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Dec. 9, 2016, 9:00 a.m. EST

Two defense stocks ready for battle as military budgets rise

NATO countries, as well as the U.S., have committed to spend more on defense

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About Roger Conrad

Roger Conrad founded and ran Utility for almost three decades before leaving to start his own publishing company. Conrad founded Capitalist Times and Conrad's Utility Investor, which provided research and in-depth analysis of profitable investment opportunities. He is an expert on utility stocks, as well as master limited partnerships and the Canadian energy sector. Follow him on Twitter @Roger_Conrad.

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By Roger Conrad

The F-16 Fighting Falcon released by General Dynamics in 1978 for the United States Air Force. Its variants are still in use today.

Last year marked the first time in a long while that 57% of NATO members increased their defense spending, with France committing to boost expenditures 12% by 2019 and Germany by 6%.

Geopolitical developments will increasingly shape the global economy and how investors allocate capital. More specifically, the world may be entering a period when countries steadily increase military spending.

In the U.S., one of President-elect Donald Trump's campaign promises was to increase military spending. Early indications are that active-duty Army personnel could increase by about 13% to 540,000 soldiers; the Navy could expand its fleet by about 25% to 250 ships; and the military could add fighter aircraft.

Initial assessments put the cost of this plan at $80 billion to $90 billion, a range that would increase U.S. military spending to at least $650 billion.

Defense-company winners

U.S., Canadian and European defense contractors stand to benefit the most in such a scenario.

The president-elect also has talked about the need for NATO members to increase defense spending to 2% of their gross domestic product (GDP). Trump repeatedly has said that U.S. support will be limited, if not nonexistent, to countries that ignore the 2% rule.

Two hurdles stand in the way of all NATO's European members complying with this financial obligation in the future.

Some countries' sizes or locations make their armament obsolete or insignificant; for example, Luxembourg is part of NATO's defensive blanket, with or without its armed forces.

How Europe's largest economies will respond is also important. The U.K. already spends 2% of its GDP on the military. France is almost in compliance with the rule, suggesting that any incremental spending will probably go to domestic companies.

Germany, Italy and Spain have the largest shortfalls. Germany has committed to bumping up its military spending, but political and economic developments in Italy and Spain will dictate defense budgets in those countries. Trump's advisers may be aware of these realities — if they don't, they soon will.

The Reagan-Trump parallel

As the Trump administration prepares to take office, trends in military spending over the past eight years resemble what transpired from the mid-1970s to the late 1980s, when the government reduced the defense budget consistently.

President Ronald Reagan's budget called for a 25% increase in defense spending relative to the previous proposal. Reagan's four-year target of $224 billion in military expenditures was so immense that the Department of Defense found itself at a loss as to how to spend the money.

Defense stocks rallied in 1980, but pulled back when reality set in that spending would fall short of Reagan's initial proposal. Although defense budgets during the Reagan era were below the initial plan, the industry still outperformed for much of the decade.

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