Downsizing the USA Military

With US sequestration cuts now taking effect and Barack Obama ordering US $85 billion in defence cuts, Colin Cieszynski assesses the impact on the stock market.  The latest budget cuts will shrink the USA army to its smallest force before World War II and are designed to reflect the new realities of prolonged government defence cuts aimed at a military without an ongoing ground war involvement.

The Aerospace and Defence sector has actually performed better in years of defence spending cuts

To analyse the effect of changes in defense spending on the stock market, we compared changes in defense spending with returns for the Dow Industrials for the periods 1900-present day and 1960 to present day.

A first glance at results suggested that defence spending didn’t have much of a bearing on stock market returns.  Considering, however, that stock markets tend to be forward-looking and that pending changes to defence spending tend to be known in advance to a certain extent, we took a second look.

Comparing returns in the stock market in one year with defence spending changes the following year shows a clear and inverse relationship between the two, excluding the return in the year-ending Sept 2011 with defence budget for year ending Sept 2012.

Changes in the stock markets tend to anticipate and factor in changes to defence spending before it occurs. Results show that stocks tend to benefit from a peace dividend when spending is being cut, and tend to fall at the beginning of wars when spending ramps up and victory is uncertain.  The exception to this is in the times of really big spending cuts following the two world wars which pushed the country into brief recessions as it demilitarised.

Crystal ball gazers

Stock traders aren’t the only group that anticipates changes in defence spending. A big chunk of the Q4 2012 US GDP shortfall was due to defence spending cuts that were made in anticipation of the fiscal cliff deadline that passed 31 December and was supposed to include sequestration

Should we move into sequestration, we may find that some of the cuts have already been made, turning the cliff into a slope.

Looking forward, the return of most troops from Afghanistan along with the sequestration suggests that we are heading into what could be a prolonged period of defence spending cuts which historically has been beneficial for stock markets. It’s more beneficial though if the cuts occur over time rather than all at once which could run the risk of tipping the US into recession.

Considering that cuts in anticipation of sequestration pushed Q4 GDP into the red there is a small but real risk that sequestration could cause a retrenchment in the economy. During the same period, however, stock markets rallied toward a retest of their 2007 highs, suggesting that many traders see sequestration as a speed bump on the road to recovery.

Trading defence stocks

One of the interesting results that stands out from our analysis is that the Aerospace and Defence sector (military-industrial complex) has actually performed better in
years of defence spending cuts.  This could be due to the increasing role of technology and equipment in military activities. Military spending can be broken down into two categories personnel (soldiers and related expenses like food and fuel) and equipment (which can include aircraft, vehicles, missiles, guns, ordnance, etc).

The biggest spending decreases occurred just after the world wars when personnel expenses were cut dramatically as conscripts returned to civilian life. On the other hand, spending on long-term weapons programmes may continue as the military attempts to keep ahead of its adversaries (and allies for that matter).  With the US already essentially out of Iraq and planning to pull out of Afghanistan over the next year or so, many of the spending cuts may come from lower spending on troops that are no longer in the field.

Because of this, companies that provide technology or equipment to the military may find themselves less vulnerable in the near term to spending cuts than one may think although anything could happen over the longer term.

Boeing’s soft performance of late has been due more to problems on its commercial aviation side. The one stock that appears to be getting hit hard is Lockheed Martin who has the contract for the big ticket and troubled F-35 program that could be a target for cuts.