Despite having entered another phase of tariffs and counter-tariffs, the U.S. stock market has remained resilient, and traders have kept their nerve while two of the world’s largest economies exchange blows. Even though the sustained uptrend in the broad market has surprised some, the truly astonishing thing is that it is doing so without the help of traditional leaders like tech, internet and semiconductor stocks, most of which are down as a result of aforementioned trade fears. Instead, the market has found a few surprising sectors, like healthcare and utilities, to drive the market in the waning months of 2018.
Perhaps the most surprising market sector to lead the S&P 500 are the industrial industries, which have pushed the Industrial Select Sector Index up 7.5 percent over the past 3 months.
DUSL vs. S&P Industrials Select Sector Index (IXITR)
Data Range: 6/25/2018 – 9/25/2018. Source: Bloomberg. The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate. An investor’s shares, when redeemed, may be worth more or less than their original cost; current performance may be lower or higher than the performance quoted. For standardized performance and the most recent month-end performance, click here.
While this uptick in industrials is seemingly just getting its legs, it’s prudent to get a sense of where this enthusiasm is coming from and whether momentum can carry the sector over the stormy waters of global trade. Below we’ll break down one of the three main industries that make up the industrial sector and determine if it can continue driving the market to new highs before the end of the year, or whether the industrial trade might break down, piece by piece. In this article we’ll take a look at Defense.
It was not until September that industrials started to diverge. It turns out that this split corresponds with a jump in the defense industry, something you can see in the chart for the Direxion Daily Aerospace & Defense Bull 3X Shares ETF (DFEN)
DFEN vs. Dow Jones U.S. Select Aerospace & Defense Index (DJSASDT)
Data Range: 9/1/2018 – 9/25/2018. Source: Bloomberg. The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate. An investor’s shares, when redeemed, may be worth more or less than their original cost; current performance may be lower or higher than the performance quoted. For standardized performance and the most recent month-end performance, click here.
Among the biggest drivers of this jump is United Technologies, which has surged nearly 8 percent (as of 9/24/18) since it reported solid Q2 earnings late in July. UTX is also rapidly nearing its $30 billion acquisition of Rockwell Collins following some divestments in conflicting areas of its business.
Others in the space like Boeing and Lockheed Martin have also climbed about 10 percent in the past month after finalizing some sizable agreements with Uncle Sam. Boeing’s up following the announcement of a $2.9 billion defense contract while Lockheed Martin rose on news on a massive $7.2 billion contract to develop a next generation GPS.
As you can probably tell by now, the best thing the industry has going for it is a government willing to make these multi-billion dollar deals. Prior to the recent late-summer rally, both companies traded down more than 10 percent from their 2018 high. On top of that, others in the industry like Northrop Grumman and General Dynamics traded at or near 52-week lows through much of the third quarter.
It’s clear that the biggest catalyst for this industry is the people’s checkbook. Since the Senate just approved a $17 billion increase to the pentagon’s budget, there’s not much reason to expect these companies to get kicked off the dole anytime soon.
However, depending on whether the less hawkish Democrats manage to flip the legislature this November — the prospect alone could cause some traders to shift some of their exposure — there’s a chance the Trump administration might see greater resistance to further spending if there’s a return of deficit hawks in congress.
If defense spending does get the axe, orders in Boeing’s international aeronautics business stand to buoy that company. However, research from McKinsey & Company shows U.S. defense spending is heavily correlated with the revenue of defense contractors, so stragglers like Northrop or Lockheed could be harder hit without a steady stream of federal contracts and a potentially tighter fiscal outlook.
For now, the lack of overexposure to international markets is a boon for defense stocks. However, if and when U.S. monetary policy really starts to tug on national purse strings, the contractors could start feeling the pinch.
Related Leveraged ETFs
- Direxion Daily Industrials Bull 3X Shares (DUSL)
- Direxion Daily Aerospace & Defense Bull 3X Shares (DFEN)