Follow-up on bearish call on Defence

Bonjour,

I am a fan of long-term trends.
In late 2009, I was becoming negative on Defence as a sector as I thought the US spending was already at the same level as during the Reagan Star Wars initiative, without any similar threat: link to previous post here.

The Stockholm International Peace Research Institute (SIPRI), one of the largest global think-tank, came out with a new report, highlighting that for the first time since 1998, military spending is declining globally in real terms. 2012 spending was down 0.5% to a still enormous $1.75trn.

In details, US and European spending cuts are not compensated by Russia, China and Asian spending rises.
See the report here.

China is driving military spending up in the East as neighbours are fearful. The Chinese are trying to keep the share of spending constant.
However, with Chinese trend GDP growth slowing down, one may think that previous growth rates will not be sustained. The Economist has several pieces of data here.
With the US and Europe representing more than 2/3 of spending and going down fast, I make the bet that defence spending continues to fall in real term for the upcoming 3-4 years.

For defence stocks, we get to the same situation as in the late 80's for US defence stocks: consolidation will happen so earnings can keep increasing and stocks can get rerated.
We saw a tentative EADS-BAE merger last year but it sounds possible that midcap defence stocks combine to slow sales and earnings decline. A hurdle for European stocks is the fact that it is complicated to merger companies across countries.
In the US experience, companies merged but remained on low PEs but were given a lifeline with the first Gulf war, which provided solid replenishment orders just when costs were being cut.

At the moment, defence stocks in Europe and also the pure players in the US are valued lowly. With significant earnings cut now coming, tangible capital growth looks unlikely unless one can identify precisely the M&A targets.

To me, it looks like the sector will continue to offer poor prospects unless a new conflict arise - something I cannot predict.