With polling continuing to show a very close U.S. presidential race , investors looking to hedge their bets may want to consider the defense sector. While defense stocks have slightly underperformed the broader market in 2024, the industry’s outlook is unlikely to hinge on which candidate becomes the commander in chief. Instead, the makeup of Congress could matter more, especially if investors perceive lawmakers will be more willing to boost the Department of Defense’s budget. Tensions in the Middle East remain a catalyst as geopolitical unease has historically driven valuations in the sector. “The point here is that what matters is the geopolitical situation and policies toward foreign conflicts, rather than the political party in the White House,” Bernstein managing director Douglas Harned wrote in a September research note. The S & P Aerospace & Defense Select Industry ETF (XAR) , which includes prominent industry names like L3Harris Technologies and Lockheed Martin , has added 17% this year, while the S & P 500 has advanced more than 20%. XAR YTD mountain The S & P Aerospace & Defense Select Industry ETF (XAR). The relative underperformance is largely due to gridlock in Congress, analysts say, as it has led to minimal increases to the defense budget in recent years. Morgan Stanley analyst Kristine Liwag sees an opportunity because the stocks she covers were trading on Oct. 1 at a roughly 10% discount to the S & P 500 on a next 12 months price-to-earnings basis, compared with the sector’s median 5% discount. No matter who voters choose, whether it is former President Donald Trump or Vice President Kamala Harris , Liwag doesn’t expect a meaningful shake-up in the outlook for defense stocks. “Our discussions with Defense Primes teams suggest that the industry is not bracing for material changes post-election, which should keep capital return momentum intact,” Liwag said in a note, referring to the leading defense players. Bernstein’s Harned said both candidates are likely to push for bigger budgets. “The mainstreams of both parties tend to support more defense spending, as it is also a strong job stimulus with primarily domestic supply chains,” Harned said. Liwag added, “We see few material distinctions between candidates on core defense issues, save Ukraine.” A bigger factor will be how willing Congress is to approve the requests the next president makes. Congress holds the purse strings Harris is more likely to face a divided Congress if she emerges as the victor, according to Wolfe Research’s head of U.S. policy and politics, Tobin Marcus. That scenario could lead to more stringent ceilings on defense spending even though there’s support for an increase from both parties. “I do think that that will end up putting some artificial cap on discretionary spending, despite the fact that there’s pretty broad bipartisan agreement on defense needs,” Marcus said in an interview with CNBC. “So my guess would be that that means you get slower growth in base defense budgets under Harris.” Bank of America analyst Ronald Epstein agreed with Marcus’ assessment, and expects a Harris presidency with a Democratic majority in the Senate and a Republican quorum in the U.S. House of Representatives, will continue the pattern of sluggish spending increases. “This scenario could result in growth as little as 2% [for defense spending], not enough to cover inflation,” Epstein wrote Tuesday. A Trump White House, coupled with a Republican Senate and a Democratic House, is the more bullish case for defense spending, according to Epstein. He forecasts this scenario could result in as much as a 17% annualized increase in fiscal years 2025 to 2027, in current values. The question of Ukraine However, Marcus expects it is more likely that Trump would have a unified government in both chambers of Congress, which could allow him to raise spending at a faster pace. He also is expected to slash aid to Ukraine. “I think you see faster and more unconstrained growth in base defense budgets. But I do think that there’s no more Ukraine aid forthcoming,” Marcus said. “I can’t picture what sequence of events would [lead to] Trump to changing his mind on this.” The Republican nominee has said he’d like to see a diplomatic approach to end the war , and has insinuated that he’d limit new funding to Ukraine. Under a Harris administration, aid is expected to continue. “Because of our support, because of the air defense, the ammunition, the artillery, the javelins, the Abrams tanks that we have provided, Ukraine stands as an independent and free country,” Harris said in the September presidential debate , where she reiterated her support. Roughly $33 billion in presidential drawdown authority money has been sent to Ukraine since Russia’s invasion in 2021, per Morgan Stanley. These funds represent the U.S. tapping into its own stockpile of weapons and military equipment for Ukraine’s use, and are closely tied to domestic producers of weapons. Trump’s priorities are “improved readiness,” Harness said. This could include beefing up domestic defense systems and expanding the Space Force . This strategy could benefit Lockheed Martin, Northrop Grumman and L3Harris Technologies, he said. Bernstein remains neutral on the defense sector, with all stocks rated market perform, because of the lack of clarity on the defense budget. “We have not yet seen a path to break through the budget logjam,” Harned said. Still, the analyst notes that even cases where an administration cuts defense spending, stocks can still carve out gains. During the Obama administration, the defense budget fell 3.3%, but defense stocks gained 2.1%. (The S & P 500 gained 17.3% during that time.) That’s because geopolitical tensions support valuations, and the Obama example occurred as Russia invaded the Ukrainian territory of Crimea in 2014 , according to Harned. This remains true. The defense stocks Morgan Stanley covers have outperformed the S & P 500 since Russia’s invasion of Ukraine, Liwag said. The “defense primes,” a basket of stocks composed of Lockheed Martin, Northrop Grumman, L3Harris Technologies, General Dynamics and RTX , have advanced about 38% over this time period, while the S & P 500 rose roughly 26%. At the moment, all eyes are on the Middle East. The Israeli conflict with Hamas, which began last year, has spread to multiple fronts. Over the past week, defense stocks have ticked higher as the world waited to see what Israel’s response would be to Iran’s recent missile attack. “If we see a broader conflict, increases in defense share prices could be justified. But, if current activities remain confined to narrower retaliatory attacks between Iran and Israel, we would not expect any sustained upside for defense stocks related to this conflict,” Harned said. Morgan Stanley said it prefers General Dynamics and Northrop Grumman . “A refreshed line-up of Gulfstream aircraft coupled with strong demand for GD’s defense products (e.g., ammo, ground vehicles) together present strong earnings growth potential, in our view,” Liwag said. She also likes General Dynamics’ balance sheet and said it historically has not slowed capital returns such as share buybacks or dividends around elections. The stock has advanced 15% in 2024. Morgan Stanley’s outperform rating and $345 per share price target implies 16% upside from Tuesday’s close. Northrop Grumman’s stock could benefit as the company improves the profitability of its B-21 strategic bombing plane. Her $592 per target implies 11% upside from Tuesday’s close. The company’s shares have gained roughly 14% this year. Tax policy To be sure, tax policy will matter for most defense companies as they are heavily reliant on U.S. sales. “A Democratic victory in November and corresponding move to increase corporate tax rates would be a clear negative for the defense sector and implied valuations,” Truist senior research analyst Michael Ciarmoli wrote on Sept. 26. Truist said the ramifications would be most notable for the stock valuations of Leonardo DRS and Moog , both of which are buy-rated. The firm modeled the potential effects of both corporate tax plans and the impact on the compound annual growth rate for earnings. The estimates were based on Trump’s plans to slash corporate taxes to 15% , and an increase to a 28% rate under Harris . At the end of the day, investors may not be served by relying on stereotypes commonly applied to Democrats and Republicans because they may be overstated at the moment, according to Harned. “Historically, the conventional wisdom has been that Republicans are positive for defense spending and defense stocks, while Democrats are negative,” Harned said. “This is not the case. It is external threats that are most important for budgets and the stocks.”
