On 1 March, President Barack Obama signed an order requiring indiscriminate cuts to US Federal budgets worth $85bn (£56bn) in 2013, so-called sequestration. Given the American fiscal year runs from 1 October, those cuts will be squeezed into just seven months, half of which will come from defence. "A shave with a chain saw" is a popular description and Rolls-Royce North America chief James Guyette recently predicted "significant chaos" if the cuts were enforced.
But the reality could not be more different. Since November, the aerospace & defence sector has risen 22 per cent, and by 29 per cent since last June, significantly outperforming the FTSE 100 and FTSE All-Share index. In fact, it's one of the best performing sectors and most UK defence names, despite making 40-50 per cent of sales in the US, now trade at multi-month, or even multi-year highs, without appearing overbought on technical measures.
"We’ve had a year-and-a-half to get used to it," explains Sandy Morris, defence analyst at broker Jefferies. "The irony is, that damage done by speculation, which came at a time of distress in Europe, is actually worse than the impact. Now we've got it, it doesn’t look too bad." But decisions taken on the major programmes will be the real acid test and it’s quite possible that may not happen until the end of 2013 anyway.
In the meantime, defence contractors will be left guessing. Andrew Gollan at Investec Securities slams America's "dysfunctional" procurement system and blames Continuing Resolution (legislation used to fund government when Congress is unable to agree a budget) for increasing delays. However, there's talk of a deal before the 27 March deadline, or at least some agreement on defence spending, either of which would be healthy for British firms.
Get some clarity and they'll be able to assess the potential damage and cut their cloth to suit. "The beauty of defence companies is that once they've scaled the problem, they have phenomenal and predictable cash flows," says Mr Morris. That should underpin dividend growth and, given none, including BAE Systems (BA.), have any prime contracts running, there's no major piece of business to lose.
