Xi Jinping, Obama and the US Budget

This week’s visit by Xi Jinping, Chinese President-in-waiting to the US, brought together the future leader of the world’s largest growth economy with the premier of its only super power.

Both countries have proclaimed the need for greater ‘understanding and co-operation’ but each has also announced the deployment of an increased fleet to the Pacific and South East Asia as the US seeks to counter China’s increasing projection of influence from the Indian Ocean to the Pacific.

Asia is not the only area where the two powers are likely to be drawn into diplomatic conflict this year as, with hardening rhetoric between traditional US ally Israel and Iran, a major provider of oil to China, over Iran’s nuclear ambitions (themselves a major concern to NATO), conflict looks increasingly likely without decisive international intervention. Syria is proving that this remains difficult: Shiite Iran is no friend of the Sunni-dominated Arab League and many analysts saw direct Iranian influence in China’s veto of UN intervention.

China’s capabilities remain far behind those of the US, but with a believed spend of $160bn last year and growing at 10%+ per annum, the Asian giant is rapidly becoming a global power just as the US seeks to scale back its navy and land forces.

What does this mean for Defence manufacturers and sector M&A?
We believe that, with strong Republican resistance to much of the defence reduction and a Presidential election set for November, Obama cannot afford to be seen as weak and therefore the cuts to defence spending at the Department of Defence are likely to be far less than feared. Indeed, most analysts expect the DoD budget to return to growth from 2014.

The White House has been clear that its focus will be on securing superior technology advantage and this continues to be reflected in the p/e multiples of specialist communications & security products providers as well as companies in the UAV and robotics spaces. Meanwhile, the larger ‘Prime’ manufacturers continue to struggle on lower ratings as the large scale equipment projects that supported Iraq and Afghanistan are wound back.

In the UK, very visible cuts at the MoD have temporarily diluted international interest in the general defence space, although businesses with exploitable technologies that can be leveraged across new platforms or internationally remain very attractive. As the bow wave and subsequent dip in spend caused by Iraq and Afghanistan and the initial cuts to spending captured in the Defence & Security Review work through UK manufacturers and service providers should be able to forecast with a greater degree of certainty, a factor that will be key to a strong M&A environment.

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