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Investing in Defense in a President Trump Administration

By Scott Sacknoff, SPADE Defense Index


Point Roberts, WA - November 9, 2016 ( Newswire) newswire and (HDS) release commentary from Scott Sacknoff, of the Spade Defense Index (NYSE: ^DXS).

With the Presidential election behind us, we wanted to get Scott Sacknoff's thoughts on the sector. Scott is the manager of the SPADE Defense Index, an investment benchmark for the sector which serves as the underlying core to the Powershares Defense ETF (NYSE: PPA).

Scott Sacknoff:

Prior to the election, analysts were in agreement that based on comments during the election, certain themes would benefit regardless of who ultimately won the Presidency: defense, border issues, cybersecurity and infrastructure all warranted increased attention and funding. With the conclusion of the election, it is likely that defense firms, a player in the aforementioned sectors will continue to remain in favor. Throughout 2016, the SPADE Defense Index is up more than 13%, more than double the S&P500 and has reached a number of historic highs driven by factors that include increased military sales to foreign nations, continued expansion and upgrading of global aircraft infrastructure, a rising cybersecurity market, and the beginnings of a recovery from the U.S. defense budget trough.

For a number of years, I've cited that investors interested in the defense sector need to understand two critical underlying and related themes-"perception vs. reality" and "defense as an insurance policy."

With respect to "perception vs. reality"-I'm sure a number of people could cite any number of comments made from both parties during the election process. What is believed to be true, the "reality," is not necessarily their perception of what is true. Spending on defense is dependent on how secure and comfortable people think they are. The less secure they feel, the greater the perceived risk and hence, the more money that is allocated toward activities that make them feel safe. It is why a terrorist action in Southeast Asia can lead to increased concerns in the United States, even if the underlying source of concern is different. We see an incident on one side of the country, where someone fires a gun in a school or a place of work and envision it happening in our own backyard. The possibility exists, but isolated incidents move from reality of "my office needs better security because I've noticed unauthorized people gaining entry" to the perception that, "it happened somewhere else, so we definitively need to boost security immediately." So it is not the reality of immediate fear but the perception that "I need to protect myself from this fear" and this cycles back to the concept of "defense as an insurance policy." One does not put extra locks on a door or buy a real-time home monitoring service unless they feel they are at risk of crime in the area or have a lot to lose.

Defense as an insurance policy-When it comes to managing a portfolio, the defense sector also provides a measure of insurance to geopolitical risks. Spending on the defense sector rises and falls based on the perception of how secure a nation feels-not necessarily on the economic and cyclical factors, interest rates or inflation, that drive the direction of other sectors.

So with the U.S. election in the rear view mirror, what does this mean for investing in the defense sector? Obviously there is a lot to decipher; election rhetoric rarely translates into policy recommendations. The next administration will see a number of concerns-Aleppo/Syria, the typical hotspots of Iran and North Korea, China, Russia, etc-and although the relationships compared to that of the Obama administration will change, the players and the issues will not.

I can only take some statements and considerations and extrapolate. I use as my guide the concept of "scenario modeling," a business technique that attempts to provide a series of stories that prepares for varied contingencies and allows managers to adapt to not just the ebb and flow of business but radical shifts. When thinking of defense as insurance to geopolitical risk, let's envision one scenario with negative consequences for world stability but which is positive for defense.

The protectionist theme

President-elect Trump cited a protectionist theme in a number of different ways: protecting the border, renegotiating trade deals and ensuring that the U.S. retain economic elements inside the country and reverse the outsourcing trend of the past few decades. This scenario is very good for the defense sector. As said, defense spending thrives in periods of destabilization.

An environment of tariffs and price wars could destabilize the economy of China, which in turn, could lead to increased Chinese aggression in the Pacific region. To counter, increased defense spending by a number of nations including Japan and Korea is likely.

China has also been a source of cybersecurity intrusions. With an adversarial environment, their support for these activities would likely increase. Cyber is a game of cat and mouse between brilliant black hats trying to impact a digital system and brilliant white hats trying to stop them. It is a game with extreme consequences to people, organizations, and economics. Defense companies have a leading role in this area and U.S. government expenditures are likely to accelerate.

Third, Latin America in recent years has been relatively stable from a U.S. perspective. If we were to deport millions of illegal immigrants back to Latin America, this could destabilize the region. Countries like Colombia and Nicaragua have become safer and more open since the 1980's but a number of serious issues in the region remain - including drug lords controlling parts of Mexico, the Honduran murder rate, etc. Once again, this would require increased monitoring of the situation, a possible re-militarization of the region, and would add a third front for our security forces to focus attention on in addition to the Middle-East and China/Asia.

Lastly, the idea of getting our strategic partners (NATO, South Korea, Japan) to pay more for our overseas defense efforts is likely to be met with some resistance but I imagine some middle ground can be identified, or at least one which allows all sides to save face without severely impacting the economies of other nations. Ultimately, this is likely a wash for the U.S. defense sector. I'd anticipate this would not add 1-to-1 to the total U.S. spending; instead replacing U.S. outlays net/net. It is possible that the "deal" will see U.S. contributions being more in terms of materials and equipment and our partners re-allocating their costs toward operations.

As we are only less than a day removed from the election, there are a lot of moving elements associated with how the Trump Administration will actually proceed. It is dependent on how good a relationship Congress has with the White House, the key staff Trump puts in place to run the agencies, and the agenda it wants to follow. One thing that should be very clear is that no matter who won the election, global instability over the next several years was unlikely to change. No matter what happens to the overall economy or social initiatives, it appears that the defense sector would be on more sound footing; gaining with global growth and critical portfolio insurance for an unstable world.

Scott Sacknoff, of Spade Defense Index (NYSE: ^DXS) .

Spade Defense Index Disclaimer: The information presented here is for information purposes only and should not represent a solicitation or an offer to purchase an investment product.

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