German equity weakness, commodities, and defence stocks

While the equity market is rallying the overall risk picture has not changed. Putin’s recent comments suggests that the Ukraine situation has not been solved and the geopolitical risk can quickly come back and haunt investors. We continue to maintain a positive view on the commodity sector and the defence industry which we believe could do well in the current environment (see discussion below). While our travel basket has done well this year the ongoing energy crisis will cause difficulties for travel activity as jet fuel is getting expensive.

DAX futures are only 7% above their pre-pandemic levels suggesting the meager equity returns for shareholders of German blue chip companies. Structurally Germany’s corporate sector is weak and the larger weight on industrial production has made Germany vulnerable to the current energy crisis. Electricity prices are not coming down and the low investments in oil and gas will continue to support elevated energy prices and commodity prices will also remain strong leading to a potential decline in corporate profits this year in German equities. German equities have underperformed European equities over the past five years and they seem to be a good for hedging against the energy crisis (besides having exposure to energy companies) and the unfolding crisis in Ukraine.

Commodities are a must in any portfolio

Two weeks ago we wrote a note on equities during the 1970s discussion some of the causes on why it was a difficult decade for equities despite robust earnings growth adjusted for inflation. Part of the equity story during the 1970s inflation period was that commodities did well because a lot of the inflation came from the supply side of the economy. This time is no different and we have remained positive on the commodity sector for over a year now. The Bloomberg Commodity Spot Index rose to a new all-time high yesterday and as long as investments in energy and metals remain low we expect the commodity cycle to remain in positive momentum. India’s growth engine combined with rapid urbanization will also be a source of big demand for commodities over the coming decade. Our commodity theme basket is up 5.6% this year and provides some inspiration for how to get exposure to the various industries (energy, chemicals, metals, and agriculture) in the commodity sector.

Defence stocks in a new NATO era

Last year in September during the US chaotic retreat from Afghanistan we introduced our defence theme basket consisting of 25 defence stocks. In our note we highlighted that if the EU27 countries lifted their military budgets to the agreed 2% of GDP then the military industry could see a 8.4% growth rate over the following decade.

The EU27 bloc spent 1.2% of GDP in 2019 on defence corresponding to €168bn and the talks in Brussels are already mustering around the need to increase the military budgets and increase coordination on key security issues such as the Arctic area, the Baltic Sea, and EU’s outer borders. The EU27 military spending is down from 1.6% of GDP in 1995 and it is very likely that the EU27 bloc will over time move back to 1.6% and beyond offsetting the reduction and reliance on the US military umbrella. If we assume trend growth for EU27 and military spending goes to 2% by 2030, then the bloc will spent €346bn in 2030 translating into 8.4% annualized growth over the next nine years. If we assume 1.6% of GDP on defence by 2030 then annualized growth in spending will be 5.7%.

With the recent conflict in Ukraine the incentives to increase military budgets have gone up considerably and our defence theme basket has also been one of the best performing baskets this year. The list below shows the basket constituents.