trumps pentagon push barely lifts defence giants 2687522017

UK aerospace and defence engineering shares rallied on Tuesday though their U.S. rivals were already giving back their gains, on continuing uncertainty ahead of a speech by President Trump.

Major military shares move minimally

The President has been trailing potential policy moves for weeks that could define his administration for years to come. A few weeks ago he said a reform of corporate and personal tax rules he’s planning would be “phenomenal”. Last night, he tacked on a few details to earlier comments about ratcheted up defence spending.

The White House says it will ask Congress for additional defence spending that’s worth around 10% of the military’s current expenditure. If Congress grants the request it will be the biggest military spending rise since 2008.

The upshot was a broad—though fairly modest—advance of aerospace and defence (A&D) names like Northrop Grumman, Lockheed Martin, Boeing, Raytheon and United Technologies. The biggest movers, however, were relatively small firms, like Kratos Defense and Security Solutions, which added around 5% on Monday, only to give back a similar amount on Tuesday.

Shares of the biggest military-facing groups rose around 1% or less on Monday and, again, were slipping by the same amounts on Tuesday.

The tardy reaction reflects the fact that the projected extra $54bn spending would be less than 10% of 2015’s $598bn military expenditure, suggesting only a modest, if any addition to order books at big A&D groups.

Even that ‘modest’ hike might turn out to be a big ask for Congress. One former congressional official and a budget expert rated the president’s chances as 50:50 in an interview with the FT. Perhaps that’s little wonder. Republican budgetary hawks are led by House Speaker Paul Ryan, potentially setting up an internecine battle to get a boost of any size passed.

Furthermore, the president also pointed to “greater savings and efficiencies across the Federal government”, meaning the funding rise at the Pentagon (U.S. Department of Defence) would partly be paid for by reductions in other discretionary spending. That does not rule out the possibility that other parts of the defence budget might come under scrutiny for potential savings.

These cautions suggest that Tuesday’s rise of UK engineering shares, many of which have significant aerospace and defence ties, was less to do with Trump’s defence comments, and more to do with strengthened earnings and trading that two key ones reported on Tuesday

UK defence signals

These shares were largely reacting to strong earnings from the FTSE 100’s GKN (which traded between 5%-7% higher) and mid-cap Meggitt (which rose 13%). Gains were across the board, including dominant manufacturers like BAE Systems, Rolls-Royce, Babcock, and beleaguered Cobham, together with more focused groups like Chemring and Senior.

In view of uncertainties on any U.S. defence spending rise, investors looking to position might well consider focusing on shorter-term momentum over value. In many cases, such positioning may have to be reversed if confirmation of legislative plans (and it’s a big ‘if’) is forthcoming.

Short-term technical signals were largely neutral for all of the above shares on Tuesday, though a modest positive bias was present for Babcock and Meggitt. Babcock is best known as one of the Ministry of Defence’s biggest outsourcing contractors, whilst Meggitt is an established specialist machinery, electronics and components group.

For Babcock shares, the struggle below its 200-day moving average (200-DMA)—always a closely watched threshold among traders—is a major technical focus at present. The stock had been favoured by a largely unblemished performance above the average between 2004 and August 2015. Since the latter date, the shares have struggled to get back above the 200-DMA, signalling the end of a cycle of positive investment sentiment. Despite this, the stock surged 7% higher on Tuesday after the group stated that it was on track to meet full-year targets. The jump took the shares to within 3% of the 200-DMA with clear short-term momentum, at least.

Meggitt’s cash flow record is poor

As for Meggitt stock, a 13% vault was its best one day rise since August 2016 and less than 5% from a 52-week high. It cleared its 200-DMA and rose to touch the same average on a weekly time frame too. The latter is one investors regard as just as important as the 200-DMA.

It’s worth noting however that all but one of the companies in our UK A&D/engineering ‘universe’ have performed poorly in terms of free operating cash flow growth over five years. Meggitt is the worst, with a compound annual growth rate (CAGR) decline of almost 35%.

Chemring, the advanced technology and materials maker (including explosives) is the best over five years, with a 27% CAGR in underlying cash flow. Even for Chemring though, the pace of that growth is weaker over five years, down 14%. The rate of deterioration was ‘best’ at Babcock (down less than 1%) backing, to an extent, its expectation of “good opportunities for growth” going forward. Its financial year ends next month.