At Historic Highs, Aerospace & Defense Forecast For 2014

| About: PowerShares Aerospace (PPA)

The aerospace and defense sector continues to be one of the top plays by investors and the sector ended 2013 at historic highs and it has maintained this level through the beginning of the year. Although 2013 was anticipated by some to be a down year, fueled by declines as budget sequestration reduced spending by the Department of Defense, the sector ended up 48.18%, outperforming the S&P500 by nearly 20%.

Increased international sales combined with the upcycle in commercial aerospace spending offset a decline in defense spending associated with the impact from sequestration and a budget on a downward slope from the peak in war spending.

2013 saw investors favoring individual companies over funds-whether Boeing (NYSE:BA), which gained 81% or Lockheed Martin (NYSE:LMT), which gained 61% and offered a 4% dividend. Overall, 40% of the companies found in the SPADE Defense Index gained more than 50% during the year.

Toward the end of 2013 and continuing into the beginning of 2014, inflows were detected into the ETF products such as the Powershares Aerospace & Defense ETF (NYSEARCA:PPA) reversing a trend that had existed for the past several years. Shares outstanding have risen 50% in the past two to three months although they remain roughly 75% below its peak. After the sector's significant gains in 2013, this can be expected as ETF products offer exposure to the sector while providing diversification from positions in any one company. Following comments from Boeing executives during its most recent quarterly report regarding their forecast for 2014, investors spooked and caused the stock to tumble by more than 11%. Fund products that can offer diversification in an era considered to be a stock pickers market, provides some investors with a level of comfort so a shift was probably inevitable.

Going forward, the balance of the year should see the sector perform at least in line with the broader market with upside potential barring a significant downward move in the broader market. Critical for the positive forecast is the budget agreement between Congress and the White House that starts to clarify what the Department of Defense can and will do with the funds allocated to them. According to Defense News, as part of the budget deal agreement put forth by Sen. Patty Murray and Rep Paul Ryan, the expected budget to be submitted to Congress on March 4th for 2015 is roughly $496 billion and it includes about $30 billion restored to the Pentagon in 2014 and 2015. We can start to think of the current year and next as the bottom of the budget cycle which should stay flat before improving over the next several years as the budget allocated to defense begins to see a boost starting in FY2016. A proposed $535 billion core budget in FY16 would be $36 billion over the sequester-mandated cap with the administration offsetting this increase by reducing other areas in the federal budget.

Meanwhile, international sales continue to provide a boost to the domestic market and have a meaningful impact on the bottom line of the large prime contractors such as Raytheon (NYSE:RTN). Commercial aerospace, which is still in the early innings of a multi-year cycle, is highlighted by Boeing's backlog for new planes stretching to the end of the decade. Newly announced plans to bridge the 777 with a newer plane in 2020 could stretch the commercial aerospace upcycle to the early part of the next decade fueled by global travel growth. A number of companies will benefit from expanding aircraft production, from manufactures of structures like Precision Castparts (NYSE:PCP) to those providing electronic and mechanical components like Honeywell (NYSE:HON).

Although political risk remains high for the sector, at least for the moment, the acrimony on Capitol Hill appears to be calming down a bit. At the time of this article, the SPADE Defense Index (NYSE: DXS), the benchmark for the sector sits at 3695, just below the historic high of 3700 set in late January.

Disclosure: I manage the SPADE Defense Index (NYSE index ticker: DXS). I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.