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Iraq conflict brings defense stocks in focus

A Wall Street sign is pictured outside the New York Stock Exchange in New York, October 28, 2013. REUTERS/Carlo Allegri

By Chuck Mikolajczak

NEW YORK (Reuters) - With the possibility of escalating violence in Iraq, stocks in the defense sector could garner more attention next week.

The stock market and oil prices were rattled late in the week after violence in the nation escalated as a Sunni insurgency against the government heats up. A continued escalation of the conflict could result in a civil war and a possible break-up of the country.

Even with tensions in the region mounting, the PHLX defense sector (.DFX) was down about 1 percent for the week, retreating with the broader S&P 500 (.SPX) after both indexes had closed at record highs on Monday. Some caution in the market would be expected, but higher oil prices and concerns about a worsening of the conflict would be felt in defense and energy areas.

"As investors try to determine what stocks and which sectors would benefit if we continue to see troubles in Iraq, it’s logical that more defensive sectors would benefit and especially the defense stocks themselves," said Kate Warne, investment strategist at Edward Jones in St. Louis.

"As investors get more nervous about the situation in Iraq, it will be a typical situation where it’s positive for the stocks like oil ... and we will see more caution across the board in other stocks."

Escalation doesn't necessarily mean investors will flock to defense stocks solely on expectations they will see a revenue boost as a result of an increase in new government contracts.

Americans are wary of getting re-involved in the fighting in Iraq given forces are still in country after the U.S. invasion in 2003 that has since cost the lives of more than 100,000 civilians and several thousand soldiers.

Scott Armiger, portfolio manager at Christiana Trust in Greenville, Delaware has owned Northrop Grumman Corp (NOC.N) since August, but said, "We are not going to boost defense stocks holdings on this move in Iraq, especially with this administration. I surely don’t think it’s a build-up, it conflicts with other agenda items, domestic is still number one."

The defense index has gained 93 percent in the last three years. It has a 50-day correlation with the benchmark S&P index of 0.89, but that may begin to break down should violence in the region grow, putting stocks in the defense sector in position to move higher while the broader market retreats.

The United States does appear to be acting in a deliberate fashion for the time being. After threatening military strikes against militants from the radical Islamic State of Iraq and the Levant (ISIL) on Thursday, President Barack Obama said on Friday he will take several days to review options for how the United States can help Iraq deal with the insurgency.

Another consideration for defense stocks is they generally have other businesses to go along with revenue generated from defense contracts - Boeing (BA.N) is involved with commercial airplanes and Precision Castparts (PCP.N) also deals with medical implants - so while they may get a lift a growing conflict it will not be the sole factor for any price boost.

"Many of the defense stocks trade with the expectations that we will see cutbacks in government spending in areas like defense but the stocks are really reflecting better performance on other parts of the business," said Warne. "Any company that relies solely on defense right now is probably not in great shape."

(Reporting by Chuck Mikolajczak; Editing by Nick Zieminski)