Investing in a cynical, Thucydidean world

It’s springtime for defense companies

With the fall of the Berlin Wall in 1989 and the subsequent dissolution of the Soviet Union, the world had a brief moment of conflict-free prosperity in the 1990s. Remarkably, even the U.S. managed to balance its books and go from a decades-long fiscal deficit to a fiscal surplus (albeit briefly). Much of this was helped by a drop in military spending. Global military spending, which had been running at around 3.5% of GDP through the 1970s and 1980s, started to drop in the 1990s and by the mid-2000s was around just 2% of GDP (Exhibit 1).

Exh 1: Military spending (as a percentage of GDP) dropped after the end of the Cold War, before picking up recently

But defense spending is now seeing a pickup against a backdrop of what has been termed the Thucydides’ Trap. Even before the two current ground wars started, countries were already increasing their defense spending. The resurgence of a semblance of the Cold War, albeit with new actors on the stage, played a role.?Some of it was helped along by a new, improved military-industrial complex. The ongoing wars have only exacerbated the situation. ??

The Stockholm Peace Research Institute (SIPRI), the go-to custodians of military spending data, have just released their 2023 Report and it makes for some sober reading: ?

• Global military spending rose 6.8% year-on-year to US$2.4 trillion in 2023, compared to the decadal average of 2.4% p.a. (On a positive note, it has remained stable at around 2.3% of GDP for the past few years, though up from 2.1% of GDP in 2018.) (Exhibits 2, 4 and 5)
• The top 15 highest-spending countries account for over 80% of all global military spending (Exhibits 3 and 10)

Exh 2: World military expenditure, by region, 1988–2023

Exh 3: The share of world military expenditure of the 15 countries with the highest spending in 2023

• The recent pickup in global military spending comes after a benign period when it fell an average of 3% p.a. between 1990-2000 following the dissolution of the Soviet Union (Exh 4).
• However, even during that decade, China increased its military spending by 6.8% p.a. (Exh 4).
• Over the past decade (2013-2023), military spending has been on a rising trend (2.4% p.a.) but has really picked up pace in the past five years (2018-2023) where it increased 3.8% p.a. – despite global resources being diverted to fight covid during that period (Exh 4).
• What has driven this? Obvious hotspots: Eastern Europe has seen spending rise an annualized 18.7% p.a. (thanks to Russia: +11.8% p.a.), Taiwan (+8.7%), Germany (+5.7%, in response to Russia?) and China (4.5%). ?
• Actually, the global spend would have been much higher were it not for the U.S., which has grown its spending by only 2% p.a. – at just half the global growth rate. Still, the U.S. alone accounts for 37% of the global military spending (Exh 4).

This last point is quite important. The U.S. military spending growth has remained muted for the past decade or so. There are a lot of reasons for this, but recently the U.S. has also committed to several social and investment spending programs (IRA, CHIPS Act, etc). As it is, even without the military spending, the U.S. fiscal deficit is already at 6.3% of GDP (arguably it is down from 2020-21, when it ballooned due to covid-related spending).

Exh 4: Trend in global military expenditure by country

So, can the U.S. - and will the U.S. - raise defense spending again? As mentioned, despite not being directly involved in any conflicts, the U.S. is already running a deficit of 6.3% now. Also, as alluded to earlier, the U.S. has committed to spend on several social and investment programs, which is coming soon after it spent a lot of money during the pandemic. So, can it spend even more on defense?

The U.S. military spending in 2023 (US$880bn) was barely higher than the US$850bn it spent a decade ago in 2013 (Exh 4). But back in 2013, it was not facing the geopolitical challenges it faces today. In the past five years alone, China has grown its spending by a quarter and Russia by three quarters (though arguably this picked up after its war in Ukraine).

In the face of rising geopolitical tensions, a rise in U.S. (and global) spending seems quite likely. Even the U.S. spending on the IRA and CHIPS Acts is a reaction to its geopolitical challenges; thus, it is difficult to imagine how the U.S. can get by without spending more on defense itself. The first hint of that has been the recent passage of a US$95 billion bill to provide aid to Ukraine (as well as to Israel and Taiwan). ?

