame multiples is that their earnings have jumped, expected to grow from 9% to 15% yearly through 2021, well ahead of the overall market’s profitability.

A sweet spot for defense investors: Any time there is international tension, defense names usually surge, by Walton’s estimate, even when American forces aren’t triumphant. Take al-Qaeda’s October 2000 bombing attack on the USS Cole in a Yemeni harbor, which killed 17 sailors and wounded 39. Defense stocks rose 6% in the following three months.

The military buildup under Trump has been remarkable. The defense budget authorization he recently signed, for federal fiscal year 2020, is $733 billion, up 22% from Barack Obama’s last Pentagon spending blueprint.

With a leftward tilt among Democrats, though, the party’s traditional preference for domestic spending over the military kind surely will come to the fore. Post-Vietnam, Democratic presidents (Jimmy Carter, Bill Clinton, and Barack Obama) have reduced defense appropriations, although not by an enormous amount. A Sanders or a Warren might be more ambitious in their cuts. Not a good thing for defense industry investors.

Fresh Signs of Stock Market Bullishness

KKR Acquires Military Contractor Novaria Group

Tags: Donald Trump, Lockheed Martin, military spending, Northrop Grumman, Raytheon, S&P 500, Stock Market

Sitting at just 71% funded, the California Public Employees’ Retirement System (CalPERS) outlined in its December 21 Board of Administration meeting agenda the key challenges facing the system in order for it to hit the 100% funded sweet spot.

Declining interest rates, increasing profit margins less likely to repeat, and high valuations across domestic markets topped the list of challenges facing the pension program over the next 10 years. Slowing global economic growth, fewer opportunities to generate excess returns, and underfunded status limit options underscored the pension’s concerns.

The unpredictability of the current economic environment was one of the chief uncontrollable factors facing the pension.

Interest rate risk played a key role in the pension’s September 2019 update to its fixed income asset allocation guidelines. CalPERS is reeling in interest rate risk using duration management, which will be maintained at +/- 10% of the benchmark.

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The pension’s fixed income portfolio generated a 9.6% net return in the 2018-2019 fiscal year.

“We saw good returns in several key areas. Our long duration fixed income portfolio contributed positively as interest rates fell,” Chief Investment Officer Ben Meng said at the time.

The list of risks may be familiar to those paying close attention to investors’ concerns these days. Rich Nuzum, president at Mercer, shared CalPERS’s sentiment on interest rate challenges. “For most of our clients—their boards of directors, their actuaries, their stakeholders more broadly—still expect them to deliver a reasonably high expected return,” he said.

The pension plan’s investments last year generated a 6.7% portfolio return. Its holdings are currently evaluated at $395 billion.

Nuzum said a high single-digit expected return, around 8%, was easy to get 20 years ago. “But as we look forward for the next 20 years, we believe dollar-denominated investment-grade bonds are likely to only give us 3.3%, and we project global developed market large capitalization stocks will only give us 6.4%, Nuzum told CIO. “So, whatever return number stakeholders have come to believe is normal, based on their historical experience, is going to be much more challenging to achieve going forward.”

Risks to investors are wide and varied, and their ideas are even including President Donald Trump’s tweets. Christopher Ailman, chief investment officer for the California State Teachers’ Retirement System (CalSTRS), said last year that despite the “Goldilocks economy,” he’s keeping a sharp eye on the president’s Twitter page.

Climate risk is also on CalPERS’s plate, and the pension plan is focusing on it by creating a three-pronged approach: engagement, advocacy, and integration. Engagement occurs by being involved in climate-conscious organizations that are seeking to perpetuate a low-carbon strategy, such as Climate Action 100+, Principles for Responsible Investment, and Ceres – Investor Network on Climate Risk.

Climate risk poses a risk to approximately one-fifth of CalPERS’ equity portfolio, according to their first climate change risk report. Energy stocks, construction, transportation, agriculture, food and forestry holdings were exposed to the most significant risks. CalPERS said the equity could be subject to policy, market and technology changes occurring in international jurisdictions.

However despite the risks, Meng said the pension fund will not divest from fossil fuel companies, and said the pension plan should not “constrain itself to a limited set of investment opportunities.”

CalPERS and investment management firm Wellington Management launched a framework designed to help companies assess and disclose the potential risks of climate change on their business. “It is critical for us to understand how our companies are planning to adapt to the physical risks of climate change,” Beth Richtman, CalPERS’s managing investment director of sustainable investments, said in a statement.

“We advocate for changes that minimize the financial risk to our investments while quickening the pace to a low-carbon economy,” the pension said on their website.

The pension is trying to return to the glory days of pre-recession funded ratios. It had a 128% funded ratio in 1999, then dropped sharply from 101% in 2007 to 61% in 2009. The pension plan projects the funded ratio to hit 92% by 2028 if its investment returns hit 8%, 86% if investment returns reach 7%, and 80% if they hit 6%.