Will A ‘Defense Supercycle’ Boost Stocks? (BA.L, GD, RHM.F, PLTR)

Many defense stocks have experienced a significant rally over the past year, with an increase of 40% being seen by firms such as General Dynamics (NYSE: GD), catalysed by heightened global conflicts and stepped-up investments from the EU and NATO.

While European companies bask in the bullish trend, with Rheinmetall shares (ETR: RHM) up more than 80%, and BAE Systems stock (LON: BA) adding 42% their counterparts in the United States present a mixed picture.

With General Dynamics stock as an outlier, other prominent U.S. firms like Boeing (NYSE: BA) have seen their shares tumble by 18%, and Northrop Grumman (NYSE: NOC) by 6%. Boeing's problems are not due to the sector, but to wider issues in the business that are causing downwards pressure.

Meanwhile, US defense sector indexes—the Dow Jones Aerospace & Defense and the S&P Aerospace & Defense Select Industry—have exhibited uplifts, albeit not as robust as the broader market rally.

Stocks that have Defense contracts, but operate in the tech or AI sector such as Palantir (NYSE: PLTR) have also managed to ride some of this wave, adding more than 60% over 12 months.

Amidst these dynamics, analysts weigh the prospects of the defense sector. Goldman Sachs has put forth the idea of a “defense spending supercycle,” anticipating European defense expenditure to swell by a 4.5% compound annual growth rate reaching 2027.

This optimism isn't unanimous; evaluation of the sector observes caution. Analysts cast a wary eye on inflated valuations and the industry's mixed growth prospects—a reflection of the underlying volatility tied to unpredictable geopolitical shifts.

Despite such concerns, the defense sector retains its appeal for income-seeking investors, with companies generating strong cash flows and rewarding shareholders through dividends and share redistributions. A standout in this category is BAE Systems with a strong track record of dividend payouts. Its potential bullishness signalled by analysts' estimates projecting a rise in its target price by 8% within the subsequent 12 months.

Yet, the current landscape suggests caution; some components of the broader defense sector appear overheated. Indications point toward overvaluation, implying expected gains for investors may be constrained at present valuation levels. The saturation within the market and the potential for limited upside provokes the recommendation to assess alternatives, specifically in sectors with a more striking growth premise.

Investors should navigate with particular care due to the sector's inherent risks, notwithstanding its income allure. The defense industry's reliance on fluctuating political climates and defense budgets means its fortunes hinge on factors often outside the realm of market forces.