How Have Tensions with North Korea Affected the Aerospace and Defense Industries?

Andrew Ramey, Consultant, also contributed to this article.

Developments in the war of words between the U.S. and North Korea have topped headlines on a near-daily basis over the past month as both the White House and Pyongyang continue to exchange a combination of threats, tweets, and military demonstrations. Despite the stricter economic sanctions imposed by the United Nations on North Korea, it seems that not even the best diplomatic efforts can deter the country from its defiant race to establish itself as a nuclear powerhouse.  

As the rhetoric surrounding each North Korean missile launch grows, the bull market has trudged along in a seemingly indifferent manner. While investors continue to muse over the impact of increasing geopolitical tension, one industry continues to outperform the broader market, thriving in this environment. The S&P 500 has posted a strong return of 22.40% over the past year, while the 11 constituents making up the Aerospace & Defense (A&D) segment have yielded a whopping 48.23%. Expanding the sample size to include the 35 A&D securities that comprise the S&P Aerospace & Defense Select Industry index, we see an equally impressive return of 47.84%, with 32 of the 35 companies yielding double-digit returns. 

Since July 5, 2006, when North Korea broke its self-issued moratorium on flight testing long-range missiles, the country has held test launches on 48 additional dates, according to the CNS NK Missile Database. 

Following each reported missile launch, Aerospace & Defense companies have averaged a return of 27 basis points in the subsequent trading sessions—outpacing the broader market's average of 12 bps. This gap widens as the length of time following each launch increases. 

Drilling Down Into Defensive Segments

Using FactSet’s RBICS industry taxonomy, we were able to screen for U.S. companies that derive a percentage of their revenues from specific defensive segments. This allowed us to identify seven sub-industries potentially impacted by the current global environment. Of these subsets, the top contributors to the industry’s performance have revenue exposure to missile equipment manufacturing.

The RBICS Space and Missile Equipment Manufacturing sub-industry (which includes companies such as Boeing, Lockheed Martin, and Orbital ATK) has averaged a cumulative return of 370.26% since North Korea ended its moratorium. In addition, the companies in this sector have averaged a return of 23.82% since July 4, the day that North Korea successfully launched its first intercontinental ballistic missile (ICBM).

Increased M&A Activity 

M&A activity in the industry has also picked up over the past month, with the announcement of two of the largest transactions in A&D history. On September 4, United Technologies Corp. (UTX-US) announced its intentions to acquire Rockwell Collins (COL-US) for roughly $31 billion, which is expected to make the consolidated entity a premier aerospace systems supplier and will be the largest deal in U.S. A&D history. Shortly after the announcement of the UTC Rockwell deal, Northrop Grumman Corp. (NOC-US) offered to acquire Orbital ATK, Inc. for $9.2 billion. The acquisition of Orbital ATK, a company that specializes in anti-missile defense systems, will not only solidify Northrup Grumman's position as an industry leader in the RBICS Advanced Combat and Support Systems Manufacturing subset, but also allows the defense contractor to expand its presence in the missile defense command and control business to the construction of physical missiles. 

Current Market Environment/2018 Outlook & Beyond

Companies in the Aerospace & Defense industry operate in mature markets with highly competitive and regulated environments. This is especially true in the defense segment, where the U.S. government enacts the budget, determines the allocations to each military program, and the Department of Defense procures weapons and goods from companies by awarding contracts. While the escalation of threats to U.S. interests from abroad has contributed to the industry’s performance, much of the outlook can be attributed to the current administration’s commitment to modernizing and rebuilding its military forces.

In March, President Trump submitted his defense budget proposal to Congress, requesting an authorization of $639.1 billion—$574.5 in the base budget and $64.6 billion in the Overseas Contingency Operations fund. While this proposal suggested a 10% increase from the prior year’s military spend, Congress called for even more funding in July, proposing that the defense authorization be increased to over $700 billion; the Senate ratified the bill in September with an overwhelming majority vote of 89-8.

While the administration has made it clear that they are keen on ramping up spending with this latest advancement in the defense policy, lawmakers still have several hurdles to clear, as the bill exceeds the budget caps set by the Budget Control Act of 2011. With or without the amendment to eradicate the sequestration spending cuts, the Congressional Budget Office is projecting a high revenue environment for A&D companies moving forward. Outlays are anticipated to exceed the budget authorization in the near term, growing at an annual rate of 2.9% over the next five years, with steady growth expected in the years that follow.

Developments over the past month have boosted defense companies’ share prices, with 51% of the S&P Aerospace & Defense Select Industry index’s constituents reaching new all-time highs. These stock gains have driven the industry’s valuation up past its 10-year high, and it is currently trading at 22.12x  forward earnings. Passive investors have also been buying into U.S. A&D passive strategies, with these ETFs seeing over $2,451 million in fund inflows year-to-date, placing it among the top performers for sector-focused strategies.