The SPDR S&P Aerospace & Defense ETF (XAR) fell 19.3% over six completed weeks while the S&P 500 declined 1.4%. Energy inflation from the Strait of Hormuz war pushed long-term Treasury yields higher, reducing the present value of future cash flows.
XAR absorbed the shock because its equal-weighted structure gives high-multiple defense technology, space, drone, supplier, and commercial-aerospace companies weights comparable to mature primes. RTX and Lockheed Martin fell only 9.7% and 7.7%, respectively, while their backlogs, sales, and guidance remained intact.
Transmission
| Step | Variable | Observed Value | Effect |
|---|---|---|---|
| 1 | Hormuz disruption | 6–7 transits per day; Brent at $104–106 | Adds an energy war premium |
| 2 | September CPI | Headline 3.7% YoY; core 2.6% | Energy drives renewed inflation |
| 3 | Federal Reserve policy | December hike probability above 85% | Resets rate expectations upward |
| 4 | 10-year Treasury yield | 5.33% intraday peak; 5.10–5.19% afterward | Raises the discount rate |
| 5 | 30-year Treasury yield | 5.61% | Raises the term premium |
| 6 | High-duration constituents | Axon −25.0%; Red Cat −24.3%; Karman −18.8% | Compresses valuation multiples |
| 7 | Mature primes | RTX −9.7%; Lockheed Martin −7.7% | Produces smaller repricing |
The war increases demand for munitions, interceptors, and replenishment while raising energy prices, inflation, federal borrowing costs, and defense-production expenses. The discount-rate effect outweighed the improvement in expected demand.
Index Composition and Duration
XAR tracks a modified equal-weighted index spanning large-, mid-, and small-cap aerospace and defense companies. Lockheed Martin and RTX each represented about 3% of the fund in October 2026. Rocket Lab, Axon, AeroVironment, Kratos, Carpenter Technology, Karman, and other higher-multiple companies carried comparable weights.
The S&P 500 is capitalization-weighted and dominated by profitable mega-cap companies. XAR carries substantially greater exposure to long-duration cash flows, smaller companies, and high-beta defense themes. This structure explains much of the 17.9-percentage-point performance gap.
| Company | Drawdown | Duration Profile | Forward Valuation |
|---|---|---|---|
| Axon Enterprise (AXON) | −25.0% | High-duration growth | Elevated |
| Red Cat Holdings (RCAT) | −24.3% | High-duration growth | Elevated |
| Carpenter Technology (CRS) | −19.1% | Supplier with long lead times | Moderate |
| Karman Holdings (KRMN) | −18.8% | Supplier with long lead times | Moderate |
| RTX Corp. (RTX) | −9.7% | Cash-generating prime | Lower |
| Lockheed Martin (LMT) | −7.7% | Cash-generating prime | Lower |
Drawdowns increased with valuation and cash-flow duration. The basket’s 19.3% decline therefore overstates the repricing of contracted prime cash flows, which fell roughly 8–10%.
Prime Fundamentals
Lockheed Martin’s second-quarter 2026 results indicate that operating fundamentals remained strong.
| Metric | Q2 2026 | Trajectory |
|---|---|---|
| Sales | +11% YoY | Full-year growth guidance raised to about 8% |
| Free cash flow | $2.9 billion | More than $7 billion projected annually |
| Backlog | $230 billion | Record |
| F-35 production | About 156 aircraft annually | Stable |
Record backlog, rising sales, higher guidance, and improving free cash flow coexisted with a sharp decline in XAR. Mature-prime weakness primarily reflects lower valuation multiples applied to stable or improving cash flows.
Fiscal and Budget Pressure
Higher energy prices reinforce inflation and tighter monetary policy. Higher Treasury yields then increase federal interest expense, reducing the fiscal capacity available for defense expansion.
| Variable | Current Position | Trajectory | Defense Constraint |
|---|---|---|---|
| Federal deficit | $1.9 trillion; 5.8% of GDP | $3.1 trillion; 6.7% by 2036 | Limits spending growth |
| Publicly held debt | About 100% of GDP | 120% by 2036 | Raises financing pressure |
| Net interest cost | About $970 billion | About $2.1 trillion | Crowds out discretionary spending |
| Defense budget | $843.9 billion under the continuing resolution | Depends on post-midterm action | Delays new authority |
Long-term Treasury yields above 5% make a proposed $1.5 trillion defense budget harder to finance. The pressure concentrates on spending above the existing baseline, including surge contracts, capacity expansion, tooling, and new replenishment programs. High-multiple companies derive more of their valuation from this incremental growth, while prime contractors can continue converting existing backlog.
The continuing resolution also restricts new program starts and production increases. Physical demand can therefore rise faster than contractors receive authorization, recognize revenue, or collect cash.
War-Premium Unwind and Margin Pressure
By mid-August, XAR had gained 23% for the year and traded at a 15% premium to the S&P 500. Reports on September 22 of a possible reopening of the Strait of Hormuz accelerated the reversal. XAR moved from a 15% premium to a 12% discount as crowded positioning unwound before any formal settlement.
Contract economics added pressure. Many defense contracts use firm-fixed-price structures or capped incentives negotiated before the inflation spike. Higher costs for specialty alloys, propulsion systems, aerospace components, labor, and energy compress margins. Supply-chain delays also raise working-capital requirements and postpone cash collection. Long-lead-time suppliers such as Carpenter and Karman consequently suffered drawdowns near 19%.
Synthesis
| Factor | Mechanism | Most Exposed | Horizon |
|---|---|---|---|
| Discount-rate repricing | Higher yields reduce the value of future cash flows | High-multiple growth companies | Regime-level |
| Index composition | Equal weighting increases exposure to high-beta constituents | XAR relative to the S&P 500 | Structural |
| War-premium unwind | De-escalation expectations reverse crowded positioning | Defense technology and space | Event-driven |
| Budget impasse | Funding limits delay new programs and production increases | Growth-dependent companies | Near-term |
| Contract margin erosion | Input inflation and delays weaken margins and cash flow | Suppliers and fixed-price programs | Near- to medium-term |
The discount-rate shock determined the market’s direction and internal ranking. Equal weighting explains why XAR fell 19.3% while mature primes declined 8–10%. The war-premium reversal, budget impasse, and contract structure account for much of the remaining underperformance against the S&P 500.
Outlook
If yields remain elevated, cash-generating primes such as RTX and Lockheed Martin should remain better positioned than high-duration defense technology companies. Higher-multiple names require lower discount rates or earnings growth sufficient to offset them.
Structural replenishment demand remains strong, but the timing and value of future cash flows depend on sovereign financing costs, congressional authorization, contract economics, and production capacity.
Key signals:
- Reopening of the Strait of Hormuz or a verified ceasefire
- Passage of full defense appropriations
- Stabilization or decline in long-term Treasury yields
- Continued defense-stock weakness despite falling yields, indicating that earnings or demand concerns have become dominant
The next analytical step is a constituent-level decomposition of XAR’s six-week loss against ITA, prime contractors, forward earnings revisions, fund flows, and factor exposures.