Defense stocks continue to come under pressure – why Citi is ‘reluctant’ to buy the dip

Defense stocks have fallen about 10% since early March, lagging the S&P 500’s 8.6% gain over the same period. Citi says it is 'reluctant' to buy the dip because the sector faces unusual pressure from weak earnings/pre-announcements and growing AI-disruption concerns, even though it still expects a 2H rebound in revenues. The note suggests this overhang could eventually create buying opportunities, but near-term sentiment remains soft.

Analysis

The important read-through is not “defense is cheap after a pullback,” but that the market is re-underwriting the sector’s duration. If investors start pricing defense-services names as AI-exposed labor-levered businesses rather than geopolitical compounding stories, multiples can compress even while backlog and top-line visibility remain intact. That means the pain is less about near-term demand and more about a slower, more expensive path to re-rating as buyers wait for proof that AI is additive rather than margin-destructive.

This creates a bifurcation inside the space. Prime hardware/platform names with harder-to-replicate programs should be more insulated than services-heavy contractors that rely on headcount growth and recurring labor intensity; the latter are the clearest losers if “AI-disruption” becomes the dominant narrative. Suppliers with software content or systems integration exposure may also get de-rated alongside the services cohort, even if their actual earnings sensitivity to AI is low, because factor trading will punish any name that sounds strategically vulnerable.

The setup is still tactically interesting because sentiment is doing the work that fundamentals have not yet confirmed. A second-half revenue rebound is exactly the kind of catalyst that can power a sharp squeeze, but only if management teams can show faster conversion from backlog to billings and defend margin trajectories. Until then, the risk is a slow bleed over the next 4–8 weeks as every AI-related selloff drags defense proxies lower, followed by a more tradable bottom once positioning clears.

The contrarian take is that the market may be overestimating AI’s near-term ability to restructure defense procurement cycles, which are governed more by budgets, certifications, and program lifetimes than by software adoption curves. If that’s right, the current drawdown is creating a better entry point for a selective long, but not a sector-wide one. The better expression is to own quality hardware/platform exposure and fade the services-heavy names that are most vulnerable to narrative compression.

Key Decisions for Investors

• Initiate a relative-value pair: long a hardware/platform defense leader vs short a services-heavy defense contractor for 1-3 months. Expect ~5-10% spread if AI-narrative de-rating persists; stop if the long leg breaks on guide-down risk.
• Use any additional 3-5% weakness in the sector to buy selected defense leaders on a 6-12 month horizon, but only with tighter size than normal. The risk/reward improves if management guides to second-half acceleration and backlog conversion.
• Avoid broad ETF exposure in the near term; prefer single-name selection until the AI-overhang clears. The ETF is likely to remain a passive source of selling if factor flows continue to penalize the theme.
• For higher-conviction expressions, consider call spreads in the strongest-quality platform names over the next earnings cycle. Upside is a sharp mean reversion if revenue inflects in 2H, while defined downside limits damage if the narrative worsens.
• Set a catalyst watch on upcoming conference calls: any increased mention of AI/software should be treated as a short-term negative until management explicitly quantifies margin or productivity benefits. Names that can translate the theme into measurable savings are the likely relative winners.