The ongoing stock market sell-off reflects uncertainty about the global economic outlook. This is due to growing odds of a major slowdown in the Chinese economy and other emerging markets in the context of uncertainty about the course of Fed policy.

Below we discuss the headwinds that might spoil the prospects of the aerospace and defense sector in the near term.

Sequestration: The sequester that went into effect at the start of March 2013 will cut spending by a total of approximately $1.1 trillion over the eight-year period from 2013 to 2021. The approved defense spending bill for fiscal 2015 is $18 billion lower than the last fiscal. Industry players have been adjusting their operations to this changed environment, but it is nevertheless a negative for the sector.

Defense Budgets in Allied Nations Under Pressure: A country’s ability to spend on defense is a function of its economic health. The same is true at the global level – the faster the global economy grows, the higher the defense spending. Following the global crisis in 2008, there was a marked shift in defense spending growth from the developed to the emerging countries.

After a solid start to 2015, growth in the 19-member Euro zone economy lost momentum due to the Greek debt crisis and deterioration in many emerging market economies – not just in China, but in many other markets as well. The economy grew just 0.3% in the second quarter, down from a growth of 0.4% in the first quarter and well below the market expectation.

This suggests that the Euro zone continues to lag recovery in the U.S., which recorded 2.3% growth in the same period. In this context, a weak Europe is indeed a challenge for the U.S. defense players.

Given the numerous stimuli that the Euro zone economy is receiving, this slowdown is indeed disappointing. However, the outlook for the region is positive heading into the second half of the year on the back of economic tailwinds comprising ultra-cheap money flows, a boost to liquidity from the European Central Bank’s quantitative easing program, a weaker euro and lower oil prices.

Early in May 2015 the EU raised this year’s growth forecast for the overall European economy from 1.7% to 1.8% and for the Euro zone from 1.3% to 1.5%. The commission also expects the European economy to grow 2.1% and the Euro zone to grow 1.9% next year. This favorable macroeconomic backdrop for the region notwithstanding, the region’s defense spending outlook still remains weak.  

Strong U.S. Dollar: Another major headwind for the defense players is the strong U.S. dollar, which is a reflection of the growth and monetary policy divergence between the U.S. and its trading partners. This has become a major headwind for U.S. based companies as the strong dollar is not only showing up as a currency translation drag, but the strong dollar is having a bearing on foreign military sales as well. We saw this in the results from all major industry players such as United Technologies (UTX).

Intense Competition: The aerospace and defense companies compete among themselves for a number of small and large programs. Moreover, China is flexing its military muscles and is developing space technologies aimed at blocking U.S. military communications, as per a report commissioned by a panel created by the U.S. Congress. China’s goal is to become a space power at the same level with the U.S. and to promote a space industry equal to those in the U.S., Europe and Russia.

Given the looming headwinds, we advise investors against names that offer little growth/opportunity over the near term. These include companies for which estimate revision trends reflect a bearish sentiment.

Our Take

In “Defense Firms Hunt for Alternatives on Lower Military Spend,” we focused on the conditions which are expected to drive the industry forward.

The industry's position is now challenged by global competition, changes in technology, national and worldwide economic conditions and global policies affecting defense, civilian and commercial aviation.

On the whole, tighter defense budgets and the strong U.S. dollar remain an overhang on the military sector. The companies that have little diversification outside the U.S. are highly susceptible to spending cuts from sequestration, while those with an international order book remain exposed to currency translation issues.

The fast-changing world with rising global uncertainty demands the defense sector to act with speed and flexibility. With careful management and prudent spending the sector is expected to weather the headwinds effectively.

We remain apprehensive on the Zacks Rank #4 (Sell) stocks AeroVironment, Inc.(AVAV - Snapshot Report), B/E Aerospace Inc. (BEAV - Snapshot Report), CPI Aerostructures Inc. (CVU - Snapshot Report), TransDigm Group Inc. (TDG) and Triumph Group, Inc. (TGI - Analyst Report).

In addition, we are skeptical of these Zacks Ranked #5 (Strong Sell) stocks: Wesco Aircraft Holdings, Inc. (WAIR), EricksonAC Inc. (EAC) American Science & Engineering Inc. (ASEI) and Arotech Corp. (ARTX- Snapshot Report).