What next for aerospace and defence shares?

Commercial aerospace is no longer the valuation darling of Wall Street - with good reason. Oil prices have risen 65 per cent from their February lows. The Federal Reserve will raise interest rates and tighten liquidity in the bank aircraft finance market. The surge in King Dollar has dampened passenger air traffic growth. The AirAsia crash has hit budget travel in Southeast Asia. Civil wars in the Arab world, Russian military interventions in Syria and Ukraine, the Turkish coup attempt, China's 25 year lows in economic growth and Brexit have all hit cross border tourism. The IMF has slashed global growth forecasts to 2.5 per cent from 3.2 per cent. Airlines have begun to defer orders for wide bodied planes. The aerospace sector has been derated on Wall Street as storm clouds darken its macroeconomic and earnings growth outlook. Honeywell's recent 10 per cent share plunge is a dark omen.
Boeing at $133 is overvalued if the commercial aircraft cycle has peaked, as I expect it has. Boeing Commercial Aircraft (BCA) faces its first cyclical downturn since the 2008-09 global recession. CEO Dennis Muilenburg warned the Street to expect "flattish" revenues in both commercial and defense in 2017. This means soft 777 orders will reduce the production run rate while 787 Dreamliner deliveries have been flat in the past year. Aggressive pricing on the 737 MAX will not help operating margins though I expect free cash flow growth per share can rise by at least 10 per cent in the next five years. The latest lewd Trump videos mean Hilary Clinton wins the White House on November 8. This means no aggressive ramp up in Pentagon military business or boost to Boeing's military aircraft businesses (e.g. F-15's, Apache helicopters, F-18's, Starlifter transport planes etc), almost 48 per cent of total revenue.
Near term production pressures do not negate the strength of Boeing's 5700 order backlog, the scale of US/Europe replacement demand and the emerging market air travel growth potential. While US fiscal pressures will hit specific programmes, such as the C-17 closure, Boeing is one of the world's top military hardware vendors at a time when Washington confronts Russia in the Middle East and China in the Pacific Basin. I expect Boeing shares to trade in a 120-150 range in the next twelve months.
Raytheon (RTN) is the world's preeminent supplier of air defence system (the Patriot missiles that confronted Saddam's Sands in the first Gulf War), air to air missiles, radars, sensors and communications equipment to the Pentagon, Nato and Uncle Sam allied air forces all over the world.
After some botched acquisitions in the late 1990s, Raytheon has almost doubled its operating margins to 13 per cent in the past decade and has spent a staggering $5 billion in share buybacks since 2012. Raytheon shares were a fabulous winner on Wall Street, up 26 per cent in 2016. Apart from Lockheed, no other company in the world can match Raytheon's technology based global missiles sales momentum. However, after a stellar 2016, I would book profits in Raytheon at $140 a share.
Honeywell blamed a weak aerospace cycle when it guided down its estimates to $6.60, the reason its shares tanked last Friday to $105 a share. The firm now trades at a valuation discount to its peers at 15 times earnings, I expect downside on the preannouncement and the industrial conglomerate's project execution woes. Honeywell's $15 billion aerospace business is a classic barometer of demands since it produces everything from cockpit "nose to tail" instruments to landing gear. I would stay short Honeywell for a $98 target.
The resignation of Wells Fargo CEO John Stumpf was inevitable after the sordid cross selling scandal has devastated the shares of the Californian megabank, once the most valuable bank on the planet. While optically attractive after their fall from 56 to 45, I am afraid to buy the shares because, unlike J.P. Morgan's London Whale or Goldman's Abacus scandal, the victims here are not institutions but millions of Mom and Pop all-American voters in an election year. Litigation risk will be a sword of Damocles on Wells Fargo shares.