Good fences…good neighbours?

How will the U.S. achieve this? The U.S. may have to slow down other programs – and will push its partners in Asia and NATO members to do more spending on their own (something that former President Trump has hinted at, should he come back to power). Allies in Europe and Asia will need to buy more of their own military gear – and as a bonus, some of it may come from U.S. defense companies and contractors! Some of this spending has already picked up (see data for Germany, Japan, S. Korea in bullet points below and in Exhibits 4 and 5).

Over in Europe, French President Macron is already cajoling fellow European countries to stop depending on the U.S. and step up their own spending. And for a good reason: France is the world’s second-largest arms exporter after the U.S. (Exhibit 12), and would like to keep its factories humming. Even Prime Minister Rishi Sunak of the U.K. recently announced that he will raise U.K.’s defense spending to 2.5% of GDP by 2030, up from 2.1% in 2022. The U.K. is the world’s seventh-largest arms exporter (Exhibit 12).

Exh 5: World military expenditure, by region, as a percentage of GDP

We may already be moving down this path.

• Germany’s military spending has risen by almost 50% over the past decade, and grew 5.7% p.a. in the past five years alone (Exhibit 4).
• Japan has grown its military spending by a third over the past decade, while S. Korea has grown it by almost 40%. Both countries host U.S. military bases and have a security pact with it (Exhibit 4).
• Germany’s defense spending is now 1.5% of GDP, compared to 1.2% in 2013, while Japan now spends 1.2% of GDP versus just 0.9% in 2013. By contrast, the U.S. continues to spend 3.4% of its GDP on defense, well above the global average of 2.3% (Exhibit 5). Russia’s reached 5.9% last year, but then it’s in the midst of a ground war (equivalent figure for Ukraine: 37%).
• Similar to Germany, countries near Russia, such as Denmark and Finland have also increased their military spending substantially over the past decade (Exhibit 6).
• As mentioned above, Taiwan has been growing its military spending by 8.7% p.a. in the past five years – the highest growth rate of any country not currently at war (Exhibit 4).
• Southeast Asian countries around the South China Sea have had to step up defense spending due to rising maritime disputes. As an example, the Philippines now spends 50% more than what it did a decade ago while Singapore’s increase over the same period was 30% (Exhibits 4, 5).
• Vietnam, another country with maritime disputes has not released data for 2023, but its 2022 spending was estimated to be US$7.2bn, vs US$4.2bn in 2013 (Exhibit 4, 5). Even tiny Cambodia has more than doubled its defense spending over the past decade.
• Singapore spent US$12bn on defense last year – the third-highest spending (US$ 2,195) on a per-capita basis in the world, just behind Israel ($ 2,997) and the U.S. (US$ 2,694). (Exhibit 6). Qatar has not released data for 2023, but in 2022, it spent US$ 5,719 per-capita, when it hosted the soccer World Cup.

Exh 6: World military expenditure, per-capita (US$)

The Military-Industrial Complex Rears its (Beautiful?) Head Again

All in all, it looks like after a period of low spending by their customers, the world’s arms manufacturers may be seeing a bit of a tailwind. Major countries like Germany and Japan – historically low-spenders – are ramping up defense spending for the first time; both seem on track to raise spending to 2% of GDP. Other organisations like NATO and countries that are facing regional disputes are all increasing their military spending as a percentage of GDP.

So, who are the biggest arms manufacturers in the world that could benefit from this strife? It is no surprise that the five largest global arms manufacturers are all American: Lockheed Martin, RTX (formerly Raytheon), Northrop Grumman, Boeing, and General Dynamics (all listed on the stock market). The top 10 is rounded off by BAE Systems of the UK, three Chinese state-owned companies and Russia’ Rostec (Exhibit 7). (A more detailed list in Exhibit 14).

