Despite constant media attention on the fiscal cliff and sequestration, the SPADE Defense Index (NYSE: DXS) managed to outperform the broader market, gaining 16.3% in 2012. Up another 5% to start 2013, the index currently sits at 52-week highs Yet, after more than a decade of gains in the 2000s, the recognition that the core budget for the Department of Defense is flattening and will decline to some degree over the next few years did not slow this momentum. Positive conditions related to international defense product sales and commercial aerospace along with healthy balance sheets and a solid dividend have enabled many defense companies to whether the budget growth slowdown for the moment.
The question is...what actions would lead to a shift back toward security spending and benefit defense contractors such as Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD), Raytheon (NYSE:RTN), and CACI (NYSE:CACI) or an ETF, such as the Powershares Aerospace and Defense ETF(NYSEARCA:PPA)?
Threat #1: Iran
Whether it is threatening to shut the Straits of Hormuz and disrupt the world's energy supplies, use nuclear weapons on neighbors such as Israel, funding terrorism, or radical statements from a leader some see as unstable, and Iran is threat #1 on most analysts list.
Threat #2: Hackers and Cybersecurity
When you depend on technology -- economically and militarily -- protecting it becomes more and more critical. People gaining access to databases and systems are becoming commonplace and it is mostly an annoyance at the moment. If you consider the possibility of access to systems that controls transportation, water, or electrical, networks or those which control our banking and financial records and it is easy to see how significant this threat is--which is why it is gaining so much attention.
Threat #3: The Arab Spring Aftermath
Beginning in 2011 and continuing to the present, people of nations throughout North Africa and the Middle East are seeking greater freedoms and overthrew oppressive regimes and those not meeting the economic needs of the populace. Though unpopular in theory, previous leaders were still the 'devil you know'. The new governments and leaders remain an unknown and what will evolve in the region -- more stable democracies, religious rhetoric, new military leadership groups, or turmoil and chaos -- is still to be seen.
Threat #4: Pakistan
The weakness of the government to remove radical elements from its territory has created a division within the nation between those aligned more with the West (U.S. and Europe) and those who focused on regional power and the Taliban. The unannounced incursion by the U.S. into the country when it raided the compound of Osama bin Ladin, raised concerns among politicians and radicals alike. Ultimately anytime a nation has rockets and nuclear weapons and the possibility that elements in the region could overthrow or destabilize the local government and a situation that generates fear can be seen.
Threat #5: China
China has been flexing its muscles and using resources from its economic growth to fuel development of a modern Navy, Air Force, space program, etc. The fear that China could become a true threat similar to what the Soviet Union represented from the 1950s to the 1980s is generating a lot of attention. The reality is that the near-term likelihood of the country going on the offensive is relatively small (outside of course issues in their own backyard -- islands off the coast of Japan, Taiwan). Still, eyes would be focused on any nation seeking to become a world power and with the resources and technology that China possess.
Threat #6: North Korea
The death of Kim Jong-il put the Asia region into unfamiliar territory with a new leader taking control of a government that oppresses its people and has access to rockets and nuclear material. A successful orbital launch late in 2012 means the nation is one step closer toward a functioning ICBM and, at some point, could target lands as far as the United States as its guidance and rocket technology improves.
Threat #7: The Unknown
Globalization has brought greater awareness of events around the world. However, the increasing ease of the spread of information can enable threats that 100 years ago would not have been possible; whether its how to create a bomb or develop a biotech weapon. For many, the events of 9-11 and destruction caused by the possibility of suicide bombers on U.S. soil were not envisioned. Neither were the Oklahoma City bombings, events in London, Madrid, etc., or the action of a lone lunatic in Norway. Diligence can only go so far.
Increased fear levels in any of the above areas will see the defense spending cycle shift to the upside. Ultimately there is no greater function of government than to protect its people and its way of life. As long as Congress remembers that, cuts to defense spending will happen as the U.S. seeks to get its financial house in order but the cycle toward growth will eventually return. In the meantime, contrary to expectations in the months leading up to sequestration taking effect, defense has continued to be a slow and steady performer, offering a yield of 2.09% with a P/E of just 13.*
[* source: Yahoo, data for the Powershares Aerospace & Defense ETF , downloaded 6March13]