What Does a Democratic Victory Mean for the Defense Sector?

| About: PowerShares Aerospace (PPA)

As a cool wind begins to blow and the calendar shifts from fall to winter, what is moving defense and homeland defense stocks is ‘hot air’! Yes, it is election time.

Congressional Elections on the Horizon
With the mid-term elections today, the prognosticators are forecasting that the Democrats will win enough seats to capture the House of Representatives and possibly even the Senate. The question at hand is, will a Democratic victory mean a rapid pull-out of Iraq and a decline in defense spending?

Going into the month, the large defense contractors all reported healthy quarterly revenues, sales and improved margins. Based on these results, the SPADE Defense Index [AMEX: DXS] continued to rise, gaining 3.2% in October and 6.3% in the quarter. With the election approaching, the last week of the month and the first days of November have seen some increased volatility and some retraction in the value of the Index. According to comments made by a number of analysts, this has as much to do with investors capturing gains as it does with any changes that come from the election.  While the SPADE Defense Index is down about 2% from its highs, the Powershares Aerospace & Defense Portfolio ETF (AMEX: PPA) has seen several million dollars of inflows in the last week as trading volume has spiked to more than 4 times its typically 70,000 shares/day average.

So What Does a Democratic Victory Really Mean?
There have been conflicting opinions on this. There are those that pitch the ‘traditional’ belief that Democratic control of Congress (either the House, Senate, or both) would lead to a quick pull-out of the troops from Iraq and reductions in defense spending. The reality is that this is not necessarily true.

Here are some thoughts to ponder…

1. In advance of the Presidential elections in 2008, it is likely that the Democratic party will deliberately move to the middle in an attempt to take issues away from the Republican party.

2. Regardless of how the election turns out, President Bush as Commander-in-Chief, makes the final determination of when the pull-out will begin. Congress’ power to force a pull-out would be to stop paying for the war, but this in turn would lead to claims of a Democratic-led Congress not supporting the troops – an issue that the Democratic Party would not want to be pulled out in the 2008 Presidential election. 

3. A pull-out of Iraq will take a number of months and a request for supplemental funding is already planned for the March-May timeframe.

4. The budget for the next ten months (October 2007) is already approved.  The following budget (Oct 08 - Sept 09) will likely have additional procurement items devoted to replenishing and restocking hardware used in Iraq.  That budget will also likely have a stable R&D (RDT&E) spending environment for the agencies to develop technologies to imporve the safety of soldiers and equipment.  This takes us all the way to January 2009, when the budget by whomever is our next president is submitted to Congress.

5. Getting back to the theme of gridlock is good, based on the above, defense spending should be relatively stable. The wild card is the decline in supplemental spending. For the long-term, we’ve seen comments about declines in defense spending from the 2012 to 2017. Considering the unknowns in the world, we feel that it is much too early to correctly predict defense spending ten years out.

6. Last spring, the report, “Real Security: The Democratic Plan to Protect America and Restore Our Leadership in the World”, the party spelled out a five-point plan which endorsed every acquisition program in the Rumsfeld defense budget and a promise to, “rebuild a state-of-the-art military by adding equipment and manpower”.

7. The biggest effort by a Democratic-controlled Congress would likely be hearings and investigations – into the intelligence that led to the war in Iraq, cost overruns regarding the reconstruction, and certain weapons programs that have experienced substantial cost overruns. It is also likely that they will look into the contracts and performance of specific companies, such as Haliburton, which has been cited for delays and over billing.

8. Lastly, while recent history has seen declines in defense spending when Democrats have controlled the White House and Congress, ie. Carter in 1976-1980 and Clinton in 1992-2000, these are periods that could be considered relative stability. (While the Cold War with the Soviet Union during the Carter Administration was still ongoing, it had reached an element of status quo and hence stability. In the Clinton years there are those that argue whether reductions in military spending was capturing the ‘peace dividend’ or an error in strategy). However, if we expand our time horizons, there were Democrats in power during World War II and the Vietnam War in the 1960s. Whereas spending on defense and homeland security is less than 5% of GDP today, during World War II, it was nearly half.

A Time That ‘Gridlock is Good’
Looking at the increasing partisanship of the last few years on Capitol Hill and the aforementioned eight thoughts to ponder, gridlock on defense and homeland security issues is a very real possibility. Regardless of the political party (or mix of parties) in control, there is a likelihood that neither party in Congress will have an absolute majority, or at least enough that the minority party can stall legislation. This will lead to the stability and a clear direction of where things are headed that the financial markets prefer. Taking this into account, the adage of buy on the rumor, sell on the news seems to jive with Jim Cramer’s comment to sell defense before the election and buy it back after.

Legal & Disclaimers
SPADE & the SPADE Defense Index are registered trademarks of the ISBC. The ISBC is the owner of the trademark, service marks, and copyrights related to its indices. This newsletter does not constitute an offer of an investment product. The ISBC makes no representation regarding the advisability of investing in vehicles based on the SPADE Defense Index. All information is provided ‘as is’ for informationalpurposes only and is not intended for trading purposes or advice. Neither the ISBC nor any related party is liable for any informational error, incompleteness or for any actions taken based on information contained herein.

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