Guns not Butter - As Europe reluctantly re-arms, many of the old investment certainties are shifting.

As a sometime soldier, 1989 and the fall of the Berlin Wall marked the end of an epoch for me both personally and professionally. It also marked the beginning of a thirty-year bear market in European defence stocks.

Recent events have radically altered this state of affairs.

First, a bit of context, first. At the time of Suez in 1956, when we still had extensive overseas interests and territories to defend, the United Kingdom spent 7.6 per cent of GDP on defence, or 43 per cent of Government expenditure (similar to Russia today, incidentally). This more than halved to 3.2 per cent in 1989 when the Army I served in still numbered 144,000 regular troops. With the ending of the Cold War came the so-called ‘peace dividend’, resulting in Defence Reviews like  Options for Change. That was followed by further reductions in spending and numbers after the Good Friday Agreement.  Since then, and despite extensive campaigns in Iraq and Afghanistan, successive Defence Secretaries have struggled to maintain their share of the public purse in the face of political pressures to (be seen to) spend ever more on health, education and welfare, with the result that we have a Regular Army of barely 70,000 and a Navy and Air Force similarly reduced in size and capabilities. This is reflected across Europe, with the total number of tanks down 80 per cent, fighter aircraft down 60 per cent, and a halving of naval ships and submarines over the past thirty years. More recently, many European countries have sent whatever surplus stocks of ammunition and other weaponry they hold to Ukraine.

The myriad threats now posed by Russia, China, Iran, N. Korea and other rogue states have thrown the perceived weakness in the fighting power of NATO countries and other shortcomings in Western democratic leadership into sharp focus, bringing with it the need to rethink the ‘peace dividend’ and state expenditure priorities. Following US pressure for Europe to pay its way, most NATO countries now grudgingly accept the need to adjust budgets to reach the agreed NATO target of 2 per cent of GDP, although this is still far behind the US’ current spending of 3.5 per cent.

The NATO average for budget expenditure on defence hardware is now 30 per cent (up from just 10 per cent in 2014), with Brussels insisting that European nations procure at least half of their hardware within the EU. NATO now recommends thirty days of battle inventory (previously, it was only five), but many countries are struggling even to fill their own basic needs.  The entire annual revenues of the quoted European defence industry in 2022 (including the UK) was $132 billion. If this figure increases in line with the anticipated increases in expenditure by NATO nations, then these revenues will roughly double.  In order to encourage manufacturing investment to meet demand, governments are now offering longer contracts and better payment terms, which vastly improves cash flow in previously hard-pressed defence companies’ balance sheets and their abilities to reinvest and expand.

So what is the likely impact on Europe’s long-unloved defence industries?

Germany’s Rheinmetall, the global leader in the manufacture of NATO standard artillery and tank shells, is one of the best-performing stocks in Europe so far this year. Next up is BAE (the second largest holding in the CH Balanced Equity Income Fund), Britain’s dominant player in stealth activities, particularly in space and under the seas. Norway’s Kongsberg has an effective monopoly in next-generation anti-ship missiles of the kind that Taiwan now needs to buy.

Expect to hear more not just about large caps like Thales (French defence electronics), Leonardo (Italian helicopters), Rolls Royce (British aero engines – a 5% holding in Law Debenture Investment Trust, a core fund in many CH portfolios) and Safran (French aircraft, helicopter and rocket propulsion systems – a 3.5% holding in Blackrock Greater Europe Investment Trust, another core holding) but also from long-unloved companies like Saab (Swedish fighter jets), Babcock (British submarines), Chemring (British radar countermeasures) and Hensoldt (German optronics and avionics).

It is a truism to state that the next war is always different from the last one. The war in Ukraine has seen a proliferation in the use of drones, which are able to drop munitions with pinpoint accuracy, making camouflage, dispersion, deception and 360-degree armour vital; mobile air defence artillery to shoot them down is as essential as long-range missiles for striking depth targets; sophisticated cyber security measures have become vital against ever more subtle attacks designed to interfere with the workings of government institutions and large corporates or to undermine the faith in elected democracies; the vulnerability of underwater cables and pipelines and of energy infrastructure has suddenly risen up the list of priorities.

Is the mighty $ in danger of losing its primacy?

A historical perspective is helpful. Just as 1914 brought to an end almost 100 years of relative peace and financial globalisation, recent geo-political events have reversed a long period of global prosperity, low inflation and economic cycles, to a large extent managed by central banks. Has it also brought to an end the hegemony of the US and the position of the dollar as the world’s reserve currency?

The evidence is beginning to accumulate.  America has enjoyed the ‘exorbitant privilege’ of the dollar being the world’s reserve currency for the whole of the post-War period since 1945. But as Britain experienced after the First World War with Sterling, this privilege can easily be forfeit.

Chinese holdings of US Treasuries are now down to just £800 billion from their 2016 peak of £1.2 trillion. Russia, Iran, and Venezuela have adopted China’s CIPS payment system in an attempt to avoid being frozen out of international trade transacted in dollars via the dollar-based SWIFT system. The People’s Bank of China has now emerged as the biggest buyer of gold, perhaps mindful of the $300 billion of Russian financial assets frozen since their invasion of Ukraine, mostly in Belgium’s Euroclear system. 

Meanwhile, the American and Chinese economies continue to decouple (Chinese exports to the US are down 25 per cent from their peak), and many Western companies are either ‘re-shoring’ production back to Europe or ‘friend-shoring’ their manufacturing in places like Vietnam and Malaysia, India or Mexico. Russia continues to ostracise itself from Western financial systems by freezing the assets of ‘non-friendly’ countries – a warning, perhaps, to UK investors in the Chinese stock market. This new ‘Cold War’ increases the attractiveness of ‘outside’ money in the forms of cash, gold, crypto assets and, for the non-aligned countries, their own currencies.

But returning to the theme of ‘guns not butter’, apart from the increased demand for defence technologies and equipment, history shows that conflict stimulates the demand and competition for commodities, particularly when their supply is not indigenous. Added to the exigencies of Net Zero, AI, and new energy technologies, it is hardly surprising that China is consolidating its position in ‘rare earth’ markets or that BHP should tilt at iron ore and copper miner Anglo American.
The ground under investors’ feet never stops shifting.


With thanks to Lt Gen Sir Andrew Graham Bt, CB, CBE, former Director of Army Resources and Plans and Director-General of the Defence Academy of the United Kingdom, for his review of this piece.


Previous articles in this series

Markets in a moment - May 2024

Markets in a moment - April 2024

Markets in a moment - March 2024

Markets in a moment - February 2024

Markets in a moment - January 2024


Important Information

The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment arrangements.

Please also note that the value of investments and the income you get from them may fall as well as rise, and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.

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