China is limiting the supply of vital minerals to Western defence manufacturers, leading to production delays and higher costs in the U.S. defence sector. These minerals, crucial for items ranging from bullets to advanced weaponry, are increasingly hard to source as companies search for non-Chinese suppliers.

Earlier this year, Beijing increased export controls on rare earth elements amidst rising U.S.-China trade tensions. Despite some shipments resuming after Washington’s concessions in June, China continues to restrict minerals specific to defence. China provides about 90% of the world’s rare earths and dominates many strategic material productions.

Impact on the US Defense Sector

A U.S. drone parts manufacturer reported up to two-month delays when looking for non-Chinese magnets. Industry sources note that prices for some minerals have surged, with one company offered samarium, vital for jet fighter engine magnets, at 60 times the standard cost.

This situation reveals the U.S. military’s heavy reliance on Chinese supply chains. Numerous advanced defence technologies, such as drone motors, missile guidance systems, night-vision goggles, and satellite components, depend on rare earths largely sourced from China. The supply restrictions are giving Beijing leverage during ongoing geopolitical and trade tensions.

Given China’s tightening grip on minerals crucial for defense manufacturing, we are seeing significant pressure on the stocks of major contractors. Defense sector stocks have underperformed the S&P 500 by nearly 8% in the last quarter as investors begin to price in production delays and cost overruns. This trend presents a clear opportunity for bearish positions in the weeks ahead.

Investment Strategies and Market Opportunities

Traders should consider buying put options on major defense firms like RTX and Northrop Grumman (NOC) with expirations in late October. We anticipate these companies will issue weaker forward guidance during their next earnings calls due to these specific supply shocks. This strategy positions us to profit from the expected drop in their share prices following those announcements.

Conversely, non-Chinese mining companies are set to benefit immensely from this supply squeeze. The VanEck Rare Earth/Strategic Metals ETF (REMX), which tracks these global producers, has already climbed over 15% since the restrictions tightened in June of this year. We see further upside and believe buying call options on REMX or individual miners like MP Materials (MP) is a strong counter-play.

The geopolitical situation creates extreme uncertainty, which means volatility is likely to increase. Implied volatility on options for the iShares U.S. Aerospace & Defense ETF (ITA) has already jumped to a 52-week high, suggesting the market is bracing for a significant price swing. A long straddle on ITA could be an effective way to profit from a large move in either direction without betting on the specific outcome.

We are also looking directly at the underlying commodity markets for opportunities. Just as we saw cobalt prices surge during supply disruptions in the Democratic Republic of Congo back in 2018, the price for specific rare earths like samarium and neodymium could see dramatic spikes. Taking long positions in futures or equities of pure-play producers of these specific elements offers a direct way to trade the supply shortage.

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