Defence stocks: a clear overweight

Credit Suisse believes investors should be overweight defence stocks

Exposed to rising defence spending: EU and US defence spending as a share of GDP is 18% and 10% below its 20 year norm, respectively, but is on the increase. Japan is debating amending its pacifist constitution, which would enable it to increase defence expenditure beyond 1% of GDP, and in China defence spending is increasing by around 10%. Against a backdrop of heightened political tension, we would also note Russian defence spending is up nearly 50% as a proportion of GDP since 2011 and double that of NATO.

A potential Trump hedge: Presidential candidate Donald Trump has said he would increase defence spending by 15% (compared to Obama’s 2017 budget). Moreover, Trump has suggested that US support for NATO members would be conditional upon them raising defence spending to 2% of GDP (only two European countries meet this requirement currently). We highlight the close correlation between the relative performance of defence stocks and Trump’s popularity levels in polls.

A fiscal easing play: We are increasingly seeing signs of an easing in fiscal policy globally. We think it is quite possible that such policies will eventually be focused on physical and social infrastructure, i.e. where there is a payback and a potential benefit to society. Defence fulfils both criteria (via technological improvements), and some members of the European Commission have already called for a change in the European Investment Bank’s mandate to finance military infrastructure and the issuance of EU defence bonds to fund joint military projects.

Little exposure to disruptive forces: In our view, the defence sector faces only limited disruption from either Chinese competition or new technologies as the sector is heavily regulated and as a matter of national security protected from foreign competition, which creates large barriers to entry. Defence companies have modest exposure to cyber security, a theme we like.

Defensive characteristics: The sector’s performance is uncorrelated to PMIs at a time when we are underweight cyclicals.

Valuations: US defence valuations are back to their 2003-08 norm (2% premium to the market). In Europe, defence stocks’ P/E discount to the US is c20%, close to a 16-year extreme. Earnings revisions are strong. We would focus on the purer defence companies (rather than civil aviation). This would highlight Raytheon, Thales and Dassault which have more than 40% of sales coming from defence, show upside potential on Credit Suisse HOLT® and are Outperform-rated by CS analysts.

Equity Research – Credit Suisse