The Tailwinds for Aerospace/Defense in 2023…and Beyond

Geopolitical tensions are rising around the world. Sane human beings hate war, but expanding expenditures on the aerospace/defense sector represent a huge, long-term growth opportunity that investors shouldn’t pass up.

One fine day, the human race will beat its swords into ploughshares. But until then, shrewd investors must take the world as it is, not as they want it to be. If you’re looking for an outsized growth opportunity that’s also an inflation hedge, aerospace/defense stocks fit the bill.

Let’s take a break from my day-to-day coverage of the markets for a 30,000-foot perspective, so to speak. For insights into how you can profitably tap the mega-trend of soaring aerospace/defense budgets, I recently interviewed my long-time friend Richard Aboulafia, one of the top defense analysts in the world.

Richard Aboulafia [pictured] is a managing director at AeroDynamic Advisory, an aerospace/defense consultancy headquartered in Ann Arbor, Michigan. Prior to joining AeroDynamic in January 2022, he was vice president of analysis at the aerospace/defense consultancy, the Teal Group. [Full disclosure: I once did consulting work for Teal.]

Richard writes regular columns for Aviation Week & Space Technology and His articles have also appeared in Foreign Policy, the Royal Aeronautical Society’s Aerospace magazine, The Wall Street Journal, Slate, AIAA’s Aerospace America, The Financial Times, Professional Pilot, and other publications.

Richard also has appeared on numerous television news and radio programs including ABC, BBC, Bloomberg, Reuters, CBS, CNN, NBC, NPR and PBS. He is a Fellow of the Royal Aeronautical Society. My comments and questions are in bold.

Richard, back when I covered the global aerospace/defense industry as a reporter, I used to interview you while we enjoyed an expensive bottle of wine together in the nightspots of Paris, London, Rome, Berlin…you name it. Now you and I converse in more mundane venues, like this Zoom call between my home office and yours.

[Laughs] Corporate travel budgets are under serious pressure, as opposed to military budgets, which are sharply rising.

Yes indeed. The Russia-Ukraine war has spawned enormous opportunities in the aerospace/defense sector. Give us a concise overview of how U.S. and global defense budgets are booming in the wake of Russian President Vladimir Putin’s invasion of Ukraine.

This is the strongest global defense budget environment I’ve seen in 35 years of tracking the market.

[Editor’s Note: see the following chart for current and projected U.S. spending.]

The debt ceiling agreement reached in June caps U.S. defense growth for this year, but also de-risks it against any cuts.

Worldwide, growth is strong too, led by NATO countries, and Japan, Australia, South Korea, Taiwan, and other key Asia/Pacific powers.

Germany, with a defense budget currently in the 1.3% of gross domestic product (GDP) range, has led with an upfront commitment of $111 billion, aimed at making good on years of neglect. Germany is the largest economy in Europe and since the end of WWII the country had embraced pacifism to atone for its Nazi past, but that stance is changing.

World defense spending exceeded $2 trillion for the first time in 2021 and looks set to grow at a high single digit pace for years to come.

Unfortunately for the world but fortunately for defense spending, the reasons for this strong growth are likely to persist. History has returned, in the form of the threat of peer adversary conflict. Militaries are tooling up to cope with Russia as the acute threat, as the Pentagon terms it, and China as the pacing threat, that is today, the long-term problem.

Which areas of aerospace/defense are poised to receive the greatest largesse?

The highest spending priorities will be immediate concerns: ammunition, radios, logistical support. This will be followed by increased spending on guided munitions, particularly anti-tank and surface to air missiles.

Programs with active production lines, ones that can quickly increase output, will benefit. So will combat aircraft, due to their flexibility, and to the strategic relationships they bring.

The immediate and strongest segment to benefit is missiles and munitions. Not only is Russia’s Ukraine invasion draining Western inventories; the war has also caused a major re-think about necessary inventories moving forward.

It’s also clear that one lesson of this war is the need to make Taiwan a “bristling porcupine” i.e., one with a large, deployed force of missiles as a deterrent, and one with a large in-country stockpile in preparation. Missiles and munitions have also seen the greatest problems in supply constraints, implying a very long growth market cycle.

The share prices of the mega-cap contractors and the benchmark exchange-traded funds (ETFs) have been soaring in tandem with rising defense budgets. These investments are the obvious plays. What areas are underappreciated right now? What’s the investment herd missing?

The big companies get much of the attention, but there’s also a growing awareness of cybersecurity. Numerous companies that specialize in that discipline are predictably doing very well.

Also, the renewed emphasis on sovereign defense capabilities in emerging producer nations, think South Korea, Australia, Turkey, and others, is producing new, fast-growth companies in these countries.

Castings and forgings are a key bottleneck in production, so the combination of surging demand and limited capacity implies higher prices. Also, production delays mean sustainment and refurbishment opportunities for the existing fleet, which means aftermarket companies should prosper, too.

Can you suggest promising pick-and-shovel segments in aerospace/defense?

In addition to missiles and munitions, military aircraft look extremely strong, with current production programs hitting their stride, and numerous new development programs getting underway.

Also, commercial aircraft look set for an extended growth cycle, partly due to a strong and sustained recovery, and partly due to supply constraints limiting jetliner deliveries. While most primes are pure-play defense, most suppliers are exposed to both markets, to varying degrees.

Global inflation is coming down but remains elevated. Explain why aerospace/defense is not only a growth play, but also an inflation hedge.

Many investors underestimate the power of aerospace/defense as an inflation hedge. However, the sector can help protect your portfolio from inflation for two reasons.

One is that defense spending is completely de-linked from any economic indicator, including inflation or debt. If people feel threatened, defense spending rises above the rate of inflation. That’s the way it’s been since World War II, and before.

Two, and even more important, is that defense contracts have a much greater level of inflation protection for contractors than civil contracts.

Cost-plus contracts allow military contractors to include higher input costs into what they eventually charge the Pentagon. Not all defense contracts are cost-plus, but many are, and even contracts that aren’t often feature some protection from inflation.

The rise of artificial intelligence (AI) is dominating headlines. How will AI change the military and where can investors find new opportunities in AI-related military technology?

AI is obviously important for defense for many reasons, but particularly as a way to create new autonomous systems, and to defeat enemy autonomous systems.

Keep in mind, AI already is apparent on the battlefield. Notably, the Patriot missile system, which Ukraine has obtained from the U.S., features automated operations with human-in-the-loop override.

Pilot-less drones are revolutionizing the projection of power around the world. Republican and Democratic presidents alike have widely deployed “hunter-killer” drones in combat theaters overseas. These drones increasingly are linked with AI systems.

While all major defense primes are looking at AI for new business, we’ve seen several new companies aggressively pursue this segment as a new opportunity.

It should be mentioned that military planners are concerned that AI could trigger an apocalyptic global war, as warned about in science fiction. We’ll see if governments are able to make greater use of AI in weapons systems, but with sufficient guardrails.

PS: As the above interview makes clear, aerospace/defense is poised to hand investors outsized gains. If you’re looking for additional growth opportunities, consider the time-proven advice of my colleague, Dr. Stephen Leeb.

As chief investment strategist of The Complete Investor, Dr. Leeb has produced a special report on how to survive the tectonic shifts facing the financial world. Click here for details.

John Persinos is the editorial director of Investing Daily.

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