Editor’s note: The following was adapted from our 4Q 2024 Commentary..

In a world where geopolitical tensions are escalating and global conflicts are high, the defense sector faces unprecedented challenges and opportunities. Despite the recent downturn in these stocks, we believe that the current environment underscores the enduring value of defense stocks.

We have a long history of investing within the defense space. We like the strong, predictable cash flows and solid balance sheets. While the sector experienced a downturn during the fourth quarter, we tend to push back against the market’s knee-jerk reaction. There are several reasons for this stance.

Growing Geopolitical Risks

First, defense spending trends with the threat environment—and the global threat environment is VERY high. Worldwide, there currently are 56 conflicts—the most since World War II, according to the Global Peace Index. Vladimir Putin is threatening NATO allies in the Baltics. Xi Jinping has told China’s military to be ready to invade Taiwan by 2027 with a 2027-2035 timeframe for action. A two-front war later in the decade is certainly among the many possibilities.

A Taiwan invasion especially would be a global economic disaster due to the high percentage of advanced semiconductors made there. Both sides of the Taiwan Straits contribute heavily to global trade, and both would be shuttered for a time. No presidential administration will want to have on their record that they allowed such a calamity, and military strength is the best way to avoid a conflict.

Source: ACLED

Political Support Remains Strong

Second, Congress has the power of the purse, according to the Constitution, and there is strong bipartisan support for defense spending. There is also bipartisan support for most of the rest of U.S. Government activities once one gets past the simple stump speeches.

We respect Elon Musk and his driven nature (despite his history of over-promising); serving in his DOGE capacity, he will certainly look for cuts and hopefully find significant legitimate savings. However, we suspect the biggest impact to government spending will be caused by the short-term uncertainty in the ranks of contracting officers throughout many government agencies. This could cause some quarters of weak government orders impacting the backlogs of both civil and defense contractors.

Defense Budget – Absolute and % of GDP

Chart Source: Macrotrends.com / data provided by SPIRI

Over time, we believe the vast majority of civil and military missions will not go away, and any changes made will tend to favor outsourcing. The historic rule of thumb has been that Republicans favor government outsourcing, while Democrats favor insourcing. Partly due to this, we continue to have a favorable view of defense-exposed contractors who benefit from outsourcing.

Given these structural tailwinds, we remain confident in the long-term stability of defense spending. While market sentiment may fluctuate, the fundamental drivers supporting the sector remain strong.

For a more comprehensive analysis of our investment perspectives and strategies, read our 4Q 2024 commentary.