The annual round of defence spending in the US and the UK will be a focus of anxiety for UK-listed companies over the next 12 months, as governments on both sides of the Atlantic grapple with growing budget deficits. However, it is worth keeping an eye on oil prices, which could also determine defence spending as Middle Eastern countries assess their budgets.
Negotiations to fix the US defence budget will be firmly in focus after President-elect Barack Obama is sworn in as President at the end of January. It is widely predicted that there will be a levelling off in spending as the commitment to withdraw from Iraq within 16 months is implemented, although the retention of Robert Gates as defence secretary has given some hope that the level of defence procurement will be maintained throughout the year.
If a consensus is reached relatively quickly, then Congress will sign off the new budget in September. All of the UK's defence companies, with the exception of Babcock, have a major presence in the US, built up through the expensive acquisition of local companies, and are acutely sensitive to any changes. It is likely there will be a slowdown in the number of merger and acquisition deals as companies conserve cash.
Efforts to close a yawning £2bn hole in the UK defence budget will dominate the year and this could see several projects either mothballed or delayed. The Ministry of Defence has already put back the delivery date of its new aircraft carriers by two years, and the future of major PFI projects, such as the Defence Training Review in which QinetiQ has a major stake, is uncertain while credit markets are frozen.
The Gulf states, traditionally a major source of revenue for BAE Systems, will also be under pressure this year because of the fall in oil prices. It is estimated that the oil price needs to stay at $50 a barrel or above in order to meet budget requirements in the region. Brent Crude is currently trading around $45 a barrel and if the oil price stays at these depressed levels this could delay the delivery of big ticket items. BAE's Typhoon deal with Saudi Arabia could be affected by this.
The least troubled should be sub-contractors such as Cobham and Ultra Electronics who traditionally benefit from a slowdown, as prime contractors look to cut costs by outsourcing the design and supply of secondary systems such as radio and telecommunications.
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