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The recent escalation of tensions between Iran and the United States has served as a reminder of the deteriorating global geopolitical environment. In addition to the always contentious Middle East, North Korea remains undeterred in its nuclear ambitions while the United States and China can be expected to remain rivals for global influence for the balance of the century. A major beneficiary of these disturbing circumstances will be the global defence industry. Selected defence stocks will continue to benefit from the combination of two major factors, geopolitics and the evolution of technology.

Other geopolitical considerations are serving to boost defence spending aside from the major factors mentioned above. The absence of leadership among Western coun, combined with U.S. President Donald Trump’s skeptical view of the North Atlantic Treaty Organization (NATO), will encourage European nations to become more self-sufficient in their defence capabilities. Russia’s annexation of Crimea and activities in the Ukraine have served to focus European countries on defence matters. In Asia, China’s rapid growth in defence spending and provocative presence in the South China Sea has created unease among neighbours such as Japan and Taiwan.

The changing geopolitical landscape has influenced defence spending. In 2019, the Stockholm International Peace Research Institute published a study suggesting that global defence expenditures in 2018 were the highest in 30 years. The Trump administration has already announced the largest defence spending program in American history of some US$700-billion. The United States alone accounts for more than a third of global defence expenditures. In addition, China is rapidly increasing its military spending as is Saudi Arabia.

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In addition to geopolitics, technology can also be expected to propel defence spending higher in the next decade.

Warfare has always attracted the latest technology and spurred technological innovation. The rapid pace of technological change in the 21st century is creating significant gaps in military capabilities among countries that will require enormous expenditures to address. One current example is the lead in the development of hypersonic weapons by Russia and China over the United States and other Western countries. Hypersonic missiles travel at speeds greater than five times the speed of sound. There is currently no effective defence against such weapons. The Russian Avangard missile is said to travel up to 20 times the speed of sound. Russian Defence Minister Sergei Shoigu stated that the first regiment of Avangard missiles was deployed in the Urals region of Orenberg late in 2019. The United States is said to be two years behind in the development of hypersonic technology and is spending accordingly.

In addition to hypersonic weapons, artificial intelligence (AI) is playing a major role in the evolution of weapon systems. AI is a particularly important factor in the development of unmanned weapon systems. Autonomous aircraft (e.g. drones) and ships have been in development for some time. Major advances have also been made in the development of robots that may eventually replace human soldiers.

The combination of changing geopolitics and technology has placed unprecedented pressure on militaries around the world to update and expand their defence capabilities in the coming decade. These pressures have been reflected in the performance of defence stocks and we expect this trend to continue.

Since first being discussed in the February, 2017, issue of the Global Investment Letter, the defence sector – using the U.S. Aerospace and Defence ETF (ITA) as a proxy – has gained 62 per cent versus an approximate 45-per-cent gain in the S&P 500 (not including dividends). In the past year, the ITA has risen 29 per cent versus a gain of approximately 26 per cent in the S&P 500. The ITA exchange-traded fund is an efficient means of gaining exposure to the defence industry and offers the benefit of diversification.

We especially favour the aerospace companies that produce products incorporating the highest technology. Investors who prefer individual stocks may consider Lockheed Martin Corp. (LMT), Northrup Grumman Corp. (NOC), Raytheon Co. (RTN) and General Dynamics Corp. (GD), among others. Foreign defence contractors such as Airbus SE (France), BAE Systems PLC (U.K.), Rolls-Royce Holdings PLC (U.K.) and Thales SA (France) may also be considered as they offer geographic diversification, which may be desirable in an era of shifting alliances.

The strong tailwinds provided by geopolitics and technology suggest global defence spending will rise for the foreseeable future. Aside from general market risk, the major risk for the defence sector is a decline of global tensions, which sadly seems unlikely.

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Jonathan Baird CFA is the editor and publisher of the Global Investment Letter.

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