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Aerospace & Defense - Increasingly Positive to Investors

|Includes: PowerShares Aerospace & Defense Portfolio ETF (PPA)

The perception is that its been a tough year to be an investor in aerospace and defense. Yet even though for the first time in a decade its likely the sector won’t outperform the broader market, a 20% gain for the sector in 2009 and the Powershares Aerospace & Defense ETF (NYSE: PPA) is still possible.

With just a month to go in the year, the A&D sector has failed (so far) to break out of the trend of moving as the broader market moves. Even President Obama’s primetime speech calling for 30,000 more troops to head to the Afghan region has failed to spark a rush of investors into the sector. Overall though, the past month has seen some gains in performance and an increasing number of analysts being more positive about the sector.

 There was little in the speech that provided insight into the strategic changes in defense philosophy and future spending plans that will emerge from the 2010 Quadrenniel Defense Review however it did call for the addition of $30 billion and 30,000 troops for the Afghan-region effort while highlighting some of the budgetary pressures that he faces. Combined with some recent news and “trial balloons from Congress” the past month has given us some things to ponder about when identifying the direction of, and the factors that will influence the business and investment performance of the sector -- for the next month, the next year, and the next several years.

 1. The Concept of a War Tax: Congress in late November floated the concept of a special tax on high-income Americans to help pay for the wars in Iraq and Afghanistan. When discussed on CNBC it was pointed out that this is not a new concept, has been done in the past, and that it presents an interesting challenge to those who want to support our troops yet are against new taxes.
 2. The bad press concerning the launch of Boeing’s 787 Dreamliner aircraft has finally been supplanted by positive news focused on the anticipated first test flight, scheduled to take place most likely the week of December 14th but before the end of the month. Next year should see a shift from R&D to production and enable companies with commercial exposure to this program to begin recording billions in backlogged revenues.

 3. The growing threats in Asia and the Middle East continue -- Unlike prior “post-war” periods when defense budgets declined significantly, comparing today’s climate with that after the Cold War or Vietnam is folly. Military and defense needs will still exist after 2011/2012 when the Afghan and Iraq pullouts are proposed to be completed. In fact, if one looks at the news items on page 2 related to Iran’s nuclear expansion plans and China’s expanding cyberterrorism activities, calls for offensive weapons in space, and increasing naval capacities, a number of possible conflict scenarios can easily be seen....and this assumes that the violence associated with Islamic fundamentalism has been resolved.

4. As highlighted in the president’s speech, the vice that keeps defense spending in check is the economy and the national debt. Between now and 2013, it is likely that improvements in the U.S. economy and an expansion that creates jobs, leads to economic growth, and improves the tax revenue stream will relieve some pressure in the budget. Similary, the government relief programs have yet to be played out and the total cost may still be less than forecast once private companies repay the government. By the pullout in FY-12/FY-13, we’ll know more about our economic situation and the impact it’ll have on discretionary spending for the military. Until then though, future budget pressures are a risk although it appears that the FY- 11 and FY-12 budget levels appear stable.

The second factor impacting where monies in the defense budget go is the steady rise in military personnel costs; those associated with health care, retirement, training, housing, etc. In a flat budget environment, “M-1” increases
have to be offset with declines in procurement (P-1), R&D (R-1), and/or Operations (O-1). Reduced force levels after troops return from combat should help (and reduce O-1 costs and preserve procurement and R&D spending)
although the reality is that the budget is a complicated juggling act.

Ultimately though, these are not new problems. While they will impact the total amount allocated, from an investor standpoint, changes to which programs DoD invests in, the types of contracts, and how well individual firms have positioned themselves to align with strategic defense changes are more important to a company’s revenues and profits and their stock’s performance in the market.

It’s beginning to appear that there may be more positives for 2010 than negatives.

Disclosure: Manager, SPADE Defense Index