Future of Defence ETF Report | February

Defence ETF Key Takeaways

Europe Plays Catch Up – Thanks to the war in Ukraine that began almost two years ago, demand for weapons in Europe has soared. Experts expect these growth trends to continue for at least another five years, even if the Ukraine war were to end immediately.  Add to that, rising conflict in the Middle East, and the market for defence stocks is booming globally.  The Stockholm International Peace Research Institute (SIPRI) reports that global military expenditures increased by 3.7% last year, reaching a record high $2.24 USD or €2.04 trillion.  While the U.S. leads in spending, Europe is now in second place in terms of defence spend, growing by 13%, benefiting European defence companies such as BAE Systems in the UK and Leonardo in Italy.  Europe is playing catchup after years of underinvestment. One German media report found that the country only had 1-2 days of ammunition stocks versus the recommended 30-day allocation.  Going forward, for the next few years, European defence budgets are expected to grow at least 10% a year over the next 5 years, helping European defence companies the most.

NATO Begins Largest Exercise Since Cold War – NATO is about to embark on its largest exercise since the 1988’s Reforger excercise.  Named Exercise Steadfast Defender 24, it will include 90,000 service members from the 31 NATO allied countries and Sweden.  The purpose of the exercise is to deploy forces to test NATO’s new defence plans approved at least year’s Vilnius Summit event in Lithuania.  The exercise will take place in Finland, Estonia, Greece, Germany, Hungary, Latvia, Lithuania, Norway, Poland, Romania, Slovakia, and the UK, and will also include pending member Sweden.  There are expected to be 50 naval assets including aircraft carriers and destroyers, and air assets to include F-35s, FA-18s, Harriers, F-15s, helicopters and unmanned aerial vehicles.  There will also be more than 1,100 combat vehicles, with more than 150 tanks, 500 infantry fighting vehicles and 400 armoured personnel carriers.  While Steadfast Defender has been in the planning stages for years, the exercises incorporate defence actions specific to Russia’s Ukraine aggression.

Can Defense Products Be “ESG”? – A recent Bloomberg article highlights the fact that asset managers, even those with ESG mandates, are getting more comfortable with defence exposure.  The development is the result of a campaign to get ESG investors to support European military capabilities in the face of aggressive actions like the Russia-Ukraine war.  NATO Secretary General Jens Stoltenberg called for more money to be allocated to defence, arguing “there is nothing unethical about defending our freedom.” But the issue is divisive for ESG investors as defining what weapons are being used for defence instead of aggression is a difficult undertaking from a due diligence standpoint. Danish pension fund AkademikerPension draws the line at controversial weapons such as cluster bombs and nuclear weapons.  They own SAAB which manufactures the Gripen fighter jet and Kongsberg Gruppen, which recently sold missile systems to Poland to help defence against Russia.  Another part of the argument is the continued outperformance of defence stocks in the current market environment.  While some ESG managers refuse to compromise on the topic of defence exposure, that decision comes with the trade-off of investment performance.

Baltics See Spike in GPS Jamming – The war in Ukraine has brought to the forefront new military tactics such as unmanned vehicles and electronic warfare. Recently, aircraft flying in the Baltic region have been subjected to the jamming and interference of GPS signals, putting both military and commercial aircraft at risk.  Military analysts think almost certainly that Russian is to blame.  In addition to being a safety issue, deliberate interference with GPS is a violation of international law.  NATO is under pressure to take decisive action to address this problem before it results in significant loss of life or escalates into armed conflict involving NATO.  The silver-lining from a cybersecurity standpoint, is a renewed focus on public-private cooperation against such cyber threats.

Sources available upon request. Please remember that when you invest in ETFs, your capital is at risk.

Macro Outlook

Spurred by the Russia-Ukraine war and global aggressions in regions like the Middle East, Europe is now second behind the U.S. in defence spending, growing at an annual rate of 10%. Europe is playing catch-up after years of underinvestment and large-scale military exercises are underway, that consider these new global realities.

These trends are likely to continue for many years to come as Europe restocks equipment and ammunition and modernizes its defence and cyber defence capabilities. This has led many ESG investors to reevaluate defence exposure.

Whereas traditionally defence companies have not been part of ESG allocations, NATO’s new defensive posture to defend freedom and democracy around the world, has caused re-evaluation of those positions.  Meanwhile, defence and cyber defence stock performance continues to benefit from increased spending.

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