Granted that geopolitical uncertainty has improved the outlook
for the broader defense space, there are still certain issues
holding the sector back. The global markets witnessed a
Brexit-begotten June and the sell-off induced by that event. On top
of it, weak second-quarter economic data has certainly put the
brakes on the positive momentum.
Apart from tepid economic data, "disproportionate" cuts to
modernization and research and development funding could act as
major impediments for the defense industry.
Below we have discussed the headwinds that might spoil the
prospects of the aerospace and defense sectors in the near
The U.S. and the U.K. maintain a close tie when it comes to
national security matters. Britain-based companies, such as, BAE
Systems, develop platforms for the U.S. military, and the British
military buys goods from U.S. companies, such as the F-35.
Among the biggest purchases between the two countries, the U.K
has plans to buy 138 F-35Bs from Lockheed Martin Corp. (LMT). The
decreasing value of the pound means the price tag on these
joint-strike fighters will go up in the short term. Although this
may not hold in the long term, Brexit could weaken the British
pound and the euro in the near term, prompting countries to scale
back purchases of American-made weapons, such as, the F-35 Joint
Strike Fighter, which is being bought by Britain, the Netherlands,
Denmark and Italy.
A Positive-But-Cautious Fed Meet:
As expected, the Fed stayed put in its July policy meeting and kept
the short-term interest rates steady in the 0.25-0.50% band.
Although the Fed painted an encouraging picture and said other
indicators were pointing to growth, it still believes the domestic
economy is still too vulnerable to move rates beyond the 1/4 to
1/2% it established seven months ago.
The U.S. has been the world's largest defense consumer since
World War II. Iraq and Afghanistan wars in the past decade boosted
spending, driving it to historic heights. However, the winding down
of those wars and severe pressure to lower the national debt burden
following the country's major financial distress since the Great
Depression had cast a long shadow over the U.S defense budget.
Although the defense market received the latest two-year budget
deal with much enthusiasm, as it brought military stability, one
cannot overlook the risk of an economic downturn.
A country's ability to spend on defense is a function of its
economic health. The same is true at the global level - the faster
the global economy grows, the higher will be the defense spending.
Following the global crisis in 2008, there was a marked shift in
defense spending growth from the developed to the emerging
Notably, U.S. gross domestic product or GDP, the broadest
measure of goods and services produced across the U.S., grew at a
seasonally adjusted annual rate of 1.2% in the second quarter, well
below market expectations. With this, the economy has grown at less
than a 2% pace for three straight quarters.
The gain marks only a slight acceleration from the first
quarter, when GDP advanced at a downwardly revised 0.8% pace. The
first quarter was previously seen as increasing 1.1% from the prior
Moreover, the White House has released figures showing that the
FY 2016 budget deficit will be $162 billion more than originally
projected. That brings the deficit back up to $600 billion after a
few years of declining deficits from a high of $1.4 trillion in
Strong U.S. Dollar:
A gradually recovering U.S. economy, slower global growth and
expectations of more rate hikes from the U.S. Federal Reserve had
led to the U.S dollar appreciation. This has affected U.S.-based
companies as the strong dollar is not only showing up as a currency
translation drag, but is also having a bearing on foreign military
Although the Fed has held itself from raising interest rates
again given market jitters and Brexit concern, it will ultimately
resume rate hikes. It has kept its benchmark rate at a record low
for seven years. The dollar is expected to gain further if the
rates start to climb north. A stronger dollar could damage U.S.
Will Weapons Programs Be Hit in Fiscal 2017
The U.S. Department of Defense (DoD) announced this February
that it plans to purchase fewer F-35 fighter jets from Lockheed
Martin over the next five years than it had originally planned. The
Pentagon's next five-year plan, beginning fiscal 2017 through
fiscal 2020, covers the purchase of 299 jets (down by 37 units from
the previous expectation). Total funding - procurement, research,
and development - drops from $11.602 billion in FY 2016 to $10.504
billion in the FY 2017 proposal.
Certain limitations on the budget related to training, personnel
costs and force structure may have an implication on weapons
programs in the fiscal 2017 budget plan.
Lockheed Martin's F-35 fighter jet is undoubtedly the single
largest weapons program of the DoD. Apart from that, total funding
proposal for the P-8A Poseidon program - procurement, research, and
development - in FY 2017 dropped to $2.165 billion from $3.373
billion in FY 2016. Funding proposal for FY 2017 for Stryker, the
Amphibious Combat Vehicle (ACV), DDG 51 Arleigh Burke destroyer
along with Space Based Infrared System (SBIRS) and the DoD's Global
Positioning System (GPS) program has also witnessed a sharp
Some defense suppliers may have to migrate their business models
toward other channels to offset the secular decline in
Aerospace and defense companies compete among themselves for a
finite number of small and large programs.
Moreover, China is developing space technologies aimed at
blocking U.S. military communications, per a report commissioned by
a panel formed by the U.S. Congress. China's goal is to become a
space power as forceful as the U.S. and to promote a space industry
equal to those in the U.S., Europe and Russia.
Given the looming headwinds, we advise investors against names
that offer little growth/opportunity over the near term. These
include companies for which estimate revision trends reflect a
We remain apprehensive of Zacks Rank #4 (Sell) stocks like BAE
Systems plc (BAESY), CPI Aerostructures Inc. (CVU), Curtiss-Wright
Corp. (CW), Esterline Technologies Corp. (ESL), LMI Aerospace Inc.
(LMIA) and Moog Inc. (MOG.A).
In addition, we are skeptical of these Zacks Ranked #5 (Strong
Sell) stocks: Embraer SA (ERJ), AAR Corp. (AIR) and Triumph Group,
War On Terror" a Boon for the Defense
we focused on the conditions which are expected to drive the
The industry's position is now challenged by global competition,
changes in technology, national and worldwide economic conditions
and global policies affecting defense, civilian and commercial
The fast-changing world with rising global uncertainty requires
the defense sector to act with speed and flexibility. With careful
management and prudent spending the sector is expected to weather
the headwinds effectively.
Want the latest recommendations from Zacks Investment Research?
Today, you can download 7 Best Stocks for the Next 30 Days.
Click to get this free report
TRIUMPH GRP INC (TGI): Free Stock Analysis
MOOG INC A (MOG.A): Free Stock Analysis Report
LOCKHEED MARTIN (LMT): Free Stock Analysis
LMI AEROSPACE (LMIA): Free Stock Analysis
ESTERLINE TECHN (ESL): Free Stock Analysis
EMBRAER AIR-ADR (ERJ): Free Stock Analysis
CURTISS WRIGHT (CW): Free Stock Analysis Report
CPI AEROSTRUCTR (CVU): Free Stock Analysis
BAE SYSTEMS-ADR (BAESY): Free Stock Analysis
AAR CORP (AIR): Free Stock Analysis Report
To read this article on Zacks.com click here.