The Congressional Budget Office (CBO) has laid out the bull case for defense stocks, concluding in a report that the full military buildup advocated by the Trump Administration would boost spending by $683 billion over the next decade. Those would be massive gains, but investors would be wise to hold off on making stock purchases based on this report.
The report excluded overseas contingency-operations funding because they are, by nature, hard to predict. It does include Trump campaign promises that call for increasing the Navy fleet by 25%, to 355 vessels, and expanding the Air Force by five additional fighter squadrons. Those orders would create windfalls for General Dynamics (NYSE: GD) and Huntington Ingalls (NYSE: HII), the nation's two primary military shipbuilders, and for F-35 fighter manufacturer Lockheed Martin (NYSE: LMT), among others.
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Overall, the CBO estimates that the Administration's goals for the military would see the budget climb to $688 billion by 2027, which would be 20% higher than the peak in U.S. defense spending that occurred during the 1980s.
That's great, but what does it mean for defense stocks?
Shares of individual defense companies have climbed by as much as 30% year to date on anticipation that, after years of budget battles and sequestration, single-party control of both the White House and Congress would allow for a Pentagon spending surge. Sure enough, the White House and both houses of Congress have floated budgets that call for military spending to increase.
Still, it seems unlikely that the full buildup Trump had envisioned -- and that the CBO was scoring -- will ever be realized. For one, any increase would require Congress to raise caps on spending imposed by the Budget Control Act of 2011. That's no small task for a government that, for the second time in a matter of months, is struggling to come up with a short-term spending plan needed to avoid a shutdown.
According to the CBO analysis, under the Trump plan, total national defense costs for 2018 to 2021 would exceed caps imposed by the Budget Control Act, by $295 billion. The caps are scheduled to expire after 2021.
It's also unclear how this spending uptick would be paid for, even if Congress decided they wanted to fully fund it. The CBO, in a separate report, has estimated that the Republican tax plan making its way through Capitol Hill could add more than $1.4 trillion to the federal deficit by 2027. That estimate doesn't include any amount that would be offset by economic growth spurred by cuts, but even if that revenue materialized, it would seem challenging to get lawmakers to agree to significant additional spending in the years to come.
The CBO, for example, estimated that the Navy portion of the buildup alone would cost more than $20 billion a year over the next 30 years.
The news is good... just not that good
Finally, investors need to remember that, even if the headline figures are somehow agreed to, much of that money would not go toward new equipment. The CBO projects that, under the Trump request, the total size of the armed forces would grow by about 11%, or 237,000 service members, by 2027.
The CBO projection calls for the Pentagon's budget for acquisitions, which includes procurement and research and development, to grow on average 1.2% above the rate of inflation through 2027, reaching $220 billion. In 2018, for reference, the Department of Defense requested $198 billion for acquisition.
That's healthy growth, and contractors and their investors would undoubtedly do well should this projection come to fruition. But with defense companies already trading at near record valuations thanks to the post-election rally, it doesn't seem like the level of growth needed to sustain a further significant rally.
Investors with established positions in defense companies can sleep well at night knowing that, regardless of what agreements are reached on Pentagon spending levels, a steady stream of additional business is on the way. But if you're not yet invested in the sector, fresh headlines about a potential buildup are no reason to dive in now.
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