Defense Contracting Stocks: Navigating Thematic Investing & Geopolitics - Part I

This is part I of III in a limited series on the intersection of geopolitics with thematic investing in sectors with geo-strategic significance.

Speak Softly But…

In December, the Biden Administration approved an unprecedented defense policy bill, earmarking $886 billion for annual military spending. This National Defense Authorization Act (NDAA), a testament to a longstanding tradition, marks the 63rd consecutive year of its passage by Congress.

Despite the prevailing political polarization, this act signifies a rare unity within Congress on military matters, even amidst debates over aid to Ukraine. The significance of defense contracting companies in the U.S., with the government as their primary client, cannot be understated.

Fortified by the nation's ability to borrow due to its reserve currency status, Washington's deep pockets facilitate increased defense budgets to meet growing needs.

A pivotal aspect of this increased defense spending is the strategic competition with China, especially pronounced in the Indo-Pacific region. The Pentagon's Indo-Pacific Command's budget request for the fiscal year 2024 stands at approximately $15.3 billion, nearly $4 billion above the previous year's allocation.

The NDAA notably includes a 40% increase for the Pacific Deterrence Initiative, reaching $9.1 billion, the largest request in its history. This escalation is a direct response to the challenges posed by multipolarity, unilateralism, and fragmentation, highlighting the growing imperative for enhanced preparedness and security measures.

The budget also emphasizes research and development, with a request for $145 billion, and procurement to maintain air, sea, and land dominance, including $61 billion for new initiatives like the B-21 Raider and $48 billion for the construction of nine battle force ships for the U.S. Navy​

Asia: The Flashpoint

China's strategic pivot away from the Western-centric global order, especially evident in its maneuvers in the South China Sea, underscores the geopolitical tensions in the Indo-Pacific.

Read more about the impact of geopolitics on defense contracting stocks here.

The region, teetering on the brink of becoming a major flashpoint of hegemonic rivalry, has prompted regional states, including Washington's five treaty allies—Japan, South Korea, Australia, the Philippines, and Thailand—to bolster their defenses, primarily through procurements from the U.S., their largest foreign defense supplier.

The defense spending surge extends beyond the Indo-Pacific, with notable increases among U.S. allies such as South Korea (61%) and Japan (171%).

2023 overall witnessed a dramatic 7.4% increase in combined defense spending by the United States and its regional allies, including Australia, Japan, South Korea, Taiwan, and the Philippines.

This surge, escalating from $984 billion to over $1.05 trillion, underscored heightened regional anxieties. While the Philippines opted for a budgetary decrease, it strategically counterbalanced this move by fostering deeper military cooperation with the United States and solidifying its strategic presence in the contested South China Sea.

Among these allies, Taiwan exhibited the most significant spending jump, bolstering its defense budget by $3 billion (a 20% increase) amid escalating concerns about a potential Chinese invasion.

However, China remained the undisputed heavyweight in terms of military expenditure. The International Institute for Strategic Studies (IISS) report revealed that China's 2023 defense budget of $219.5 billion accounted for a staggering 43% of all Asian defense spending, solidifying its overwhelming dominance in the region's military landscape.

This collective uptick in defense spending across Asia can be attributed primarily to the growing tensions with China, fueled by territorial disputes and anxieties about potential military action.

While the Philippines presented a unique case with its budgetary decrease, its enhanced cooperation with the U.S. military underscores a strategic shift towards bolstering its defense capabilities despite financial constraints.

This trend is mirrored in the Middle East, where Saudi Arabia, Qatar, and Egypt rank among the top 10 global arms importers, predominantly sourcing from the U.S., which accounts for 54% of arms imports to the region.

This reflects a broader global momentum towards armament in response to escalating geopolitical tensions, with the U.S. at the forefront of meeting this international demand.

Lockheed Martin, a leading entity in the Aerospace & Defense industry, exemplifies the economic underpinnings of this global defense posture. The company's stock has seen a nearly 800% increase over the past 20 years, with an average annual return of about 19.09%, significantly outperforming the S&P 500's average annual return of 9.75% (7.03% when adjusted for inflation).

This financial trajectory is reflective of the sustained demand for advanced defense technologies and the strategic imperatives driving defense spending.

The evolving U.S.-China relationship, marked by increased hostility and competition for influence in the Indo-Pacific, remains a bipartisan concern, transcending administrations and their differing policies.

From the tariffs imposed by the Trump administration to the targeted trade restrictions under Biden, the consistent posture towards China underscores a broader strategic continuity.

This geopolitical landscape sets the stage for emerging thematic risks, including advancements in AI, semiconductors, and quantum computing, further emphasizing the critical nature of defense spending in navigating the complexities of international security and technological supremacy.

Stay tuned for next week’s thematic analysis of semiconductors and quantum computing.

*NOT financial advice.