In a historic vote, Speaker Kevin McCarthy was ousted from his position in the House of Representatives. This development is expected to have significant implications for defense investors in the coming months.
The removal of McCarthy was the result of a 216-210 vote on Tuesday, following his nine-month tenure. The decision came after several Republican members, including Matt Gaetz from Florida, expressed dissatisfaction with McCarthy’s compromise to maintain government operations for a few weeks, thus avoiding a shutdown.
Impact on Defense Stocks
The repercussions of this leadership change are expected to extend to the markets, particularly in relation to defense stocks.
According to Deutsche Bank analyst Scott Deuschle, one possible scenario is the election of an effective new speaker well before the November 17 expiration of the current continuing resolution. This could lead to bipartisan cooperation and the implementation of a legislative agenda that maintains the current financial outlook for Defense.
However, there is also a bear case to consider. If the leadership crisis prolongs, it may jeopardize the passage of the fiscal year 2024 Defense Appropriations bill. As a result, defense spending could face a 1% cut.
Deuschle emphasizes that companies heavily reliant on shorter-cycle projects and future budget growth may be more vulnerable to these risk factors compared to those engaged in long-cycle businesses with substantial backlogs from previous appropriation cycles. Thus, nuclear component supplier BWX Technologies (BWXT), Huntington Ingalls Industries (HII), and General Dynamics (GD) are deemed relatively attractive compared to L3Harris Technologies (LHX), Lockheed Martin (LMT), and Northrop Grumman (NOC), according to Deuschle.
In conclusion, the removal of Speaker Kevin McCarthy has set in motion a series of uncertainties, with potential implications for defense stocks and the overall financial outlook for Defense. As the search for the next speaker begins, the market will closely monitor developments in order to gauge the future trajectory of these industries.
The Impact of Shutdowns on Defense Stocks
While shutdown drama may cause some concern among investors, history shows that it typically doesn’t have a significant impact on defense stocks. According to Rob Stallard, an analyst at Vertical Research Partners, defense stocks tend to underperform the S&P 500 by only one percentage point during shutdowns and outperform by two percentage points after shutdowns end.
It’s important to note, however, that Wall Street isn’t particularly enthusiastic about the sector as a whole. On average, analysts’ Buy-rating ratios for aerospace and defense stocks in the S&P 500 hover around 54% to 55%. If we exclude Boeing (BA) and Honeywell International (HON), which are more focused on commercial aerospace than defense, the Buy-rating ratio drops to 50%.
Among individual stocks, Lockheed Martin and Northrop Grumman are currently the least popular with Buy-rating ratios in the range of 30%. On the other hand, Textron (TXT) is the most favored stock, with 63% of analysts covering the company giving it a Buy rating.
Although RTX (RTX) still has a Buy-rating ratio of 54%, this is down from over 60% just a few weeks ago. Analysts downgraded shares due to escalating problems with its geared turbofan engine, which powers some A320-family jets.
L3Harris Technologies and Huntington Ingalls Industries fall in the middle ground, with Buy-rating ratios of 50% and 45%, respectively.
Looking at valuations, excluding Boeing and Honeywell, shares in the sector are currently trading at approximately 14.5 times estimated 2024 earnings, compared to the historical average of around 17 times in recent years. Boeing’s earnings are still suffering from the impacts of the Covid-19 pandemic and the issues surrounding the 737 MAX, causing its stock to trade at around 38 times estimated 2024 earnings.
In terms of performance, the iShares U.S. Aerospace & Defense ETF (ITA) has seen a modest gain of about 7% over the past 12 months. In comparison, the S&P 500 and Dow Jones Industrial Average have shown stronger growth, up about 12% and 9% respectively over the same period.
Overall, while shutdowns may not have a major effect on defense stocks, it’s clear that there are mixed sentiments among analysts in the sector. Valuations have also seen some adjustment, presenting potential opportunities for investors.
Written by Al Root