Northrop Grumman Corp. (NOC, Financial) is making headlines and hitting new all-time highs this week for its planned $7.8 billion acquisition of missile manufacturer Orbital ATK Inc. (OA, Financial). In what may at first seem to be an unrelated event, the Federal Reserve is also making headlines this week as its September meeting is widely perceived to be the start of its great balance sheet unwind. What do these two events have to do with each other?
Given Fed decisions have a big effect on equities in general, there is more of a direct connection here.
It is no secret Northrop and its peer companies high up in the military-industrial complex, like Raytheon (RTN, Financial) and Lockheed Martin (LMT, Financial), are heavily dependent – in some cases almost exclusively so - on the federal military budget. Now that the national debt has ballooned to over $20 trillion as the debt ceiling has been all but entirely erased from existence and the Trump administration plans to spend $1 trillion on infrastructure projects, investors need to prepare for an explosion in U.S. federal debt levels beyond anything we have seen until now.
So what? As debt surpasses gross domestic product and keeps growing, the ability to maintain the military budget, and any budget for that matter, will rely more and more heavily on consistently low interest rates. As debt continues to grow, so does the interest on that debt. As I have pointed out previously, interest rates at 2007 levels of around 5% across the board with a constant federal budget deficit will leave only about $300 billion in discretionary spending, with the rest eaten up by Social Security and Medicare.
The military budget is around $600 billion now. If that is going to stay constant and feed these defense contractor companies, the deficit – and debt – is going to have to explode higher.
The thing is interest rates do not even have to go as high as they were in 2007 to cause major havoc to the military budget and, by extension, Northrop and its peers. Interest rates even at early 2011 levels of around 4% will probably be enough to break the bank. While we can look back at 2007 as if it were a different world pre-financial crisis, 2011 was not that long ago. Interest rates at those levels for a sustained period is very conceivable.
If the Fed is seriously intent on paring its balance sheet and gradually hiking the Fed funds rate, interest rates across the board are headed higher. It will be key to see how Treasury markets react to the Fed ostensibly beginning its balance sheet pare-down this week. Bond traders could bring long-end interest rates higher faster than the Fed is willing to act on the overnight rate, making the problem more imminent than it may at first seem.
The military budget could be about to get squeezed, and the companies at the forefront of the military-industrial complex will feel the brunt of the blow if it does. Northrop Grumman may not see these highs again.
Disclosure: No positions.
