slogan created to boost morale of the British civilian population during World War II
Malcolm Gladwell once wrote about the nature of courage in the context of The Blitz in London. By 1940, basically all of Europe had fallen before the Nazis – France, Scandinavia, and the Low Countries — while Italy was a German ally and the Soviet Union had signed a non-aggression pact with Germany. At the time, the United States was neutral. Many thought it was only a matter of time before the United Kingdom was finished. Hitler looked to his Luftwaffe to scare the English populace into submission with daily air raids for months on end. Unexpectedly, however, the civilian population of London was largely unfazed, and in some cases actually invigorated by, the bombing. The fact that they had repeatedly survived made them begin to think they were invincible. In fact, it was the law of probability working: 40,000 people were killed during the raids, with slightly more than that injured. London’s population was about 8 million at the time, meaning that about 99% of the population was unharmed by the bombs. The English won the Battle of Britain, and the rest is history.
Recent events have added to our own global worries about safety. A Russian jetliner exploded over Egypt on Halloween. On Friday the 13th of November, 130 were killed in Paris. On December 2, the violence came to California, with 14 killed in San Bernardino. The recent Brussels attacks came in apparent response to the arrest of one of the Paris terrorists. A suicide bomber at a soccer match in Iraq. Easter bombings in Pakistan. All appear to be directed or inspired by the so-called Islamic State.
The goal of all terrorists is to disrupt normal life and, as the name implies, create an atmosphere of “terror.” In limited ways, in fact, the terrorists have succeeded – screening for airline passengers has become more rigorous, for example. Nonetheless, we carry on, and our basic values and the rhythms of our lives have not changed. This behavior is neither surprising nor unprecedented. Israel, for one, has faced existential threats for decades and managed to prosper. Of course, there is some tension between tradeoffs of privacy versus security.
The Threats Today
In present day United States, threats abound, and new threats seem constantly to be popping up. In fact, there is an annual “Worldwide Threat Assessment” by the U.S. Intelligence Community presented to the Senate Armed Services Committee every February. Even in its unclassified format, it makes for chilling reading. Some of the threats are obvious, such as China and Russia, both of which are rivals for global influence and both of which at times view the United States as an adversary making efforts to marginalize them.
Other threats are less obvious. For example, the world is being introduced to the internet of things, where devices are able to talk to one another without human intervention such as a computer printer able to reorder ink when it begins to run out. While some may laugh at the possibility of hackers getting into your refrigerator, it’s not quite so amusing if they hack into a driverless car. Former Vice-president Cheney had his pacemaker reconfigured at the insistence of the Secret Service so that foes could not hack into it and assassinate him by remote control.
Other new threats include terrorist groups, many of which are evolving and mutating – with ISIS and Al Qaeda being perhaps the most well-known while others, such as Boko Haram or Lord’s Resistance Army, are more obscure but still quite deadly. As with so much of modern life, the reach of these groups has been dramatically amplified by virtue of the internet, specifically social media.
The influence of such terrorist groups in specific parts of the world have compelled many people to flee their homelands, creating a huge global refugee crisis. At 60 million and rising, the number of refugees worldwide (half of whom are children) is the highest since World War II. Voters in advanced democracies are rightly concerned that terrorists are using the surge of refugees as a cover to slip through borders. These fears have led to further political polarization in many western countries, with previously fringe elements (such as France’s National Front) gaining noticeable public support. The timing of the Brussels attacks may have increased the odds of a “Brexit,” (the UK leaving the European Community), with potentially negative consequences for world trade and economic growth. Further attacks could also ultimately influence this year’s U.S. presidential election.
It is worth noting that “traditional” warfare is very computer driven now. Could China or Russia hack into our defense capabilities and cause war plans to go awry? Have things become so automated that a Hollywood-style doomsday scenario takes place whereby computers orchestrate war plans so efficiently and so quickly that humans have no time to react? And it wouldn’t have to be U.S. technology that malfunctioned; Chinese or Russian computer problems would present exactly the same issue. There are also other international players who are clearly threatening. North Korea, for example has made efforts to sell missile technology to Syria and Iran. What if the quality of that technology is so poor that there is some kind of accident, putting at risk either the U.S. or our allies?
