Last week, we discussed how we have been active investors in the defense industry for years. There are a number of aspects we find attractive in the industry:

• Solid free cash flow yields
• Strong growth since the 2015 budget trough following the Iraq and Afghanistan Wars and the Budget Control Act (BCA)
• Relative stability compared to other industrials in the case of recession. 

We also discussed defense names performing as expected during the selloff (outperforming) but lagged during the sharp rebound. We also began to explore how the upcoming presidential election could impact defense spending. This week, we look closer at President Trump’s historic defense spending patterns and attempt to get a sense of how Joe Biden would approach the situation were he to win the nomination.

What might we expect from a second Trump Administration? Over the past four years, the Trump Administration grew the defense budget at a 5.3% compound annual growth rate (CAGR). Going forward, even before the coronavirus pandemic appeared, it was forecasting just 2.2% annual growth over the next four years. Meanwhile, the DoD forecasted 2.2% inflation, leading to a flat real budget under the next four years of President Trump. President Trump himself has occasionally spoken of cutting defense, though the context is unclear. Nonetheless, the consensus view is that the Administration’s goal is to hold the budget relatively flat from here. It is a common practice of the U.S. Government to control programs by holding budgets flat and allowing inflation to bring down the real cost over time.

What might we expect from a Biden Administration? Biden himself has not said much on the defense budget, likely intending to steer clear of the issue in advance of the election to avoid alienating parts of his party. The best communication we know of came in November 2019 when he told Military Times:

“We can maintain a strong defense and protect our safety and security for less … We have to make smart investments in technologies and innovations — including in cyber, space, unmanned systems, and artificial intelligence … We have become over-dependent on the military to advance our security interests overseas — and underinvested in other tools including diplomacy, economic power, education, and science and technology.” 

Clearly, he prefers advancing soft power and alliances, and is pointing to a budget cut, though it is unclear if any cut is before or after inflation. Nonetheless, he is no Elizabeth Warren or Bernie Sanders. The latter two have called for drastic cuts to the defense budget in favor of domestic programs. Historically, Biden has been supportive of defense and foreign policy, and has a good reputation for bipartisanship. It is not clear that he would expend significant political capital cutting defense strongly, especially as the economy digs out of recession and benefits from simulative defense spending. Recent comments by former Obama Administration officials suggest cuts in the range of 0-5%. These cuts would likely be in nuclear weapons spending, having a separate Space Force, and perhaps from the Army. Essentially, the Obama veterans were suggesting a traditional Democratic platform of supporting equivalence between domestic and defense programs.

In the case of a Biden Administration, it is also interesting to consider potential changes within the Republican platform. The midterms in President Obama’s first term brought forth the Tea Party, and they were budget hawks as our wars wound down. Out of power, the Republican Party may once again become fiscally conservative and budget focused.

Net net, whoever wins in November, defense manufacturers should continue to grow for another two years as budget outlays catch up with prior budget authorizations. Meanwhile, the stocks are likely to be constrained until certainty of a budget bottom appears. We are moving our sector exposure more towards earnings recovery stories in commercial aerospace and industrials. Nonetheless, the absolute downside to defense looks contained and we continue to value their properties during market pullbacks. Within our defense stocks we look to programs and technologies that still have reason to grow, such as submarines, unmanned systems, sensors, hypersonics, and cloud migration. At the end of the day, personnel is the military’s largest cost. If the Defense Department is to minimize this cost, meet rising overseas threats, and do more with less, it will need the defense industry to offer a broad array of solutions.

Read Last Week's Post: Playing the Recession Playbook in Defense, Part 1