News that President Barack Obama has requested a substantial increase in US defence spending has come as welcome news for a host of UK defence contractors. As part of a $4 trillion 2016 fiscal budget shopping list presented to congress, the US president surprised onlookers by asking for a base defence budget of $534bn (£350m), plus $51bn to fund wars in Syria, Iraq and Afghanistan.
Rising geopolitical tensions, and cyber attacks, are pressing priorities for a US government under pressure from Republican opposition, although questions are already being asked over whether this ambitious request for more funds will be granted. As the limit set by sequestration is just shy of $500bn, Obama's latest appeal breaches the austerity fiscal policy by about 7 per cent.
Nevertheless, shares in the UK defence companies most closely aligned to the spending patterns of the world's biggest buyer of military hardware climbed following the announcement. And while still nowhere close to the $664bn the US shelled out in 2010, the likes of BAE Systems (BA.), Chemring (CHG), Cobham (COB), Meggitt (MGGT) and Ultra Electronics (ULE) will be hopeful that the days of hefty cuts are finally over.
If the US defence budget does increase to $534bn as submitted, analysts at UBS expect a potential profit uplift of 3-4 per cent for the biggest beneficiaries: BAE, Cobham and Ultra Electronics. But given the six- to 24-month delay between budget and outlay, this is not likely to have an impact until 2017.
But analysts at UBS reckon that the sequestration law will remain in place for the foreseeable future, albeit with the option of a one-year deal to stretch it past the current threshold. Having previously forecast single-digit growth, UBS analysts now say the budget will probably increase to between $506bn and $516bn.
Regardless of the outcome this time around, sentiment towards defence stocks has started to improve amid rising geopolitical tensions and the growing possibility that Republicans can build on their mid-term success by winning the 2016 presidential election. One of the Republicans' top legislative priorities is to roll back defence spending cuts and do away with sequestration.
In the meantime, eyes will also be on the atmosphere between China - the world's second biggest military spender - and Japan. At the beginning of the year, Japan announced its biggest ever defence budget outlay to counter Chinese fighters intruding into its air space in a bid to lay claim to islands in and around the energy-rich East China Sea.
Russian bombers and spy planes have been probing its northern flank, too, prompting Japan's cabinet to approve a record military kitty of 4.98 trillion yen (£27bn). According to reports, Japan has responded to these long-running maritime disputes by buying Boeing's (US:BA) Osprey tilt-rotor troop carriers, Lockheed Martin's (US:LMT) F-35 stealth fighters and BAE's amphibious assault vehicles.
That is a far cry from the UK, where defence budgets are expected to be cut even further after the election in May. Despite a recent report by the Commons Defence Select Committee urging the government to do more to defeat Islamic State militants in Iraq, analysts at UBS expect budgets to be cut again post-May, regardless of who wins the election.
According to its estimates, nominal declines of about 20 per cent from 2015 to 2019 could be expected under a Conservative government, and 10 per cent should Ed Miliband's Labour party emerge victorious.
This will come as a big blow to Qinetiq (QQ.), one of the Ministry of Defence's biggest customers. The Farnborough-based group generates about three-quarters of revenues from the UK defence market, leading UBS to calculate that a Tory win would reduce its fair value by 17 per cent and a Labour one by roughly 8 per cent.
