Merrill strategist likes defense stocks

By Jennifer Coogan

NEW YORK (Reuters) - Industrial stocks, in particular those of defense companies, are poised to lead U.S. equities as countries around the world build up their arms supplies, said Merrill's chief investment strategist.

Year to date, industrials are ranked third-best among the 10 Standard & Poor's major industry groups, up 3.5 percent for the year, compared with a 0.1 percent gain on the S&P 500.

Just as energy stocks benefited from the lack of new refinery construction in the past decade, the defense sector has seen a lack of infrastructure spending that put their products in short supply.

"If you remember President Clinton, one of the ways he balanced the budget was by cutting defense spending," said Rich Bernstein, speaking at the Reuters Investment Outlook Summit in New York.

With defense equipment supply already constrained, demand is now set to rise, he said.

"Six years later, there's actually an arms race starting to build around the world -- which people don't really understand," Bernstein said.

"When you talk to Americans about geopolitics, they'll talk about Iraq or if you're lucky, Afghanistan, or now Iran, but there's also an arms race building in northeast Asia," he said.

One sign Bernstein sees as bullish for defense stocks is that China is spending more on defense than on rural development.

"The world is a very unstable place and our attitude is that it's becoming much more unstable," Bernstein said. "If you're an investor and you're looking for where the revenue streams are going to be, unfortunately, defense companies do really well in that environment.

Even if Democrats win control of Congress in November's elections, Bernstein said, any decline in defense sector stocks would only be temporary and would give investors a chance to buy them at cheaper prices.

"Democrats can't afford to ignore defense issues," Bernstein said.