The US defense sector has not strengthened as some investors anticipated, despite the ongoing escalation of geopolitical conflicts in the Middle East. Conversely, since the outbreak of the Iran conflict, share prices of major defense contractors have generally fallen between 13% and 26%. Analysts at Bernstein point out that the short-term catalysts driving defense stocks higher are fading, and the sector lacks the momentum to re-attract capital inflows before the November midterm elections.
Since the Iran conflict began, the market had widely expected that rising geopolitical tensions would directly benefit US defense stocks. However, the actual price movement has been contrary to these expectations. As of early June, Lockheed Martin Corp (NYSE: LMT) had fallen approximately 13%, Northrop Grumman Corp (NYSE: NOC) had declined over 20%, and Raytheon Technologies Corp (NYSE: RTX) also recorded a double-digit drop, falling around 26% over the period. Although the US Congress is still debating increasing the defense budget and the Trump administration has proposed a defense spending plan as high as $1.45 trillion, the overall performance of the defense sector has been notably weaker than the broader market.
Primary Cause: Capital Rotation, Fundamentals Not Deteriorating
Addressing this anomalous trend, Bernstein analyst Douglas Harned stated in a research report published on June 2nd that the main reason for the decline in defense stocks is not a deterioration in industry fundamentals but rather a rotation of market capital between sectors.
"At the outset of the Iran conflict, valuations for defense stocks were already near historical highs," Harned wrote. "This made the sector particularly vulnerable as investors shifted towards higher-growth opportunities." He noted that as investors turned their attention to sectors with faster revenue growth, such as technology and consumer discretionary, capital has been consistently drained from defense stocks. However, he also admitted that the magnitude of this sell-off exceeded Bernstein's previous expectations.
Fundamentals Remain Solid but Appeal Diminishes, Lacking Catalysts Pre-Election
"We believe the fundamentals of the defense industry remain solid," Harned stated. "But at current valuation levels, the appeal of defense stocks has significantly diminished for investors seeking higher revenue growth opportunities." Bernstein maintains its "robust" assessment of the industry's fundamentals but acknowledges a lack of short-term catalysts powerful enough to reignite market enthusiasm. Analysts expect this situation is unlikely to change before the November congressional midterm elections. Harned stated bluntly: "The biggest issue right now is that we don't see any strong catalyst before the election that could inject new momentum into defense stocks."
Another layer of market concern is that if Democrats win a majority in one or both houses of Congress, it could lead to efforts to cut defense spending. Bernstein offers a different perspective on this. Harned pointed out that historical experience shows that, against a backdrop of persistently high geopolitical threats, which party controls Congress has minimal practical impact on actual defense budgets. "Investors may be overestimating the political risk brought by the election."
Long-Term Optimism Persists, but Revenue Conversion Questions Linger
From a longer-term perspective, Bernstein maintains a positive outlook on the defense sector. Even if Congress ultimately scales back the $1.45 trillion defense plan proposed by the Trump administration, the firm still expects defense spending to rise further from current levels. However, Bernstein also reminds investors to pay attention to a key question: How quickly can higher defense budgets translate into revenue growth for contractors?
The report points out that many contractors are already operating near full capacity in critical areas such as missile production and shipbuilding. This implies that even if military orders increase rapidly, capacity bottlenecks could limit the speed at which revenue is realized.
In the short term, defense stocks are facing dual pressures from a "catalyst gap" and capital rotation. The sector may struggle to find trend-driven opportunities before the midterm elections. However, based on fundamentals and long-term defense spending trends, Bernstein has not turned pessimistic. What investors currently need to weigh is the timing gap between valuation digestion and capacity constraints, as well as the clarification of the post-election policy path.
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