Risk of U.S. midterm ‘blue wave’ leaves defence stocks out of favour

The ramp-up in geopolitical tensions around the globe, along with a push toward higher defence spending in Europe and around the world, bode well for military contractors. Photo by Michael Nagle/Bloomberg via Getty Images

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After two years of breakneck gains, shares of United States military contractors have hit a wall this year. Traders are expecting the pain to deepen further as they position for protracted negotiations and funding delays should Democrats take control of one or both houses of Congress following the United States midterm elections.

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Stocks of companies that manufacture everything from tanks, fighter jets and Navy ships to missiles, drones and other defence technologies have deeply lagged behind the broader market this year amid doubts about U.S. President Donald Trump’s ambitious budget for the Pentagon and steep valuations.

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Hopes that Trump’s pledge to turbocharge the budget to US$1.5 trillion would lead to a bonanza for weapons makers had sent defence stocks on a historic rally. But now polls and prediction markets are pointing toward the strong likelihood that Democrats gain control of the House of Representatives following the Nov. 3 vote, while the outlook for which party controls the Senate is closer to a toss-up.

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“If Democrats win and split Congress, then the fight for additional defence spending will be under a much tighter microscope where justifications for each program will undergo greater scrutiny,” said Wayne Sanders, an analyst with Bloomberg Intelligence. “This means that munitions will most likely be looked at individually instead of a larger pool of money that could cover air defence platforms and other weapon systems.”

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A gauge for the group of stocks — the S&P Composite 1500 Aerospace & Defense index — is down 13 per cent since Feb. 27, right before the Iran conflict started. The S&P 500 index has gained nearly 10 per cent over the same period. A fund tracking the sector — the iShares U.S. Aerospace & Defense ETF — is on pace for two back-to-back quarters of net outflows, for the first time since 2023.

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The biggest decliners in the group include space and missile systems provider Karman Holdings Inc., defence-tech company Kratos Defense & Security Solutions Inc., and drone maker AeroVironment Inc., with drops of at least 38 per cent since the end of February. Larger traditional big-ticket defence contractors such as Northrop Grumman Corp., Lockheed Martin Corp., Huntington Ingalls Industries Inc. and L3Harris Technologies Inc. have also fallen by at least 18 per cent.

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“There might be some more pressure on the group just because of its elevated price-to-earnings ratio, at least as it relates to its average over the past 30 years,” said Eric Sterner, chief investment officer at Apollon Wealth Management. “We could see some more weakness between now and election day.”

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The defence stocks index is currently trading at 27 times forward earnings, according to data compiled by Bloomberg. That compares with a 30-year average of about 18, and S&P 500’s current multiple of 19.

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The Trump administration has requested a budget of US$1.5 trillion for national defence in fiscal 2027, including US$1.15 trillion in discretionary funding and US$350 billion through reconciliation — a fast-track approval process Congress can use to provide mandatory defence funding. The 2027 fiscal year starts Oct. 1. Senate Majority Leader John Thune has said he doesn’t expect Republicans to take up the budget resolution before the midterm election.