Can A Defense Spending Cut Trigger Another Deep Recession In The United States?

Includes: BA, LMT, NOC, RTN
by: Disruptive Investor

A new report by the National Association of Manufacturers - "Defense Spending Cuts: The Impact on Economic Activity and Jobs" analyzes the probable impact of cuts in defense spending (on the economy and jobs) under the Budget Control Act of 2011.

This article puts forward the key impact on the economy and jobs market (as discussed in the report) and its impact on the defense sector stocks.

The key conclusions related to the economy and the jobs markets in the report are:

1) 1,010,000 private sector jobs, including 130,000 manufacturing jobs, will be lost in 2014. With the additional loss of over 200,000 military jobs in 2014, including civilian workers, the total loss will be over 1.2 million jobs

2) GDP will be almost 1 percent lower by 2014.

3) Total job losses will increase the unemployment rate by 0.7 percent.

4) California will experience the largest job losses in 2014 (148,000), followed by Virginia (115,000) and Texas (109,000).

5) Certain industries will be hit particularly hard, with the aerospace industry losing 3.4 percent of its jobs, the ship and boat industry losing 3.3 percent of its jobs and the search and navigation industry losing 9.3 percent of its jobs.

The probable job losses in different regions is shown in the chart below:

Job Losses in US States Due to Cut in Defense Spending in 2014

The report concludes by saying that:

In discussing programmatic changes to the defense sector during the current effort to address our nation's fiscal challenges, it is critically important that policymakers understand that deep cuts in defense expenditures will impair our national security, cripple a vital part of the manufacturing sector and have far-reaching negative effects on a broad spectrum of the U.S. economy. As illustrated in more detail above, potentially deep cuts in defense procurement will have a massive ripple effect throughout the manufacturing economy, affecting large defense contractors, tens of thousands of small and medium-sized manufacturers in the defense supply chains and over 1 million workers throughout the United States. It is critical that policymakers take action as soon as possible to avoid these negative impacts on our manufacturing sector and our economy as a whole.

My opinion on the conclusion:

I am not sure what the NAM is suggesting: another war or to focus on other areas, which will help offset the defense spending cuts. I would certainly like to believe that they are not suggesting to the politicians to engage in another conflict (possibly with Iran) in order to prevent the economic damage mentioned above. In my personal opinion, the job losses in the defense sector can be offset by renewed focus on infrastructure and manufacturing (not necessarily defense equipments).

At the same time, I see the Iran issue still very open-ended where one of the possible outcomes can be a war.

To answer the question I put forward in the title, the defense sector spending cut is unlikely, and the projected job losses will not be an actual outcome when 2014 comes. Therefore, the defense sector should not be the reason for another recession. I must add here that the defense spending under the Bush era has been a big reason for huge government debt pile-up, which can have pretty undesirable long-term consequences.

Therefore, how to play the Defense sector:

If one is betting that the defense spending cuts will happen, it would not be a great idea to have defense sector stocks in the long-term portfolio.

However, in my opinion, the defense sector will thrive on rising and sustaining geopolitical tensions globally. Iran or any other country might not be the only reason for betting on the defense sector. Having said that, Iran does remain the focus in the near-term and with no peaceful outcome in sight, another conflict in the Middle-East remains a high probability.

With this opinion, I would consider exposure to the following stocks with a medium to long-term perspective. I had mentioned about the prospects of a global recession in my previous article. Therefore, I would look to consider exposure to the discussed stocks on any meaningful correction in equity markets in the next 2 quarters.

Lockheed Martin (NYSE:LMT) - Investors positive on the defense sector need to have LMT in their portfolio. LMT has a huge pie of revenues from government contracts, which ensures steady revenue inflow. LMT also has a very attractive dividend yield of 4.6%. Future growth for LMT will primarily come from continued global conflicts and the thrust on innovation at LMT

Raytheon Co. (NYSE:RTN) - is a provider of integrated defense systems and is another attractive long-term buy in my opinion. RTN also has a relatively attractive dividend yield of 3.5%, with an attractive TTM PE of 10.31. Another positive about the stock is its low beta of 0.78, which makes it a good buy (along with other factors) in a highly volatile market

Two other names worth mentioning and considering as a buy option are The Boeing Company (NYSE:BA) and Northrop Grumman Corporation (NYSE:NOC).

I would personally look at any further negative news on the defense sector related to spending cuts as an opportunity to accumulate more defense stocks. The defense sector is a "Too Big to fail" or "Slowdown" sector in some countries (including the United States). More importantly, politicians and dictators globally keep giving enough reasons for the sector to cheer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.