I just finished reading a headline article out of Minyanville.com ("Budget Cuts Could Hit Aerospace and Defense ETFs Hard") and copied by TheStreet.com with a similar title ("Budget Cuts May Hit Aerospace/Defense ETFs"). And while the topic has been beaten like a dead horse by the media, the shoddy commentary deserves a reply to give investors an alternative interpretation. So, paragraph by paragraph:
1. M/TS Comment
In the wake of the sovereign debt crisis in Greece, many of the world’s largest economies have pledged to hefty spending reductions painting a bleak picture for the aerospace and defense sector.
It is true that several countries in Europe and the United States are planning cuts to their defense spending because of the upside down budget and national debt issues related to their individual economic situations and Greece is an example of a country with debt issues; however, the article seems to have ignored several other facts. Among these are that Greece spends little on aerospace and defense, so drawing an analogy is faulty; coutries outside Europe and the U.S. continue to INCREASE their defense spending (leading to increased global exports); and declines in defense spending in the European Union will lead to increased acquisitions by U.S. contractors as they seek to reduce their R&D spending.
2. M/TS Comment
...the United States, has already warned defense contractors Lockheed Martin (NYSE: LMT) and Northrop Grumman (NYSE: NOC) to prepare for a slowdown in orders as the Pentagon aims to trim spending in the coming years.
Everyone is aware of the comments coming out of DoD so singling out Lockheed and Northrop is a bit irresponsible unless they are trying to drive the share prices of those specific companies down. The current plan is for defense cuts to be strategic in nature which will mean the elimination of some programs with the savings shifted toward higher profile needs. The bulk of the announced reductions relate to costs asssociated with shrinking bureacracy (procurement and management) and bringing down costs associated with personnel issues (health care, retirement, etc.). The anticipated decline in U.S. defense spending as part of the budget released in February of this year is much stronger than analysts anticiapted prior to its release. Maintaining security is a top priority of the White House and Congress.
3. M/TS Comment
In Europe, a similar mood is being set as England has scaled down its order for the A400 military transport aircraft and is expected to cut its overall military budget between 10% and 25%. Additionally, similar cuts are expected in France, Spain, Greece, Germany, and Italy, with key projects being reassessed.
True, but the budgets associated with most of these programs go to European contractors, not those headquartered in the U.S., so their impact on ETFs listed on the NYSE will be minimal.
4. M/TS Comment
To put a further strain on the industry, funding of commercial aircraft could get more difficult as stimulus programs wind down and grants and other forms of aid are either drying up or being canceled; lack of cash and liquidity may make it difficult to finance future commercial orders. This likelihood of increased funding constraints is expected to have a negative impact on both Boeing (NYSE: BA) and Airbus, the world’s two largest airplane manufacturers.
Stimulus programs, grants, and other forms of aid? I'd love to hear specifics but I assume these have just been pulled out of thin air by the author to state their case. If anything, considering the sector is a major U.S. exporter and contributes a positive to the trade balance, the government didn't need to put many resources here.
As far as lack of cash and liquidity making it difficult to finance future commercial orders... reports on CNBC at the Farnborough Air Show indicate that the sector is bullish on their prospects and orders are flowing in from Asia, the Middle East, and Latin America. Boeing continues to increase its rate of production and announced that its forthcoming 787 aircraft is booked solid through 2020! If anything, the commercial aerospace cycle is getting ready for a multi-year bull cycle.
5. M/TS Comment
ETFs...will likely be impacted...
Much of the fear is already baked into existing stock prices. After outperforming the S&P500 every year for a decade, the benchmark SPADE Defense Index [DXS] has essentially tracked the market the past two years and is down by roughly a third from its all-time high. (The Index is outperforming 2010 YTD). The reality is that one can never anticipate what the market reaction will be, however, investors should have all the facts and not just rely on an article with an obvious bias.
Disclosure: Manager of the benchmark SPADE Defense Index [DXS]