While renewed hostilities in the Middle East may seem outrageous to anyone aged say below 40, to older realists it is just the latest turn in a simmering Arab-Israeli conflict that inevitably boils over.
There are upshots for specific equities, and without being alarmist, I think we should be aware of some parallels about how oil prices could spike further if there is a repeat of events as during the 1973 Arab-Israeli conflict.
After a surprise attack by Palestinian armed group Hamas against Israeli territory last Saturday, equities have so far absorbed this well. Yesterday, the FTSE 100 index held firm, if buoyed by defence contractor BAE Systems (LSE:BA.) up nearly 5%, and also BP (LSE:BP.) and Shell (LSE:SHEL) up 3% or so. Among more sensitive smaller oil stocks, Tullow Oil (LSE:TLW) jumped 10%.
Defence and oil are back in the frame
The sense of BAE as a prime defensive stock in all respects is justified, I believe, by this further breakdown in international order. Near 1,040p, it trades on around 15 times earnings (rolling 12-months forward consensus) yielding just over 3% - backed by a strong free cash flow profile, around 1.5 times expected earnings.
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Unless markets slump, such a valuation is fair and not stretched despite BAE’s 20-year chart looking like a great run. With the Israeli prime minister speaking of “a long and difficult war ahead”, BAE should be resilient despite other industrial stocks potentially affected by higher oil prices raising input costs. Scarcity value implies its risk/reward profile still favours upside and I continue to regard BAE as a prime equity holding hence strong "hold".
BAE Systems - financial summary
Year-end 31 Dec
|Turnover (£ million)||17,790||17,224||16,821||18,305||19,277||19,521||21,258|
|Operating margin (%)||9.8||8.2||9.5||10.4||10.0||12.2||11.2|
|Operating profit (£m)||1,742||1,419||1,605||1,899||1,930||2,389||2,384|
|Net profit (£m)||913||827||1,000||1,476||1,299||1,758||1,591|
|Reported earnings/share (p)||28.7||24.1||31.1||46.1||40.5||54.7||50.5|
|Normalised earnings/share (p)||28.8||33.3||35.6||43.4||38.4||41.6||47.9|
|Operating cashflow/share (p)||38.6||59.3||37.5||49.9||36.3||76.2||90.0|
|Capital expenditure/share (p)||15.4||14.9||15.5||14.7||14.9||14.4||22.0|
|Free cashflow/share (p)||23.2||44.4||22.0||35.2||21.5||61.8||68.0|
|Covered by earnings (x)||1.4||1.1||1.4||2.0||1.7||2.2||1.9|
|Return on capital (%)||11.0||9.2||10.4||11.5||10.6||13.0||11.0|
|Net Debt (£m)||1,452||723||901.0||1,954||3,723||3,245||3,499|
|Net assets per share (p)||110||148||174||169||144||235||364|
Source: historic company REFS and company accounts.
Babcock International Group (LSE:BAB) should also benefit as its turnaround gains traction: net profit is already expected to be near £200 million in its current year to March 2024, on a 12-month forward price/earnings (PE) ratio around 10 and dividend yield close to 3%. This roller-coaster stock is quite the opposite to BAE’s model behaviour, although it put in a “double bottom” at around 300p at end 2020 and early 2021, and is steadily rising in volatile fashion. Its operating margin was only 1% in the last financial year to 31 March versus 11% for BAE, warranting a lower PE, although the historic table shows high single digits pre-2019.
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With a more favourable headwind both from the industry and stock sentiment, Babcock merits more attention and around 400p currently I regard as at least a “hold” and worth investigating.
Babcock International Group - financial summary
Year ended 31 Mar
|Turnover (£ million)||3321||3997||4158||4547||4660||4475||4429||3972||4102||4,439|
|Operating profit (£m)||227||382||387||416||439||280||-17.0||-1750||247||45.5|
|Operating margin (%)||6.8||9.6||9.3||9.2||9.4||6.3||-0.4||-44.1||6.0||1.0|
|Net profit (£m)||181||260||287||312||336||199||-118||-1,803||164||-35.0|
|Reported earnings/share (p)||43.8||53.2||56.8||61.7||66.5||39.4||-23.3||-357||32.1||-6.9|
|Normalised earnings/share (p)||49.0||53.2||56.4||61.2||65.8||73.5||51.2||-33.2||3.2||21.3|
|Earnings/share growth (%)||20.1||8.4||6.1||8.5||7.5||11.6||-30.3||575|
|Operating cashflow/share (p)||46.6||62.7||77.4||77.4||63.3||76.3||59.6||83.7||1.3||51.7|
|Capital expenditure/share (p)||13.0||35.6||38.0||40.9||36.1||44.9||43.6||37.7||39.8||24.8|
|Free cashflow/share (p)||33.6||27.1||39.4||36.4||27.1||31.5||16.0||46.0||-38.4||26.9|
|Dividends per share (p)||22.5||23.6||25.8||28.2||29.5||30.0||7.2||0.0||0.0||0.0|
|Covered by earnings (x)||2.0||2.3||2.2||2.2||2.3||1.3||-3.2|
|Net debt (£m)||581||1430||1347||1361||1237||1891||1881||1415||999||564|
|Net assets per share (p)||245||434||464||528||572||503||455||42.1||135||70.0|
Source: historic company REFS and company accounts.
