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North Korea Summit Prompts Defense Stock Selloff

05.07.2018 | Ben Phillips, CFA

EventShares Policy Investing North Korea Trump

On March 8, 2018, the South Korean National Security Adviser appeared outside the White House to announce President Trump accepted an invitation to meet with North Korea’s Kim Jong Un.

 

The meeting agenda was to be North Korea’s denuclearization. Reactions from diplomats ranged from cautious optimism to skepticism of Kim Jong Un’s intent. How has news of the U.S.-North Korea denuclearization summit impacted markets?

 

Historical Inter-Korean Summits

 

This isn’t the first time North Korea has committed to a denuclearization summit. Inter-Korean summits between North Korea and South Korea were previously held in 2007 and 2000. Notably, neither inter-Korean summit produced material movement. However, both summits occurred under Kim Jong Il’s leadership. Kim Jung Un, his son, represents a new generation and may provide an opportunity for denuclearization progress.

 

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EventShares Policy Investing North Korea Trump kim jung uh

Prior Global Nuclear Peace Deals

 

Kim Jong Un will almost certainly look to prior denuclearization deals for guidance and historical reference. It should be noted, however, that not all prior nuclear deals have ended well for countries agreeing to denuclearize.

 

  • Ukraine 1994 Denuclearization: Ukraine agreed to destroy its nuclear weapons and join the Treaty on the Non-Proliferation of Nuclear Weapons. In 2014, the Russian Federation annexed the Crimean Peninsula from Ukraine, a threat which had initially been identified when Ukraine agreed to give up its nuclear weapons.

 

  • Libya 2003 Disarmament: Muammar Gaddafi agreed to end his country’s weapons of mass destruction program, including the decades old nuclear program. A multi-state NATO-led coalition waged a military intervention campaign starting in 2011.

 

Outside of the two denuclearization examples above, the 2015 sanctions placed on Iran provide another historical reference for Kim Jong Un. President Trump has called the Iran nuclear deal and sanctions a one-sided deal and is currently debating pulling out of the deal after decertifying it in October 2017. From North Korea’s point of view, what’s to stop the next administration from going back on this administration’s deal with North Korea?

 

While historic first steps have been taken, we believe there are numerous details that will need to be finalized. It may take months, even years, of negotiations to finalize an agreement.

 

EventShares Policy Investing military defense tanks

Federal Defense Appropriations & Rhetoric

 

Meanwhile, the White House and Republican controlled Congress continue to push for a military buildup and return to higher defense spending levels after years of decreased defense spending under the Obama administration.

 

The Bipartisan Budget Act of 2018 raised the caps for the national defense base budget by $80B (+14.5%) in FY 2018 from the previous limit of $549B and increased the FY 2019 cap by $85B (+15%) from $562B.

 

The Trump administration also permits the sale of defense products to foreign countries, which is a departure from prior administrations’ tight restrictions.

 

Outside of the White House and Congress, Defense Secretary Mattis continues to lobby for increased Department of Defense budgets. In addition, newly appointed Secretary of State Mike Pompeo called on NATO allies last week to increase their defense spending. Taken together, we continue to believe defense spending is a priority for the Trump administration, Congress, and Department of Defense.

 

EventShares Policy Investing military defense jet

Download the Policy Tracker (PDF) 

 

Impacted Companies

 

Investors began selling defense stocks in anticipation of a denuclearized North Korea as soon as the headlines of the historic summit were released. In our view, this selling is misplaced, as investors are reacting solely off of headlines while overlooking the potential for growth in defense companies. Instead, we think defense companies stand to benefit materially from increased government spending.

 

Below are the companies we’re watching:


  • U.S. Defense Contractors: Defense contractors may be positioned best to benefit from increased U.S. defense spending. Lockheed Martin (LMT), Boeing (BA), Raytheon (RTN), Northrop Grumman (NOC), and General Dynamics (GD) were each within the top 6 defense contractors by 2016 defense revenue. Each company may experience strong revenue growth under increased defense spending.

 

  • Defense Industry Suppliers: In our view, suppliers to the aerospace & defense industry benefit from increased defense spending. 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, which the Government and Defense business unit accounting for ~36% of the firm’s Q1 2018 revenue.

 

In our view, the recent defense industry selloff represents a buying opportunity.

 

While headlines of a denuclearized North Korea present a small step to a more peaceful world with less defense spending, we believe investors are discounting the Trump administration’s federal appropriations requests and long-term defense goals.

 

 

 


 

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Important Information

Active Weighting Advisors LLC ("AWA") is an SEC-registered investment adviser that manages ETFs under the brand name EventShares Funds. Mr. Phillips is the Chief Investment Officer of AWA. The views expressed are subject to change, and no forecasts can be guaranteed. The comments may not be relied upon as recommendations, investment advice or an indication of trading intent. AWA is not soliciting any action based on this document. In preparing this document, the author has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. Investing involves risk, including the possible loss of principal and fluctuation of value. Mr. Phillips and AWA disclaim responsibility for updating information. In addition, Mr. Phillips and AWA disclaim responsibility for third-party content, including information accessed through hyperlinks. For more information about EventShares, contact us by calling 877.539.1510 or visit our website at www.EventShares.com.

 

Policy Investing

Policy investing focuses on understanding the laws and regulations that impact companies. It attempts to find mispriced assets and invest in those companies before the market understands the implications to a company’s profitability and operations.