August 1, 2023
Equity Insights offers research and perspectives from Putnam’s equity team on market trends and opportunities.
This month’s author: Adam J. Krajewski | Analyst
We recently passed the 500th day of the Russia-Ukraine War. Russia failed in its original plan for a rapid invasion partly due to the arms supplied by Western nations and intelligence provided by Western space assets. While we don’t know how much longer it will last, the lessons provided by the war have near-, medium-, and long-term implications for defense spending.
Near term: Accelerated export sales. Most of the supplies to Ukraine have come from existing European and U.S. stock, which is now depleted. We are just now seeing orders to replenish these depleted stocks, which will cause an acceleration of export sales for U.S. defense suppliers starting in 2024. The war has taught Western nations that they need higher inventory levels for ammunition and missiles. This will lead to a structurally higher level of demand relative to post-Cold War production levels. The war has also given life to areas of defense budgets that have been structural bill payers, such as tanks.
Medium term: Reversal of disarmament cycle. European countries have habitually underspent NATO’s long-held target of countries spending 2% of GDP on defense. However, we believe public opinion toward defense spending has changed enough to make 2% a floor for many countries in Europe — even after the war ends. This would mark a reversal of the disarmament cycle that started in the 1990s. While a lot of press has focused on increases in German defense spending, we’ve seen increases in defense spending targets in other countries within Europe and around the world, most notably Japan and Australia.
Long term: Countering an assertive China. So far, the war’s impact on the defense industry has affected Europe more than the U.S. The U.S. was already the world’s largest defense spender in absolute dollars, and U.S. defense spending is comfortably above 3% of GDP. Large multiyear directional moves in defense budgets typically happen for complex reasons, not in response to regional conflicts. However, an emboldened China could be a significant turning point. While increased U.S.-China tensions pre-date the Ukraine invasion, China’s current alignment with Russia has exacerbated the situation. We anticipate an increasing share of the U.S. defense budget will go toward nuclear triad modernization, space, and classified spending — at the expense of aircraft funding — to counter an increasingly assertive China.
Large multiyear directional moves in defense budgets typically happen for complex reasons, not in response to regional conflicts.
Space: The fastest-growing component of military spending
The U.S. Department of Defense increasingly relies on satellites for daily operations, including surveillance, communications, missile targeting, and GPS. This is not new. The new developments in space defense have come in response to the end of a moratorium on anti-satellite testing in 2007. Since then, the U.S., China, and Russia have all tested anti-satellite weapons, which are becoming part of their future warfare doctrines. Essentially, our existing space assets are not safe.
In response to this challenge, the U.S. formed a new branch of the military in 2020 — Space Force. Carving out a new military branch is significant for the defense budget, as the Air Force has historically raided space funding for planes. For context, when the Air Force was formed in 1947, it went from 0% of the budget to 49% in a few years. While the magnitude of change won’t be the same as with the Air Force, the new branch signals the priority space assets will have when competing for funding.
Space has been the fastest-growing part of the U.S. defense budget, with growth rates in the teens expected for the next few years. Why is it growing? The military is changing the architecture of space assets to make them safer. This is done by outfitting large, complex satellites with defensive capabilities, or by placing many smaller satellites in low Earth orbit that are individually less capable but are replaceable. Much is unknown about this largely classified endeavor, but we do know it has resulted in a large step change in orders for Northrop Grumman.
Space has been the fastest-growing part of the U.S. defense budget, with growth rates in the teens expected for the next few years.
Perspectives from our company-specific research
We are wary of chasing windfall profits from war-fueled demand or replenishment. Those stocks’ multiples will contract well before fundamentals have peaked. This was the case for stocks levered to that spending during the peak of the Iraq/Afghanistan wars. That said, the global resurgence in defense spending this coming decade will create inevitable opportunities. Today we highlight Northrop Grumman and Thales as two compelling investments.
Northrop Grumman. We expect Northrop will outgrow the defense industry for the remainder of the decade. This is partly reflected in its premium multiple. However, we believe investors underappreciate the duration and rate of growth from this well-managed and historically shareholder friendly company. Northrop’s premium growth is underwritten by:
- A prime position as a contractor on two legs of the nuclear triad: B-21 and Sentinel
- Large classified space exposure
- Missile components, where it is gaining share from Aerojet
Thales. On the defense side of its business, this dominant French company has unprecedented growth visibility this decade. This has been complemented by a management team that hasn’t let expectations run too far ahead.
- Before the war, Thales already had a massive backlog, which will be further bolstered for the more complex mid- to late-cycle type of work it does.
- Over the next few years, we expect operating leverage on the commercial aerospace side of its business to be above average.
- Thales is a net cash position, with large proceeds to come from its rail signaling business, providing balance sheet optionality. All of this comes with a fairly reasonable multiple.
The rapidly evolving defense industry offers compelling near-term and long-term investment opportunities. Lessons provided by the Russia-Ukraine war, shifts in public opinion around defense spending, and innovation in space defense assets are just a few examples of trends we continue to monitor as part of our fundamental research.
The inclusion of specific securities information in this commentary should not be interpreted as a recommendation to buy or sell or hold any security. It should not be assumed that an investment in the securities mentioned was or will be profitable.
The views and opinions expressed are those of the author, are subject to change with market conditions, and are not meant as investment advice.
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