Defense stocks have outperformed the market in the wake of the Russian invasion of Ukraine, according to a recently published Bank of America global research report.

“The Russo-Ukrainian conflict has ensured investors of a rising defense budget and triggered the recent outperformance of defense names related to the S&P500,” said the March 7, 2022, report by research analysts at Bank of America Securities and Merrill Lynch.

The report said predicted a boost in defense spending in both the U.S. and Europe that would bring the U.S. defense budget to a record $900 billion by fiscal year 2025.

“We estimate the U.S. defense budget could rise to at least 3.5% to 4% of GDP on this paradigm shift. We now expect U.S. defense spending in FY2023 to be $800bn with the likely return of Overseas Contingency Operations (OCO) Funding and exceed $900bn by FY2025,” it said.

“We expect the NATO ‘soft’ target for defense spending (2% of GDP) to become a ‘firm’ target or floor. Currently, only four countries meeting this target; there are 20+ more to go. Our UK analyst Benjamin Heelan expects more governments to announce plans to meet the 2% of GDP NATO targets,” it added.

The report also said defense stocks had been undervalued over the previous year as investors weighed concerns of a declining defense budget under the Biden administration.

However, investors saw a “strategic shift” when the Senate Armed Services Committee planned for a $740 billion National Defense Authorization Act in July.

“The NDAA included an additional $25 billion in top line defense spending above the Biden administration’s previous budget proposal, reflecting bipartisan support for greater defense spending to counter rising tensions in Asia-Pacific,” it added.

Still, investors “sought a catalyst that would confirm a real defense budget increase.”

“We see the Russo-Ukrainian conflict as this catalyst, which has consequently triggered a re-rating of defense stocks; investors are now surer of a rising defense budget as the U.S. balances between newfound concerns in Eastern Europe and existing threats in the Pacific,” it said.

The analysts also said the conflict was shaping up to be the largest in Europe since World War II, and both the U.S. and NATO members are now focusing on how to defend against a “mounting Russian threat and a potentially larger Russian border with NATO.”

“The U.S. will now need to balance defense priorities between Eastern Europe and Asia-Pacific,” it said.

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