By Ben Phillips, Chief Investment Officer, EventShares.
The EventShares US Policy Alpha ETF (PLCY) invests in companies that EventShares believes will be impacted by US government policy and regulation.
The 2019 appropriations process is underway in Washington DC, and Congress is making progress on the annual defense bills. There are four key bills, including a defense authorization bill in both the House and Senate and an appropriations bill in both the House and Senate.
Authorization bills control how the money is spent and typically set long-term policy mandates, while appropriation bills control how much of the authorized money to actually allocate the government department or agency. In this structure, it’s difficult for the authorizers to overrule the appropriators.
Historical DoD Budgets
The Department of Defense (DoD) budget tends to be cyclical and correlated to periods of war and peace. As the chart below indicates, defense spending dropped materially under the Obama administration due to the Budget Control Act of 2011 and associated sequestration, which imposed statutory caps. Subsequent legislation modified the spending caps through 2019; however, the caps remain in place for FY 2020 and FY 2021.
Source: EventShares.
FY 2019 Defense Appropriations Status
The House initiated the process by passing its version of the 2019 National Defense Authorization Act (NDAA) on May 24, 2018. The Senate passed its version on June 18, 2018, which authorized slightly less spending on warship and fighter jets. The next step is for the House and Senate to work out the differences in their versions of the authorization bills through a joint conference committee.
The House appropriations committee passed its defense appropriations bill, while the Senate appropriations committees currently is marking up its version. Since appropriations tend to carry more weight, we’ve listed the major funding categories of the House and Senate appropriations committees:
- Ships & Submarines: The House and Senate both appropriated funding for two Virginia class submarines, at least two littoral combat ships, and three DDG-51 guided missile destroyers. Separately, the House passed a $1 billion amendment to buy two aircraft carriers, while the Senate appropriated a total of $850 million for advanced procurement (AP) of one each of an amphibious assault ship and amphibious transport dock. Most notably, the House and Senate both omitted the House authorizers’ request for $1 billion AP of Virginia class submarines, with the Senate instead appropriating $250 million for submarine industrial base expansion.
- Aircraft: The House appropriated more funding for aircraft, such as Black Hawk and Apache helicopters, F-35s, and F/A-18 Super Hornets, than the Senate. In our view, FY19 aircraft spending will follow the trend of FY18 with slight differences among single name aircraft programs.
Impacted Companies
Below are the companies contracting with the US government to build military aircraft, ships, and submarines and supply missiles and munitions. Each of these companies may benefit from increased government defense spending.
- Defense Contractors: Defense contractors may be positioned best to benefit from increased U.S. defense spending. Companies such as Lockheed Martin (LMT), Boeing (BA), Raytheon (RTN), and Northrop Grumman (NOC) each contract with the DoD to build military aircraft. In addition, Huntingtin Ingalls (HII) and General Dynamics (GD) both contract with the DoD to build aircraft carriers and submarines. Separately, BWX Technologies (BWXT) contracts with the US government to research, build, and store nuclear related weapons.
- Defense Industry Suppliers: Hexcel (HXL) manufactures composite materials, such as adhesives & honeycomb, for the aerospace market. FLIR Systems (FLIR) develops and manufactures imaging and recognition solutions for the military and law enforcement. CACI International (CACI) is an information technology company providing cyber security and mission critical support.
The EventShares US Policy Alpha ETF (PLCY US) invests in companies we believe will be impacted by US government policy and regulation. Examples of policy themes can include healthcare modernization, financial deregulation, and tax reform. As of July 6, 2018, one of the policy themes in PLCY relates to increased defense spending by the US government. In our view, the proposed shipbuilding and aircraft appropriations for FY19 mentioned above continue the trend of increased defense spending after prior years of sequestration under the Obama administration. We expect companies involved in the defense industry to grow their revenues over the upcoming years due to the long lead time of defense contracts.
In our view, the recent defense industry selloff represents a buying opportunity. As of July 6, 2018, PLCY holds positions in BA, BWXT, CACI, FLIR, HII, HXL, LMT, NOC, and RTN. While headlines of a denuclearized North Korea present a small step to a more peaceful world, we believe investors are discounting the Trump administration’s defense budget request and FY19 appropriations process. The details of North Korea denuclearization will take time and diplomacy, and the White House doesn’t appear ready to pause defense spending while that plays out.
Position weightings as of 7/6/2018: BA (2.25%); BWXT (2.36%); CACI (2.61%); FLIR (2.39%); HII (2.45%); HXL (2.43%); LMT (2.37%); NOC (2.34%); RTN (2.34%). PLCY does not own GD.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)