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BAE Systems: Benefit from uncertain world


It has been a choppy week for equities as renewed uncertainty about the outlook for global growth and US monetary policy weighed on sentiment.

The fallout from Volkswagen’s US emission testing scandal provided another setback for markets, sending the Xetra Dax in Frankfurt and the global automobiles & components stocks sharply lower. The automobile industry contributes about 30% of German GDP, so contagion among other car makers could potentially damage growth.

The CBOE Vix Volatility index, often referred to as Wall Street’s fear gauge, remained above 20, a level viewed as signalling heightened stress among investors.

September’s Federal Reserve Open Market Committee meeting last week shed little light on the timing of the first rate hike, although recent comments from various FOMC speaker suggest there will be a rate hike in 2015. The market is pricing in a 20% chance of the Fed raising rates at its October meeting and a 49% probability of a move in December, although weak Chinese data could delay the decision until 2016.

Data this week revealed activity in China's factory sector unexpectedly shrank to a six year low in September, raising fears of a sharper slowdown in the world's second-largest economy. The preliminary Caixin/Markit China Manufacturing PMI fell to 47.0 in September, the worst since March 2009 and below market expectations of 47.5. China's factory activity has now shrunk for seven months in a row, meaning authorities are likely to keep loosening monetary policy to ensure growth doesn’t slip below 7% this year.

British Chancellor, George Osborne, however, expressed his confidence in the slowing Chinese economy, saying the country was going through a necessary transformation and was still a driver of global growth. "China is going through a very necessary and challenging transformation which is essential so China's economy can go on creating good careers and jobs and higher living standards for your 1.3 billion people," he said at the start of a five-day trip to China.

The Eurozone recovery remained resilient, continuing a year of robust growth, as Markit’s flash PMI scored 53.9 for this month, down slightly from August, but comfortably above the 50-level that signifies growth. The survey also hinted at a continuation of growth for the remainder of the year, with businesses reporting that new orders were at a five-month high.

British manufacturing output failed to expand in the three months to September for the first time since early 2013, adding to signs of slowing in the country's economy. The CBI's industrial trends survey slipped to -7 in September from -1 in August, below expectations for an unchanged reading. Expectations for output over the next three months were the weakest since October 2013.

Technical analysis of the FTSE 100 shows the index failed to break to fresh short-term highs after trading a double-top at 6270, triggering a move back down to support at 5880. The mid-range oscillators offer little in the way of direction, leaving the index looking rangebound between 5880 and 6200, with additional support seen at 6000.

In conclusion, the woes of the world’s second-biggest car manufacturer have weighing on risk appetite and investors are cautious moving into third-quarter earnings season. Yet Barclays notes that having had four times more bulls than bears prior to the correction, bulls are now in the minority, which historically has signalled a market bottom. Support global central banks and low interest rates maintain the attractiveness of equities relative to other asset classes.

The defence sector got a boost this week after the UK government announced it will take a more active role in promoting weapons exports amid fierce competition for such deals globally. British Ministry of Defence head Michael Fallon said "As a government, boosting our export successes, in what is an increasingly competitive market place, has to now be the priority." The government has been trying to boost exports across its industries to raise domestic manufacturing and become less dependent on service-sector employment.

UK-listed BAE Systems (LON:BA.), the world’s second largest defence group, could benefit from such support. Britain has already committed to buy more than £300 million worth of weapons from European missile joint venture MBDA, the partnership of BAE Systems, Airbus Group and Finmeccanica.  Britain's strategic defence review is expected to wrap up at the end of November, whereby it is widely expected to acquire a fleet of submarine-hunting airplanes.

The company is a partner in the Eurofighter Typhoon fighter programme and latest results showed it needs to secure new export orders to keep production lines running. Earlier this month war-torn Kuwait agreed to spend £5.8 billion on 28 Eurofighter jets, representing a major breakthrough for the defence contractor. There is also growing speculation that Saudi Arabia and Bahrain are next in line to order over 48 more planes in the coming months, dispelling fears of oil price weakness impacting Middle East military spending.

BAE Systems is also a tier 1 partner in the F-35 Joint Strike programme and is responsible for building about 15% of each aircraft, in what is regarded as the world’s biggest defence project with a $1.5 trillion lifetime value.

Interim results on 30th July, revealed an order backlog of £37.2 billion, indicating reviving defence markets that BAE System’s diversity is well placed to exploit. The company trades on 11.3x earnings, a hefty discount to peers such as Rolls Royce and Airbus that trade on 14.2x and 17x respectively. Shareholders will also receive a 5% dividend, which is nearly covered twice by earnings, indicating it should be safe.

The chart of BAE Systems illustrates the recent share price weakness, although recent support was found from significant historical levels. The bullish divergence on the oversold oscillators suggests there has been little momentum behind the recent selling, leaving it exposed to a bounce.

At the time of writing the share price is 429p, which I believe offers an attractive risk /reward bias with a tight stop-loss below support at 416.1p. Near term targets are seen at 449.5p, 463.3p and 480p.

This report was written by Mark Allen – Head of Derivatives at SI Capital Stockbrokers. The writer does not hold a position in BAE Systems, but client accounts may. The material in this report has come from SI Capital’s internal data sources and BAE System’s corporate website.





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