It’s a bit much to think that there is one “silver bullet” solution to this. However, the United States has considerable advantages. We are the richest, most technologically advanced society ever known. The U.S. Defense budget is bigger than the next nine nations’ combined spending. We have the goodwill of people from all around the world, due to our relatively open society, and can draw on some of those people for more information about what is going on in their home countries. You name the nationality, there is probably a hyphenated community (Afghan-American, Egyptian-American, etc.) somewhere in the U.S., the vast majority of whom love this country and want to help defend it. The United States is also the leader in space and our ability to observe our enemies from that platform is the best there is. In addition to weapons systems and human intelligence assets, the U.S. is the clear leader in cyber sleuthing and electronic surveillance, enabling us to spy on our foes around the world in unprecedented ways. Whether one agrees with our government’s surveillance methods or not, it is indisputable that since 9/11, there have been no more such large-scale, coordinated attacks. We have since seen only “lone wolf” incidents, while other countries (Spain, the United Kingdom, India, France, and Belgium among them) have suffered such incursions.
Terrorism, Commerce, and the Stock Market
So what does this all mean to investors? In typical American fashion, we look to the private sector to provide the tools with which our government works to keep us safe. Whether it’s a police cruiser made in Detroit or a cruise missile made in Massachusetts, the actual products are made by private companies, not the government. We at BTR believe that this presents a good opportunity for investing. In the budget deal struck last fall, the Republicans and Democrats agreed on higher defense spending, particularly in light of recent Russian aggression but also with other regional conflicts in mind. There is a tailwind at the back of defense contractors. Making things even more attractive from an investment standpoint, military outlays are independent of the economy. Additionally, while international sales at some firms can be important, the defense industry is largely based on one customer – the U.S. government. There is relatively little or no foreign exchange risk. While we don’t know who the next Commander-in-Chief will be, nor what he or she might have in mind for defense spending, historically, major weapons programs tend to have very long lives, in a number of cases beyond the eight-year Constitutional limit on a presidency.
It is also worth noting that the nature of technology involved with defense continues to evolve. Cyber warfare is obviously a major area with many companies already involved there. However, other defense technologies, such as surveillance, facial recognition, chemical/explosives detection, and non-lethal weapons systems, as well as yet-to-be- thought-of (or at least revealed to the general public) defense technologies also can provide investment opportunities. Additionally, expertise and equipment to counter these new technologies will surely pop up.
Of course, defense stocks still are subject to the parameters against which we evaluate all stocks: growth, valuation, profitability, leverage, quality of management, etc. Having the United States government as your primary customer is a mixed blessing; the political cycle also has its ups and downs, even if they are distinct from the economic cycle. Changing weapons systems specifications, for example, can wreak havoc on planning and efficient production.
It is important to keep in mind that most crises, when viewed in hindsight, tend to be blips in the longer run trends in society, the economy, and the markets. Perhaps the best example of this is the stock market crash of October 1987, when the Dow fell over 22% in one day. By early 1989, the market had regained all it had lost and the recession many had predicted in 1987 failed to materialize. The same has been true of political shocks, whether President Kennedy’s assassination or the 9/11 attacks. The markets may have initially fallen, but they recovered relatively quickly and moved on. In the end, the economy and corporate earnings are what drive the stock market. While shocking and serious, these events did little to alter the long-term economic trend. This evidence underscores the need to remember that investing is more of a “steady as she goes” affair where one shouldn’t frequently flip-flop on strategy. Rather, investors ought to sell or pare holdings when all looks rosy and valuations are stretched, and in turn buy when prices are lower.
This is a major reason why BTR places an emphasis on setting up investing parameters and plans when accounts are established with us. Markets, of course, do go up and down, sometimes abruptly. The fact of the matter is that no one is clairvoyant and it is virtually impossible to anticipate the “Black Swan” event. Such outlying kinds of events typically have a short-lived impact on the markets. In other words, “Keep Calm and Carry On.”
The first quarter of 2016 was something of a tale of two markets. The month of January was the third worst start to a year ever for the S&P 500, with the index falling 5%. A stronger dollar, weaker Chinese economic data, and lower commodity prices, particularly for oil, contributed to pessimism in the U.S. economy and the market. However, by mid-February this trend had bottomed, after an almost 10% total correction, and begun to reverse. With the Federal Reserve signaling that it would be less aggressive in raising interest rates, the stock market recovery continued into March, when the S&P 500 moved back to positive territory year-to-date.
The economy continues to plod along, growing but not at a spectacular rate. Unemployment, now at 4.9%, is in the range of full employment, although the number of people on the sidelines not even trying to look for work, while improving, remains troublingly high. Inflation also looks encouraging. While certainly not out of control, it appears that prices are generally beginning to pick up, and outright deflation may be a receding risk. A big wild card is what will happen to the price of oil from here. While it has recovered significantly from the lows it reached in January and February, the price per barrel is still well below where it was this time last year. Further, we have yet to see the impact of lower oil prices on the general economy; for the most part, lower oil costs are a benefit for both business and consumers. Overall, we expect moderate but continuing economic and earnings growth with reasonable stock market returns, albeit amid continued angst and volatility.