Defence spending back in the cross-hairs

SPENDING: Defence spending is set to structurally rise around the world with the new normal of geopolitical tension and end of the multi-decade peace dividend. The US passed $95 billion of supplemental defence aid for Ukraine, Israel, Taiwan. And the UK committed to take the lead in Europe, by boosting spending to 2.5% of GDP by 2030. Europe spends proportionately less on defence than most but has started a multi-year catch up. Growing spending at three times the rate of the dominant US. This is driving outperformance of its smaller local defence stocks where this extra money goes a disproportionately long way versus lagging US defence giants.

READ ACROSS: More spending does not always equal better defence stock performance. This is one reason the US defence ETF (ITA) has been lagging the S&P 500 in the past year. As 1) it is lumpy, multi-year, and weapons system dependent. 2) Much of the extra outlay can be on non-weapons spending like wages, housing, and pensions. 3) Many contractors are part of bigger defence, space, and aerospace conglomerates. But Europe’s smaller and less diversified defence stocks have been on a tear. Rolls Royce (LON:RR.L) is the top performer in Europe’s Stoxx 600 the past year, with Italy’s Leonardo 3rd (LDO.MI), and German Rheinmetall (RHM.DE) 6th.

CONTEXT: World defence spending has fallen by a proportional 60% since its cold war highs (see chart) and averaged 2.3% of global GDP, or $2.4 trillion, last year. The US is by far the largest defence spender. With its $900 billion budget representing 37% of global spending and three times larger than no.2 China. These top 2 account for over half of total spending. Russia is the 3rd largest global spender, at around $100 billion. The Arab world leads proportional spending at near 5% of GDP. Europe lags, under the oft-spoken minimum target 2.0% of GDP. But has started to catch up and is growing spending at some of the fastest rates globally.