Decisions on defence spending through 2017 are likely to be influenced more by political change and the march of digitalisation than the usual fiscal strictures. Donald Trump has been inaugurated as the 45th President of the United States – and thus commander-in-chief of the world’s largest military. Some political analysts fear that his administration could pursue a more isolationist policy than predecessors, with attendant risks to US defence spending.
Yet there’s plenty to be concerned about: an ongoing proxy war in Yemen between Saudi Arabia and Iran, and the seemingly intractable situation in Syria. Throw in a territorial dispute between China and Japan over an uninhabited group of islands in the East China Sea, and you realise why Pentagon officials would be reluctant to curtail their spending plans.
A more likely scenario, and one predicated on a wholly deliverable campaign pledge, is that the new president will put the screws on Uncle Sam’s recalcitrant partners in Nato to ensure they comply with the minimum defence spending commitment of 2 per cent of GDP. Only a handful of the existing 28 member states currently comply with this baseline requirement, so Mr Trump’s inauguration is probably more likely to herald a step-up in global defence spending; a conjecture given added weight by the European Council’s recent endorsement of a ‘winter package’ to strengthen the common security and defence policy of the European Union.
Asymmetrical warfare moves into cyber space
The US election also served to highlight the growing importance of cyber security within strategic defence considerations. The outgoing Obama administration took the decision to expel 35 Russian diplomats for allegedly attempting to subvert the US election process through cyber operations, presumably to the benefit of Mr Trump given that he favours rapprochement with Moscow.
A recent analysis of defence issues by IHS Jane’s Intelligence Review states that the rise of state-sponsored or politically motivated cyber attacks is primarily attributable to their suitability in covert political activity. The IHS Jane’s analysis concludes that asymmetrical or “deniable” warfare “will increasingly shift into cyber space” in 2017 and beyond.
This is borne out by a recent £1.9bn spending pledge by the UK government as part of its new National Cyber Security Strategy. Pentagon spending in this area has increased by 31 per cent since 2015. And that’s to say nothing of the billions poured into cyber security by private businesses every year; it’s estimated that the global market in digital security will reach $101bn in value this year, and hit $170bn by 2020.
So, it’s little wonder that defence heavyweights such as BAE Systems (BA.), already a leading supplier of cyber, intelligence and security services to government agencies, is increasingly looking to leverage those capabilities in the private sector.
Commercial aircraft deliveries to hold firm
In last year’s FTSE 350 Review we ventured that 2016 would be “the first year in many when defence exposure takes priority over aerospace” – we think that balance of power will hold true this year. Nevertheless, rating agency Fitch now believes that industry deliveries for commercial aircraft could approach a peak in 2018, but it’s still far from clear whether deliveries are likely to be sustained or reverse after that point.
It’s also too early to assess whether revised trade policies from the incoming US administration will have a negative impact on aerospace volumes. Any escalation of Mr Trump’s war of words on the campaign trail over Beijing’s trade policies could have profound implications, given that China is expected to be the world’s largest destination for civil aircraft sales over the next 20 years. If the US and China were to engage in a tit-for-tat trade war, it’s conceivable that orders previously earmarked for Boeing could wend their way to Europe’s Airbus consortium, thereby benefiting prominent players in the supply chain, such as Meggitt (MGGT). Airbus recorded 731 net orders in 2016, beating Boeing’s 668.
Management at Rolls-Royce (RR.), no doubt cognisant of industry trends, will be looking closely at foreign policy developments across the pond, and will hope to move on from its £671m payout for past bribery and corruption involving its intermediaries. Hardly an ideal scenario for the UK aerospace giant a few short months after it was forced to halve its half-year dividend payout, although we maintain that the market now accepts that the iconic engineer is in turnaround mode.
| Price (p) | Market value (£m) | PE (x) | Yield (%) | 1-year change (%) | Last IC view | |
| BAE Systems | 605 | 19,215 | 14.9 | 3.5 | 18.9 | Buy, 542p, 29 Jul 2016 |
| Cobham | 140 | 2,391 | 10.8 | 7.6 | -36.4 | Hold,139p, 11 Jan 2017 |
| Meggitt | 440 | 3,413 | 13.9 | 3.3 | 25.0 | Hold, 424p, 02 Aug 2016 |
| QinetiQ | 263 | 1,510 | 15.6 | 2.2 | 7.9 | Buy, 260.3p, 22 Dec 2016 |
| Rolls-Royce | 694 | 12,752 | 12 | 0.0 | 30.9 | Hold, 717p, 17 Jan 2017 |
| Senior | 196 | 822 | 11.4 | 3.2 | -7.2 | Buy, 193p, 19 Jan 2017 |
| Ultra Electronics | 1,895 | 1,335 | 14.6 | 2.5 | 2.9 | Buy, 1,718p, 01 Aug 2016 |
Favourites: Somewhat predictably, we’re sticking by lower volatility beta play and Europe’s largest defence contractor, BAE Systems. The group is engaged in high-end, high-margin contracts across the defence spectrum that will shape the industry for years to come. There’s no better example of this than BAE’s lead role in the Taranis unmanned aerial vehicle programme, but the decision to renew the UK’s nuclear deterrent and the group’s leading cyber security capabilities also serve to justify its premium to peers on an enterprise to cash profits basis.
Outsider: Cobham (COB) has to be on this list after a series of profit warnings and growing concern about its debt pile. There may be further nasties to come out of a management review of the balance sheet, and there is uncertainty regarding an important air-to-air refuelling programme.
