Increased Tensions With Iran Could Boost Defense Spending

The U.S. killing of a top Iranian commander this week could further escalate tensions in the Middle East — and lead to further increases in defense spending just as the Pentagon budget was slated to flatten.

Such as spending boost would likely start in the Pentagon’s war budget, known as the overseas contingency operations. Legally exempt from federal spending caps, the OCO account has also been used to fund pay for expenses unrelated to wars.

“Overseas Contingency Operations was likely on a lower trajectory over the next several years,” Cowen and Company analyst Roman Schweizer wrote in a note to investors on Friday morning. “We doubt that's the case now. The U.S. will likely increase deployments of forces to the region in [the] coming weeks and could make additional strikes depending on Iran's response.” 

Lawmakers and the White House last year agreed to cap defense spending at $738 billion in fiscal 2020 and $740 billion in fiscal 2021, a decline in inflation-adjusted terms. 

The aftermath of the Jan. 2 targeting of Maj. Gen. Qassim Soleimani, head of the Iranian Revolutionary Guard Corps’ Quds Force, could also be the latest dynamic that prevents the Pentagon from completing its oft-declared shift from Mideast insurgencies of the past two decades to great power competition with China and Russia. The Pentagon has spent billions of dollars in recent years developing new weapons for these types of wars.

“With U.S. geopolitical/military focus heightened now in the Middle East, U.S. antagonists in other regions (Europe & Asia) could use this as an opportunity to create mischief or take overt action,” Schweizer wrote.

Increased tensions with Iran, and more broadly in the Middle East, could also factor into the 2020 U.S. presidential election.

“If Middle East conflict were to ratchet ... we think it could be tougher for Democratic Party electoral candidates to argue against a stronger defense budget in 2020, which would remove a defense sentiment overhang,” Citi analyst Jon Raviv wrote in a Friday note to investors. “And as is always the unfortunate case, defense stocks tend to benefit from perceptions of heightened risk and the potential for geopolitical conflict.”

Presidential candidates Bernie Sanders and Elizabeth Warren are among Democrats who have called for cutting the defense budget.

On a day when U.S. markets fell amid rising tensions in the Middle East, U.S. defense stocks rose Friday morning, led by Northrop Grumman, Lockheed Martin, and L3 Harris Technologies.

“We expect the immediate knee-jerk reaction to be improved sentiment for defense as a safe haven, but also because of expectations and a conflict will see wide-spread use of conventional precision guided weapons and surface-to-air missile interceptors. Aerojet Rocketdyne, Lockheed Martin, and Raytheon may have larger exposure to these weapons segments than other defense peers,” Capital Alpha Partners analyst Byron Callan wrote in a Friday note to investors.

“U.S weapons production is already at, or approaching capacity, so an issue is how ensuing conflict(s) use existing inventories and whether there are decisions to expand capacity to replenish weapons that are consumed,” Callan wrote. “It may take weeks or months for some clarity to emerge here.”