Though the fiscal cliff ordeal was somewhat successfully avoided, Washington has yet another hurdle to face in the coming months: budget talks. Back in January, the last minute deal cobbled together by Republican leader Mitch McConnell and Vice President Joe Biden raised income tax rates for those earning over $450,000. The tax hikes are expected to reduce the deficit by some $620 billion over 10 years, far less than Obama’s $4 trillion in deficit reduction goal. Though the American public might have sighed in relief, government spending was one crucial element that was not addressed in the New Year’s deal [Download Free 7 Simple & Cheap All-ETF Portfolios].
Come March 1, 2013 an automatic round of roughly $65 billion in spending reductions will take place if Congress does not agree on fiscal budget. Should a bipartisan agreement not be reached, the following four main areas will be cut:
- Military spending cuts: $54.7 billion, or 7.5%
- Medicare: 2% cut in payments to providers
- Other Mandatory programs: 8% across the board cuts
- Other non-defense Discretionary programs: 8.4% cut
Already, companies in these industries are feeling the pressure as the potentially severe budget cuts will have material impact on bottom line returns. Defense manufacturing giant Lockheed Martin (LMT) has already reported a slide in net profit for the fourth quarter of last year after the company was forced to slow production and cut several hundred jobs when the U.S. government cut the number of F-35 jet fighters it plans to buy [see The Sky Is Falling Portfolio].
Aerospace & Defense ETFs: Caution Ahead
As the threat of sequestration makes choosing the right investments difficult in the next few months, investors should keep a close eye on the industries that will be most affected by government budget cuts. Below, we highlight three aerospace and defense ETFs that may be in for a volatile ride in the near future:
- iShares Dow Jones U.S. Aerospace & Defense Index Fund (ITA, B): This ETF has roughly $80 million in total assets under management and invests in a basket of about 35 individual securities. Top holdings include United Technologies (UTX), Boeing (BA) and Precision Castparts (PCP).
- PowerShares Aerospace & Defense (PPA, B): In terms of size, PPA is significantly smaller than the more popular ITA, though the fund does cast a wider net over the space with its portfolio of 50 aerospace and defense stocks. Industry giants Boeing (BA), Lockheed Martin (LMT) and Honeywell International (HON) account for roughly one-fifth of PPA’s total assets [see Energy ETFs: Watch Your Big Oil Weight].
- State Street SPDR S&P Aerospace & Defense ETF (XAR, B+): Comprised of roughly 35 individual holdings, this ETF provides much more balanced exposure to the industry than ITA and PPA. Using an equal-weighted methodology, no individual stock receives more than a 4.7% allocation. Top holdings include TransDigm Group (TDG), Spirit AeuroSystems Holdings (SPR) and Hexcel Corporation (HXL).
Disclosure: No positions at time of writing.