Bernstein: 'Immediate Defense Stock Upside, and Then?'

Bernstein analyst Douglas S. Harned weighs in on Global Aerospace & Defense stocks following US/Israeli attacks on Iran.

The analyst commented: "Defense stocks are sharply higher pre-market, responding to US/Israeli attacks on Iran. On Friday (Feb. 27) we described what history says about defense stocks when geopolitical/ military events occur (see, “Global Defense: Attack on Iran? Potential short-term upside for defense stocks, but then what? Instead, look to the budget “). Key points: 1) Based on history, stocks normally rise short-term on events, but upside is not sustained unless there is extended instability or conflict driving budgets. 2) Broad support (bipartisan) is normally needed for a budget increase. 3) Stocks have already priced in a potential budget increase and some risk with Iran, making added sustained upside harder.

With the Iran attack, there should be initial rise in defense stocks, that could well fall away over time. Three issues: 1) A significant need for restocking tactical missiles and munitions, which is positive for relevant suppliers (RTX, LMT, BA, LHX, NOC) - but, they are capacity constrained and already working toward steep production ramps; restocking needs should help secure long-term agreements. 2) Unless there is a bad outcome, do not expect events in Iran to add much upward pressure for defense spending beyond current plans - if the end state is a favorable regime, it could even mean elimination of a threat and less spending. 3) Should we see a bad outcome in postKhamenei Iran, there could be greater regional instability - and lead to upward budget pressure; We doubt we will know that answer for several weeks.

There does not yet appear to be a plan to establish a path to a favorable regime. Senator Lindsey Graham dismissed the idea that the US should choose the new government, saying the idea of “you break it you own it” - “I don’t buy that one bit”. Opposition in Iran is not organized, has no recognized leaders, and has no weapons. So, the path forward is unclear unless the Revolutionary Guard could be co-opted (as Trump has suggested) or another somewhat unattractive organized group (e.g., MEK) put in place. So far, the worst case, which would be involvement of Russia or China, appears unlikely other than commentary of condemnation. But, extended instability in Iraq could open that door, particularly for Russia or terrorism. Such a bad outcome could become a catalyst for more defense spending. At this point, we see no indication that the IRGC can be co-opted, as Iranian strikes continue against targets in the region.

Expect short-term upside, particularly for companies with the strongest presence in tactical missiles and munitions (RTX, LMT, LHX). Unless we see an outcome that leads to increased regional instability, we do not expect to see sustained upside for defense overall. Beyond restocking needs, investors should instead focus on the budget, which is very strong for 2026 (particularly with$39bn added reconciliation funding). The budget is uncertain for 2027, although stocks have reacted to Trump’s recommendation for a $1.5 trillion budget. We see little chance for such a large budget, as we have described previously (see, “US Defense: Three posts, an Executive Order, and eleven questions - Where are we headed? ”). We do, however, expect a rising budget in 2027. Questions on that budget revolve around timing and election politics. Still, as above, a bad outcome in Iran could eventually lead to more spending."

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