Such defence contractors look possible to tuck away more confidently than oil stocks, which are forever hostage to output decisions by the oil-producing nations – also expectations for the global economy.
Right now, and while oil does anyway rise on tension in the Middle East (given it accounts for 31% of global supply) there is concern that if Iran is meddling by way of support for Hamas, it could lead to sanctions on Iranian oil exports, further pushing up the price.
Diplomats will be well aware, however, that the West can shoot itself in the foot; sustained high oil prices being a key factor in recession risk. If economies do experience pain in the months ahead that hurts aggregate demand, it is possible the Organisation of the Petroleum Exporting Countries (OPEC) raises output to manage oil prices back. So mind, while oil stocks do offer comfort amid bellicose headlines, they are liable also to be volatile.
For such reasons I would currently avoid airline stocks unless they do become oversold, although specialist travel stocks such as On The Beach Group (LSE:OTB) may enjoy selective appeal – for example as consumers look for better value in foreign holidays.
Parallels with the source of the 1973-74 oil crisis
Recalling the 1973-74 oil crisis, a major oil price shock impacted the global economy and stock markets, after Arab members of OPEC imposed an oil export embargo against the US in retaliation for its decision to supply the Israeli military during the Arab-Israeli war. This spread to other countries which supported Israel.
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Right now, the US Defense Department says it is “surging” support to Israel including air capabilities: “we remain in constant contact to meet Israel’s urgent requirements”. The UK prime minister has said the UK is “poised” to help Israel militarily if required.
This latest conflict is specifically Israel/militant Palestine – but if it spreads, effectively as a “proxy war” and especially if Iran declares its hand, then an historical precedent is clear.
Hopefully, all the players will recognise no point in re-visiting that, but Middle East politics is not exactly where calm heads prevail.
Another parallel with UK in early 1970s
The UK was impacted harder during the early 1970s – our stock market fell 73% from May 1972 to end-1974 - due to Anthony Barber’s 1972 budget which was designed to return the Conservatives to power in a forthcoming general election. It led to a period of growth known as “The Barber Boom” followed by a wage-price spiral and high inflation, culminating in the 1976 sterling crisis.
It helps explain why markets and the Tory party establishment reacted so strongly against the Truss-Kwarteng “go for growth” mini-budget of September 2022 – in context of inflationary pressures already. Such a policy initiative was thwarted, but we still have the dilemma of labour shortages, hence rising wages making inflation tricky to cut anywhere near the Bank of England’s 2% target.
Property prices nowadays are on very high multiples of earnings, hence a significant portion of UK households carry substantial mortgage debt. So if higher oil prices re-fuel inflation, meaning “higher for longer” interest rates, this segment of population will have further reduced spending power.
Increased risk of a US recession?
This is the big one which could potentially pull the rug from equities.
He can be rather pessimistic but it is notable how Mohamed El-Erian, the economist and asset manager, said even before Hamas-Israel hostilities kicked off, the conflating of higher bond yields with inflation makes a US recession “much more likely”.
Markets fell last week due to a rise in the 30-year US Treasury bond yield to over 5% for the first time since 2007 – meaning the US government has to pay more for its debt than at any time in the last 15 years. In the UK, 10-year gilts now yield over 4.6% - well below US rates but higher than during the fiasco of September 2022.
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More positively in Asia-Pacific trading today, US Treasuries are having their best day since March as dollar assets enjoy capital flight to safety. Mind, it also includes speculation the US central bank’s monetary tightening may be over; we shall see.
If a US recession does materialise, it would reduce corporate earnings generally and US stock ratings do not begin to factor this in.
I think it rational not alarmist, to say we need to hope this latest Middle East conflict does not fester into a wider Arab-Israeli one – albeit one which is possible in “a long and difficult war ahead”.
The global economy really does not need further upward pressure on oil prices just when the effects of higher interest rates are starting to weigh on demand – witness cyclical stock XP Power Ltd (LSE:XPP) warning last week on its outlook and debt covenants.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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