A New Era for Defence

Military spending may be entering a ‘new era’ according to German chancellor Olaf Scholz, following his announcement of Germany’s 100 billion EUR one-off injection into their military. Germany’s long term defence policy has also taken a turn with a boost on defence expenditure as a percentage of annual GDP now at 2%, up from 1.5%. To put this into perspective, the equivalent 2020 figures for the UK are 2.3%, the US 3.7% and Russia 4.2%. The war in Ukraine has materialised the growing threat to security, particularly from the East. Leaving countries, investors, and firms to reassess their positions evidenced both by changes in policy and soaring share prices in numerous aerospace and defence companies. This marks the start of a new phase for the global defence industry as well as the development of a more capable European defence industrial base.

The build-up of conventional weapons has seen shares in numerous defence companies strengthen, demonstrating investor confidence in the sector’s future. The maker of the Stinger anti-air missiles being sent to Ukraine, Raytheon Technologies Corporation, have experienced stock price increases of over 11% since the start of the invasion, including 4.6% in a single day, for a net year to date increase of 18%. Raytheon Technologies Corporation’s compatriot and co-developer in the production of the Javelin anti-tank missile (another weapon being supplied to Ukraine), Lockheed Martin, has also fared equally well in the stock market. Their stock has increased by 15% now trading 16 times over forwarding earnings. Although the Pentagon has capped the production of their reputable F-35 combat jets at 156 per year for the next few years, an output of 200 jets is now more justified, according to Richard Aboulafia, an industry analyst at aerospace consultant AeroDynamics Advisory. This trend is present across the sector more broadly with ETFs designed to track the aerospace and defence industry showing a similar pattern, such as the SPDR S&P Aerospace & Defense ETF experiencing a peak increase of 13.9% relative to its pre-invasion level.

For the US, this invasion comes at a critical point in regards to their defence budget. Following the collapse of the Soviet Union, the defence sector faced a period of budget contraction narrowing the field down to its key players. 9/11 and the subsequent ‘Global War on Terror’ revived the sector, with the US Defense Department budget increasing by nearly 70% in real terms between the 2001 and 2010 fiscal years. Since then, defence companies have been slowly falling out of favour with investors as the defence budget has been scaled back, with firms preferring to increase dividend payouts and stock repurchasing over-investing in new projects. War in Ukraine has started to turn things around; an effect that may be further amplified once the US announce their defence budget for 2023 as well as their defence programme for 2023-2027 later this year. Sector analyst at Jefferies International Ltd, Chloe Lemarie, estimates that spending on military equipment could rise by up to 50% over the next 5 years, and the decisions of the US, a country which spent more on its military than the other countries in the top 10 biggest military spenders combined, will play a pivotal role.

Unlike the US, European defence budgets have remained relatively low since the post-cold war era, with investors turning their focus to ESG issues in recent years. Although US companies are better positioned to meet unplanned demand in the short term, a change in perspective in Europe with the realisation that diplomacy is not a perfect substitute for a conventional military approach could start the development and increase in capacity of the European defence industrial base. BAE Systems plc, the largest European defence contractor, has seen its shares soar over 25% and reach record highs over the last month. It recently announced a 32% increase in profits for its 2021 year with all 6 of its divisions reporting positive figures. Other defence contractors across Europe have fared equally well with France’s Thales Group and Italy’s Leonardo S.p.A gaining 13% and 14% respectively.

Although price surges in shares for the defence sector will almost invariably be followed by a return to a more modest, less panic-driven price the underlying outlook for strong long-term growth remains, fuelled by perspective changes by governments, and in turn investors. Not only will this require substantial funding and investment from both the public and private sectors but also a significant amount of natural resources. As is apparent from the cyber-attacks surrounding the war in Ukraine, technology plays as much of a role as conventional weapons in modern warfare, an industry known for being resource-intensive, especially in rare-earth metals. The new outlook for the defence industry may be positive and allow for the development of a European defence industrial base that can one day rival that of their American counterparts yet will place further demand pressure on an already strained and limited supply side for resources.

By: Jeremy Toussaint

Sector Head: Eric Hardy