Israel–Hamas war boosts U.S. defense ETFs, but why it won’t help stocks for long

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The bloody conflict between Israel and Palestinians is pushing the exchange-traded funds that track U.S. aerospace and defense stocks higher in the past two weeks, with investors seeking defense exposure as a hedge against geopolitical tensions. 

Shares of the iShares U.S. Aerospace & Defense ETF
ITA,
which tracks U.S.-listed manufacturers, assemblers and distributors of aircraft and equipment for the defense industry, advanced 5.2% since October 6, the last trading day before Israel officially declared war after a surprise attack by the militant group Hamas over the weekend. The Invesco Aerospace & Defense ETF
PPA
gained 6.3% and the SPDR S&P Aerospace & Defense ETF
XAR
rose 4.2% over the same period, according to FactSet data. 

ITA, with over $5 billion in assets under management, attracted over $93 million of net inflows in the week to Wednesday, while the $2 billion PPA saw net inflows of $61 million last week, its best showing since July 2022, and the $2 billion XAR recorded a total inflow of $32 million over the same period, according to FactSet data. 

Seven funds in the U.S. aerospace and defense ETF sector, which in total manage over $8.8 billion, most have Lockheed Martin Corp.
LMT,
+0.70%,
Northrop Grumman
NOC,
-0.17%,
and General Dynamics
GD,
-0.78%
as their top holdings. Shares of the defense giant Lockheed Martin rallied by about 11.9%, and Northrop Grumman jumped by 15.7% since the initial attacks on Israel earlier this month, according to FactSet data. 

See: Surging aerospace and defense stocks lift these ETFs as investors monitor Israel-Hamas war

However, equity and ETF analysts warn investors should be careful about flooding into aerospace and defense sector as the dots between military combat and the profits of defense contractors do not connect as directly as they seem to be, said Nicolas Owens, an industrials equity analyst at Morningstar Research Services. 

Defense stocks are often seen as safe investments included in portfolios to generate income. An escalating geopolitical conflict, an increase in the government defense spending, and new technological advancements in warfare usually prompt investors to revisit the sector with the hope that the war could lead to more purchases of weapons manufactured by a defense firm and trigger a big jump in the corporate profit.

The narrative, despite logically sound, does not hold much water as it ignores how long in advance militaries procure weapons, and how they’re subject to strategic and political constraints, Owens said in a blog post.

Meanwhile, Owen and his team didn’t see “incremental upside” to global defense spending, especially after former President Donald Trump in 2017 unveiled a new U.S. defense strategy to protect national interests against great-power rivalry, and after Russia’s invasion of Ukraine in early 2022. 

Aniket Ullal, head of ETF data and analytics at CFRA, said the team still called on neutral ratings on most of the stocks held in the defense ETFs as they don’t see the Middle East conflict really move the needle in terms of global defense spending. 

Ullal, in a phone interview, told MarketWatch that there’s a fair amount of headwinds weighing on the defense ETF sector. For example, the supply-chain constraints could lead to a backlog that takes time to translate to corporate sales and profits, while the multi-year fixed-price weapon contract could result in lower margins given the high inflation, he said. 

“Even though there may be some positive sentiment around these ETFs, [but] from a fundamentals perspective, [it] probably isn’t very significant, which may explain some of the recent pullback [in defense ETFs],” Ullal said. 

ITA has fallen 0.4% so far this week, while PPA has dropped over 1.3% and XAR has edged up 0.8% for the week, according to FactSet data. 

See: Defense spending boosts economy as U.S. mulls more aid for Ukraine and Israel

Most defense companies get the revenue from one customer — the U.S. Department of Defense. The United States spent $736 billion on national defense during fiscal year 2023, which amounted to 13% of federal spending and represented the country’s third-largest spending category after social security and healthcare, according to the USASpending.gov.

The debt-ceiling agreement negotiated between House Republican leaders and President Joe Biden earlier this year would cap the defense budget topline at the requested $886 billion for fiscal 2024, a 3.3% increase over this year. 

“The expectations are that globally we’re going to see a buildup of defense and especially in the United States,” said Quincy Krosby, chief global strategist at LPL Financial. “The defense spending in the U.S. has to go up — we are sitting in a geopolitical environment that has shifted.” 

See: Government shutdown averted — for now. Here’s what’s next for Congress.

Meanwhile, a still-lingering concern that lawmakers need to pass another spending bill before November 17 to avoid a government shutdown also weighs on the markets. 

“The concern for many of the contractors and subcontractors for the defense spending is that they’re not going to be paid, and their share prices go down, [but] any fear that the government shuts down again in the middle of November typically provides an attractive entry [for defense stocks] if we will have a much larger defense spending,” Krosby told MarketWatch via phone on Thursday. 

As usual, here’s your look at the top- and bottom-performing ETFs over the past week through Wednesday, according to FactSet data.

The good…

…and the bad

New ETFs

• REX Shares and Tuttle Capital Management Thursday launched a suite of T-REX ETFs includes the T-REX 2X Long Tesla Daily Target ETF
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  TSLZ,
  the T-REX 2X Long NVIDIA Daily Target ETF
  NVDX,
  and the T-REX 2X Inverse NVIDIA Daily Target ETF
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