There is a longstanding investment thesis that defense stocks are a hedge against economic recessions because they are “counter-cyclical.” In other words, they don’t follow the rhythms of the commercial business cycle, and in fact often thrive while the rest of the economy is in the doldrums.
Veteran defense analyst Byron Callan of Capital Alpha Partners finds that, “looking at the last five U.S. recessions shows select large cap defense did hold up and outperform,” just as the conventional wisdom suggests. The counter-cyclical thesis might not apply to military contractors with extensive commercial exposure like Boeing, but pure-play defense companies such as Northrop Grumman have tended to perform well in downturns.
However, every recession is different. The peculiar combination of factors leading to a downturn can have variable impacts on government priorities, and government is the sole customer for defense products. For example, the depth, duration and timing of a downturn has a bearing on the outcome of national elections. Economic conditions are the single most important factor driving electoral outcomes.
At the moment, there are plenty of signs the U.S. economy is slowing down. Business investment is lagging. Farm prices are depressed. Manufacturing is stagnant. And then there is the trade war. So what would it mean for the defense industry if the economy ceased growing and fell into recession over the next year? Here are five factors that might confound proponents of the counter-cyclical thesis.
Trump’s reelection would be less likely. President Trump is the best thing that has happened to the U.S. defense industry since Ronald Reagan won the White House. He not only has increased annual military outlays by an amount greater than the entire defense budget of Germany, but (like Reagan) he has put much of the increase into buying weapons. Defense shares have risen accordingly. But Trump is not a popular chief executive, and a recession on the eve of the 2020 election might hand the White House to Democrats. It has been several decades since Democrats were big supporters of weapons spending.
Recessions increase budget pressures. When the economy softens, federal tax receipts soften with it. Taxes on family income, corporate earnings and capital gains all tend to trend downward. But demands on the budget rise as more people need assistance and Congress moves to create jobs. With the U.S. government currently borrowing $3 billion per day, deficits would rapidly approach the 5%-of-GDP threshold where Congress typically takes action to rein in discretionary outlays not deemed central to stimulating a weak economy. Defense is by far the largest category of federal discretionary spending.
Weapons accounts always get cut first. Most of the federal budget consists of entitlement spending and interest payments on the national debt, items that are nearly impossible to cut for both political and practical reasons. But if deficit concerns lead Congress to trim discretionary outlays, it will quickly become apparent that some categories of discretionary spending are more expendable than others. Within the defense budget, military pay is the hardest item to cut, followed by outlays for readiness (training, maintenance, etc.). That leaves weapons accounts as the most likely target of budget cutters, and weapons are where defense contractors generate most of their revenues.
Contractors can’t easily shift from production to sustainment. When demand for new output wanes, commercial companies often try to mine their installed base of products for more sustainment revenues—maintenance, modifications, etc. Boeing (a contributor to my think tank) has recently moved to make these kinds of services a bigger part of its revenue mix. But federal law reserves much of the military maintenance and modification market for federal facilities, limiting the availability of that work to private companies. Overseas customers also impose constraints on who can do support work for their weapons.
Selling weapons overseas will be harder. When the Budget Control Act imposed a ceiling on defense outlays in 2012, big military contractors moved to sell more weapons overseas. However, if the U.S. falls into recession, it will be preceded there by many of the world’s biggest buyers of weapons. For instance, Saudi Arabia is a major customer of U.S. arms makers; it may not technically be in recession, but low oil prices limit its ability to make additional weapons purchases. To the extent that big industrialized nations like Germany and Japan still have the means to make weapons purchases, weak economies encourage them to buy military goods from domestic sources.
Obviously, there is a counterpoint to each of these arguments. A recession might tip the balance within the Democratic Party to a left-wing presidential nominee who makes voting for Trump more palatable to independent voters. The need to stimulate a weak economy might convince Congress that it is not a good time to cut tank production in Ohio or fighter production in Texas. Defense shares have outperformed in past recessions, and they could do so again. But that doesn’t mean they will generate the kind of gains they have realized in recent years. Recessions have a way of lowering expectations.
Date: Aug 27, 2019