?Exh 7: Top arms-producing and military-services companies in the world, 2022

It’s springtime for Lockheed and RTX

Some of these companies have already started to benefit from the two ongoing wars right now. The recent US$95bn Ukraine aid package approved by the U.S. means many more orders for the U.S. defense companies, in particular Lockheed Martin (LMT), RTX (RTX; the former Raytheon), General Dynamics (GD) and L3Harris (LHX). LMT and RTX alone received US$30bn in U.S. contracts to supply Ukraine as well as replenish U.S. stockpiles that had already been shipped to Ukraine. The latest package also earmarked military equipment for Israel and Taiwan.

Though Ukraine has been receiving support from the U.S. for the past two years, these companies only book sales when weapons are delivered, so they are only now beginning to start reporting sales from weapons that were being delivered over the past two years. The current package is likely to start showing up over the next couple of years. These are higher-value, higher-margin weapons.

The positive impact on these companies’ sales may already have been visible in their first quarter results for 2024 (Exhibit 8): ?

Exh 8: Financial results for the top 5 arms manufacturers, 1Q 2024 vs 1Q 2023

Still, the aerospace and defense sector generates some well-earned skepticism. These stocks have not performed well in the past and underperformed the S&P500 in 2023. Investors doubt that the orders will flow through, or even that earnings will follow. There is a whiff of “national service” about the sector in some countries. Lawmakers - unhappy with companies they term “war profiteers” - regularly threaten their margins, and the return of capital to shareholders. Most problematic: a large number of funds that are guided by ESG principles simply cannot buy them, thus reducing a large institutional investor base for them. ?

But, then again, we are living in times we have not known for a while. We have to go back decades to find situations where two major ground wars – between proxies for superpowers – were going on at the same time. Since the dissolution of the Soviet Union, we had not seen the rise of a superpower that could challenge the U.S.

It would be nice to go back to the conflict-free 1990s, but that is unlikely to happen any time soon. You don’t have to be cynical, but just practical enough to see that the rise in defense spending is now a secular trend.

Though it helps to be cynical.

How cynical? Let me leave you with one final graphic here. Exhibit 9 (courtesy of The Economist) below shows where Russia imported its key military goods from, following its invasion of Ukraine. After China (incl HK) and Turkey, the next major suppliers were Germany and South Korea, while Italy, Japan and France all made the top 10. So, five of the top 10 military suppliers of Russia are allies of the U.S. and four are hosts to U.S. military bases.

Exh 9: Russia’s imports of key military goods by country of origin, March 2022 - July 2023, m

Appendix of more Exhibits

Exh 10: Top 20: Global military expenditure by country

Exh 11: Military spending as a share of gross domestic product, by country, 2023

Exh 12: The 25 largest exporters of major arms and their main recipients, 2019–23

Exh 13: The 20 largest importers of major arms and their main suppliers, 2019–23

Exh 14: Top 30 arms-producing and military-services companies in the world, 2022

Source: SIPRI Arms Industry Database, Dec. 2023. Please see other footnotes on SIPRI’s website. . = data not available; Corp. = corporation. Notes: Unless otherwise specified, all revenue figures are expressed in constant (2022) United States dollars and all changes are expressed in real terms (i.e. they have been adjusted for inflation). Changes refer to the change in arms revenue between 2021 and 2022 of companies in the Top 100 for 2022. Percentage shares and changes calculated using the data in this table may not precisely correspond to those stated due to rounding. For further detail on methodology see the Arms Industry Database on SIPRI’s website. a Companies are ranked according to the value of their arms revenue at the end of what SIPRI considers to be their financial year. Rankings for 2021 are based on updated figures for arms revenue in the latest version of the SIPRI Arms Industry Database (Dec. 2023). They may differ from those published in any earlier SIPRI publication owing to continual revision of data, most often because of changes reported by the company itself and sometimes because of improved estimations. b Holding and investment companies with no direct operational activities are not treated as arms companies, and arms companies owned by them are listed and ranked as if they were parent companies. Company names and structures are listed as they were at the end of their financial year. Major revisions are explained in these notes. c Country refers to the country in which the ownership and control structures of the company are located, i.e. the location of a company’s headquarters. d To allow easier comparison between years, all revenue figures—including for arms revenue in 2021—are given in constant (2022) US dollars.