Why investors should consider defence

A closer look at European NATO members’ defence spending

The end of the Cold War in 1991 was met with jubilation. No longer did the world have to live in the shadow of fear that a large-scale conflict would break out between the USA and the Soviet Union. Geopolitical risk, it appeared, had receded. Governments responded to this new outlook with large-scale cuts to defence budgets. This reduction of defence spending was called the “peace dividend”.

Source: Peter Oppenheimer – Any Happy Returns. For illustrative purposes only.

Those days, however, are long gone. Instead, there is a growing sense of geopolitical risk, from the ongoing war in Ukraine to growing tensions in the South China Sea. Both geopolitical risk and defence budgets are back on the rise. From Europe to Asia, new big spending packages, have been announced, while national defence strategies have been rewritten.

As a result, it may be opportune for investors to consider their exposure to defence.

Structural shift to higher spending in Europe

One particular area of focus is European NATO members. The declines in European defence spending post-Cold War resulted in many European NATO falling short of the 2% of GDP defence spending target, set by NATO. These cuts have left European inventories troublingly low. European nations have alarmingly less tanks, aircraft, combat ships and submarines, compared to 1992, immediately after the Cold War ended.

Source: McKinsey & Company. For illustrative purposes only.

 With the heightened sense of geopolitical insecurity in-light of the invasion, the consultancy now forecasts a spending increase of 65% from 2021 to 2026, reaching €488 billion.

Following the 2022 invasion of Ukraine, the need to address this has become apparent to governments across the continent. Germany has announced a €100 billion spending package, equivalent to double the annual defence budget, to jumpstart its modernisation. Meanwhile, Poland has committed itself to spending over 4% of GDP on defence.

According to modelling from McKinsey & Company, had Russia not invaded Ukraine in 2022, defence spending in Europe would have risen from €296 billion in 2021 to €337 billion in 2026. But with the heightened sense of geopolitical insecurity in-light of the invasion, the consultancy now forecasts a spending increase of 65% from 2021 to 2026, reaching €488 billion.

Source: McKinsey & Company. For illustrative purposes only.

The key beneficiaries of this uptick in spending will be the big European defence firms such as Rheinmetall, Leonardo, BAE Systems.

We can already see this feed through into the earnings of such companies. Rheinmetall, Germany’s weapon maker, for example, recently reported orders last year increased 44% almost reaching a record 40bn euros. Meanwhile, Leonardo forecasts a cumulative order intake of 105bn euros over the next five years.

 Global spending on cybersecurity solutions is expected to grow by an annual compound growth rate of 13% between 2022 and the end of the decade.

Cyber is a core part of defence

Investors should not ignore the crucial role of cyber defence is crucial for national security. Increasingly, cyberattacks are backed by nation-states, like Russia, China, North Korea, and Iran, with political motives. For example, since Russia’s 2014 invasion of Ukraine, it has continuously carried out cyber-attacks on the country. Such attacks have impacted government agencies, critical infrastructures like railways and ATMs.

As geopolitical tensions increase, the risk of large-scale attacks increases. As a result, global spending on cybersecurity solutions is expected to grow by an annual compound growth rate of 13% between 2022 and the end of the decade. This potentially creates an opportunity for cyberdefence firms that work with governments to protect critical infrastructure.

Geopolitical hedge

But defence exposure may appeal beyond expected growth. They can also serve as a hedge in a less certain world.

The sense of growing geopolitical tensions can be measured. Landfall Strategy Group calculates their own Geopolitical Risk Index, shown below. As we can see, since 2022, it has been sitting above the average trend of the past few decades. As a result, investor portfolios are potentially at risk of “geopolitical shocks”, meaning unexpected events that will negatively impact the price of stocks and bond.

Source: Macrobond; Economic Policy Uncertainty; Landfall Strategy Group calculations. Accessed via: https://davidskilling.substack.com/p/geopolitical-shifts-and-shocks. For illustrative purposes only.

Defence stocks provide a hedge against geopolitical shocks. It is well-known that assets such as bonds or gold often rise in the face of such shocks, known as the “flight-to-safety”. A similar pattern is often emerged when it comes to defence stocks, a so-called “flight-to-arms.”

Whether its for exposure to potential growing revenues as defence spending shifts higher, or as a hedge against market-depressing geopolitical shocks, investors cannot ignore potential exposure to defence related stocks.

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