Adopt a Defensive Mindset
As inflation continues to plague the US economy and soften demand, a surge in aerospace & defense spending is contributing to a positive outlook for the A&D industry.
This article was written with contributions from Bartlomiej Szczurek. Bart is a Research Analyst on the SPDR Americas Research Team.
Equities retreated on the whole last week, as markets digested both the strong January nonfarm payroll report and the Fed’s comments on strength in the labor market. Meanwhile, fixed income sectors dipped as both long- and short-term yields picked up and curve inversion intensified.
US Market Remains Challenged
Speaking at the Economic Club in Washington, Federal Reserve (Fed) Chairman Powell acknowledged that the “disinflationary process” has begun. But he also noted that it may take “a significant period of time” for inflation to cool down given strength in the labor market and elevated service inflation. January Consumer Price Index (CPI) inflation supported this argument to a certain extent. Annual inflation slowed for the seventh straight month to 6.4% in January.1 But the pace of easing has leveled off — down by only 0.1% from December — as services less rent of shelter stayed above 7% year-over-year for five consecutive months.2
Consumer credit increased in December by the smallest amount in nearly two years ($11.5B versus $25.0B surveyed), indicating that consumers have taken a step back from borrowing activities. Unsurprisingly, existing home sales and homebuilder sentiment data are expected to show tepid housing activity, though it might surprise to the upside given the recent decline in mortgage rates.
Geopolitical Tensions Persist
An alleged Chinese surveillance balloon was shot down after crossing into American airspace and floating over nuclear sites in Montana. Since then, three more unidentified objects have been removed from the sky. Meanwhile, retaliating against the price cap on Russian crude exports by the EU and G7 countries, Russia decided to cut its oil production by 500,000 barrels per day starting in March. The news sent WTI oil prices back above $85, benefiting energy stocks last week.
Adopting an (Aerospace and) Defensive Mindset
While the US economy remains challenged by stubbornly high inflation, softening demand overall, and weak corporate profits, the outlook for the aerospace & defense (A&D) industry remains positive. The optimistic outlook has been bolstered by increases in spending. The recently passed National Defense Authorization Act for Fiscal Year (FY) 2023 authorized $858 billion in defense spending — $45 billion more than President Biden requested, and 10% higher than the FY 2022 amount.3 NATO has also increased its 2023 military budget, 26% more than its 2022 level.4
Despite the industry’s 34.5% outperformance over the broad market last year,5 the A&D industry’s relative price-to-book (P/B) ratio remains well below its long-term median, and below the median level during the last defense spending cycle that took place between 2001 and 2011.6 This indicates potential value alongside elevated growth prospects.
Aerospace & Defense Industry Valuations Remain Constructive on Relative Basis
Implementation Idea: SPDR® S&P® Aerospace & Defense ETF (XAR)
Given weaker aggregate demand alongside corporate margin pressures, investors may want to focus on sectors with greater resiliency. The A&D industry may be one of these options, as it posted positive growth that was stronger than the broader US market during the last defense spending cycle — even as the US economy experienced two economic recessions.7
To capture the tailwinds of increasing defense spending and capitalize on current attractive valuations, consider the SPDR® S&P® Aerospace & Defense ETF (XAR), a modified equal-weighted strategy that provides unconcentrated exposure to the aerospace & defense sub-industry across the market-cap spectrum. And with an expense ratio of 0.35%, XAR is the cheapest defense-oriented industry ETF.8
XAR Standard Performance as of December 31, 2022
