Earlier this week, President Trump unveiled "a historic" increase in military spending during a speech to the National Governors Association, adding fire to the red-hot rally in defense stocks.
Trump's budget blueprint, which was submitted to government agencies on Monday, calls for a $54 billion increase in defense spending to $603 billion for the 2018 fiscal year beginning on Oct. 1.
"This budget will be a public safety and national security budget," said Trump. It "will include a historic increase in defense spending to rebuild the depleted military of the United States of America at a time we most need it."
The jump in funding for the military fulfills one of Trump's main campaign promises and comes at the expense of other government agencies, which are expected to see their budgets slashed by an equivalent amount. Nondefense discretionary spending will fall by $54 billion to $462 billion under the budget blueprint.
"We are going to do more with less and make the government lean and accountable to the people," pronounced Trump. "We can do so much more with the money we spend. The government must learn to tighten its belt; something that families all across the country have had to learn to do."
Resistance From Congress
The areas that won't be affected by the shifting budget are mandatory items such as Social Security, Medicare and Medicaid. Also known as "entitlements," these areas make up 60% of federal government spending and are forecast to take up an even greater share of spending in the coming years.
It remains to be seen whether Trump's budget blueprint ultimately becomes a reality. Congress has the final say on spending matters, and there have already been signs of early resistance to the blueprint from Trump's own party.
“There have been many attempts made to try to balance the books of the U.S. government on the backs of the discretionary dollar, and we all know that’s a fantasy because the drivers of the debt are on the mandatory side: Medicare, Medicaid, Social Security,” Republican House member Steve Womack told Politico.
Defense ETFs Outperforming
Resistance or not, it's likely that defense spending will increase in some fashion under a Trump administration―at least that's what the market thinks. Defense and aerospace ETFs have all outperformed the broader market this week, this year and since the election of Donald Trump in November.
The $2.5 billion iShares U.S. Aerospace & Defense ETF (ITA), which holds a market-cap-weighted basket of stocks in the industry, gained 18.6% since Nov. 8, outpacing the 12.8% return for the S&P 500 in the same time frame.
ITA, like other similar ETFs, tracks "aerospace & defense" firms, which are a subgroup under the broader industrials sector. A full 88% of ITA's portfolio is allocated to firms within this group. Top holdings include Boeing, United Technologies and Lockheed Martin. Together, these names make up more than a quarter of the fund's holdings.
The two other big U.S. defense-focused ETFs on the market― the equal-weighted SPDR S&P Aerospace & Defense ETF (XAR) and the cap-weighted PowerShares Aerospace & Defense Portfolio (PPA)―also outperformed, with returns of 20.3% and 16.7%, respectively, since the election. Both funds have about $515 million in assets.
More than 90% of XAR's portfolio is in aerospace and defense stocks, but each holding is equal-weighted, which gives the fund a smaller-cap tilt than the aforementioned ITA. In the case of XAR, Boeing, with a market cap of more than $100 billion, has the same 4% weighting as Taser, with a modest $1 billion market cap. This smaller tilt has helped the fund outperform recently, as small companies rallied more than their larger counterparts.
Meanwhile, out of the three ETFs in the space, PPA has the lowest allocation to aerospace and defense stocks, at 67%. The rest of its portfolio is in other groups such as industrial conglomerates, IT services and communications.
Because the fund is market-cap-weighted, top holdings are still the familiar Boeing, United Technologies and Lockheed Martin. But its broader purview has led it to slightly lag competitors such as ITA and XAR.
|Ticker||Fund||Return For 2017||Return Since Election|
|SPY||SPDR S&P 500 ETF||7.30%||12.70%|
|ITA||iShares U.S. Aerospace & Defense ETF||9.60%||18.60%|
|PPA||PowerShares Aerospace & Defense Portfolio||7.60%||16.70%|
|XAR||SPDR S&P Aerospace & Defense ETF||10.10%||20.30%|
More Federal Spending To Bolster Profits
According to an analysis by FactSet, it's not a surprise that defense stocks have risen in anticipation of more federal spending because these companies get the vast majority of their revenues from the government.
The report says that, "the U.S. government is the largest source of revenue for 19 of the top 22 U.S. defense companies by market value. Of these companies, 10 derive more than 50% of their revenue from the U.S. government."
If Trump's proposal for more defense spending passes in some form, that will likely translate into chunkier profits for these companies. However, despite this bullish outlook, not all analysts are convinced that now is the time to jump on the defense stock bandwagon. Citi Research is cautious on the group largely because of valuations.
"After nearly seven years with a positive bent on defense stocks, we are now turning more neutral on the group," said analysts at the firm. "This shift is driven by a potential disconnect in investor expectations for industry growth and by potential pressure on historic business models. We don't think the sector underperforms indices going forward per se; it's just that it's reaching fair value."
Contact Sumit Roy at firstname.lastname@example.org.
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