Right Now, Good Defense Companies Might Be The Best Offense

Right Now, Good Defense Companies Might Be The Best Offense
Reda Farran, CFA

almost 2 years ago3 mins

  • Bigger military budgets create jobs but don’t necessarily lead to higher economic growth in richer nations. And they can actually be detrimental to growth in poorer countries.

  • Higher military spending can impact markets by increasing government bond yields and by reducing the tail-risk of an invasion.

  • European defense stocks are poised to benefit after years of underperforming their American counterparts, as a host of European countries increase their military spending.

Bigger military budgets create jobs but don’t necessarily lead to higher economic growth in richer nations. And they can actually be detrimental to growth in poorer countries.

Higher military spending can impact markets by increasing government bond yields and by reducing the tail-risk of an invasion.

European defense stocks are poised to benefit after years of underperforming their American counterparts, as a host of European countries increase their military spending.

Countries around the world piled a record $2.1 trillion into their defense budgets last year, and that’s bound to be even higher going forward. After all, Russia’s invasion of Ukraine has reminded even the most pacifist regions about the need for a military that can hold its own. So let’s take a look at how this spending could pan out, and the companies that might be set to profit.

How will more defense spending impact the economy?

Government spending is one of the four components of gross domestic product (GDP) – broadly, the size of a country’s economy. Logically then, more military spending should increase GDP. But the relationship isn’t that simple. Governments, ultimately, have finite budgets. So higher military spending would generally have to be offset by lower spending elsewhere, keeping the total “government expenditure” piece of GDP flat.

What’s more, when governments spend more on their militaries, they have fewer funds available for other productive things like, say, infrastructure or healthcare. So some people reckon that higher military expenditures can actually be harmful to long-term growth and development. But once again, the relationship isn’t that simple. A study by The Economist found no consistent relationship between military spending and GDP growth for the 38 countries in the OECD.

So what relationships, if any, are there between military spending and growth? A research paper published in 2014 highlights an interesting one: military spending in poorer countries is often detrimental to growth, whereas in wealthier countries it’s more likely to be beneficial. There are two possible explanations for this. First, weaker governance in developing countries make big military budgets a juicy target for corrupt officials. Second, in poorer countries, military spending has a high opportunity cost, since it takes funds from education, infrastructure, and other growth-producing areas. For rich, developed countries, the opportunity costs are lower.

Other than growth, there’s another – and arguably less contentious – part of the economy that bigger military budgets support: employment. And here I’m not just talking about active military personnel, but also all the people employed by the industries militaries rely on: weapons manufacturing, logistics, and so on. This is becoming even bigger these days as nations take a long-term approach and prioritize developing their own domestic ammunition industries, rather than relying on arms manufacturers in other parts of the world.

How will higher military spending impact markets?

A higher military budget has to be funded somehow, and that usually means increased government borrowing. More bond issuance by governments leads to higher bond yields. So there’s a direct impact on fixed-income markets and an indirect impact for other markets, since those higher yields may pull investors away from stocks, crypto, and other assets.

Another impact is this: higher military spending can reduce the tail-risk of an invasion. This is a lot more subtle and harder to measure, but think of it like this: when a country spends on its military and defense, it pays “dividends of deterrence”. That is, it makes it more unlikely that it’ll be invaded and caught up in a war that causes its economy and markets to plunge. A foundational element for any successful economy, after all, is peace and stability that gives firms and individuals the confidence to invest.

What’s the opportunity here?

European aerospace and defense stocks have majorly underperformed their US counterparts over the past eight years. But they now look nicely set up to recoup some of that underperformance, with European countries pledging to spend more on their militaries after the Russian invasion of Ukraine. Just look at Germany, which announced a $110 billion fund to ramp up military spending. The country – Europe’s biggest economy – is also committing at least 2% of its economic output to defense spending, up from about 1.5%.

Since there aren’t any dedicated European aerospace and defense ETFs, you can build your own by allocating a small percentage of your portfolio to the sector, and splitting it evenly among its stocks. Some of the biggest ones include Airbus, Safran, BAE Systems, Thales, Rheinmetall, Leonardo, Chemring, Dassault Aviation, Kongsberg Gruppen, and Ultra Electronics Holdings.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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