Is War a Time to Load Up on Defense Stocks?

Editors’ Note: MarketMinder doesn’t make individual security recommendations—those mentioned here are incidental to a broader theme we wish to highlight.

As rocket fire and shelling continue in the Middle East, the human impacts are undeniably tragic and fearful. We feel for all those involved. From an investing perspective, the initial reaction is often fear of negative fallout for stocks. We addressed those understandable concerns here. In our experience, though, some investors will soon wonder if conflict—now underway in Ukraine and the Middle East—makes it a good time to load up on stocks in the Aerospace & Defense industry. In our view, this would be committing a similar mistake: making investment decisions based on widely known information.

With fighting frequently leading the news, some think conflict makes now an appropriate time to own defense companies (e.g., military contractors, weapons manufacturers, surveillance technology outfits, etc.). War obviously has weapons technology back in the headlines—and some fear tensions elsewhere in the globe mean more demand could come. Their conclusion? Defense stocks are poised to lead in a more dangerous world. The market reaction immediately following Hamas’s October 7 attack may seem to back this up: Some prominent defense stocks jumped after fighting began, and the MSCI World Aerospace & Defense industry has outperformed since early October.^[i] 

The rationale sounds logical, but history suggests this isn’t necessarily a winning move. Yes, since Russia invaded Ukraine in February 2022, Aerospace & Defense has led global stocks overall. (Exhibit 1) But a closer look reveals a lot of outperformance occurred before the invasion. Relative returns flatlined for roughly nine months thereafter, showing they mostly declined alongside the MSCI World Index during the bear market.

Now, Aerospace & Defense did lead for a stretch from mid-October 2022 through early January 2023. But this occurred alongside the start of the current bull market. In our view, the industry benefited from the bounce typically seen in early bull markets—perhaps because of some constituent firms’ economic sensitivity. Consider: From October 12, 2022 – January 6, 2023, the Aerospace & Defense rose 23.9%, better than the MSCI World’s 12.3%.^[ii] But several major defense-associated names performed in line—or lagged—the broader industry while companies with more commercial aerospace exposure outperformed.^[iii]

Exhibit 1: A Mixed Picture on Defense Since Last Year

Source: FactSet, as of 10/24/2023. MSCI World Aerospace and Defense Industry and MSCI World Index returns with net dividends, 11/24/2021 – 10/23/2023.

Sadly, war in the Middle East has been a regularity over the past few decades, which means recent history provides more examples of conflict not automatically setting off Defense stocks for a sustained run of outperformance. Syria’s civil war—which began in 2011—threatened to rope in major powers after an August 2013 chemical attack in Ghouta. Many thought Western nations would step in, which prompted Russian threats of “catastrophic consequences” in the event of a NATO intervention—stirring worries of a proxy war or worse. But a major escalation didn’t come to pass. And after outperforming global stocks for the rest of 2013, Aerospace & Defense stocks trailed for most of 2014. (Exhibit 2)

Exhibit 2: Stocks After 2013 Syrian Chemical Attack

Source: FactSet, as of 10/24/2023. MSCI World Aerospace and Defense Industry and MSCI World Index returns with net dividends, 5/21/2013 – 8/21/2014.

In 2006, Defense stocks lagged global markets before popping when the Israel – Hezbollah War (i.e., the Lebanon War) began. Yet the industry’s outperformance didn’t last. Rather, returns flip-flopped between leading and lagging over the next 12 months—there was no identifiable pattern.

Exhibit 3: 2006 Israel – Hezbollah War

Source: FactSet, as of 10/24/2023. MSCI World Aerospace and Defense Industry and MSCI World Index returns with net dividends, 4/12/2006 – 7/12/2007.

Consider also the 9/11 terrorist attacks—and subsequent Afghanistan invasion in October. Perhaps counterintuitively, the industry lagged for a spell after the invasion. Similarly, in the lead-up to the 2003 Iraq invasion, the Aerospace & Defense industry led before sharply underperforming—not what you would expect if fighting is automatically bullish for defense stocks. Defense did lead from April – August 2003 but then mostly trailed for the subsequent six months.

Exhibit 4: 9/11 and Invasions of Afghanistan and Iraq

Source: FactSet, as of 10/24/2023. MSCI World Aerospace and Defense Industry and MSCI World Index returns with net dividends, 6/11/2001 – 3/19/2004.

These mixed results highlight an overlooked point: Few firms in the industry are pure-play defense contractors. Many straddle defense and commercial projects. They manufacture electronics, engines and planes—some of which will be for defense, some of which won’t. Hence, the mix of revenue could affect whether a defense company wins or loses from the conflict. For example, it may seem logical for a firm with a large defense manufacturing business to benefit from the 9/11 terrorist attacks. But the event also injected uncertainty in the airline industry (e.g., demand for recreational travel)—which affects that same company’s commercial business. Which impacts it more? What do investors think affects it more? It isn’t a black-and-white picture—sentiment counts.

Beyond this, defense spending is very often about government budgeting. This tends to play out slowly and super publicly—which saps surprise power—and the outcome often doesn’t go as assumed, either. Consider all the bickering and compromising in legislatures in the US and Europe over their respective budgets recently. We highlighted the difficulties in passing the budget in the US earlier this year—and there is plenty of talk, chatter and planning about cutting deficits outside America. Whether those cuts reach defense remains to be seen, but it is a complicating factor.

As with most things in investing, we aren’t inherently for or against any particular category. However, it is always critical to ask: What do you know that others don’t? Efficient markets reflect widely known information, so acting after the fighting starts is acting on old news. Little is more widely watched than war, as the last two years demonstrate well. The onset of fighting can knock sentiment initially, as fear can be high. But forward-looking markets swiftly price the likelihood the conflict impacts commerce and corporate profits—and move on. They likely do the same at the industry level. Unless there is a high probability the fighting disrupts business, a conflict’s impact on stocks tends to be fleeting.