Will EU defence contractors benefit in a post Afghanistan period?

Equities 8 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  Europe is facing a new situation with the US exit from Afghanistan as it means that the role of NATO is changing back to its roots of local defence instead of national building but also a reduced US military presence. European politicians are right now debating how to handle the likely influx of Afghan refugees and secondly how to increase its military self-reliance. The latter will likely lead to increased military spending which currently sits at 1.2% of GDP over the coming decade leading to a potential new growth trajectory for European defence contractors.


There have been many political analyses about how the US has badly executed its exit from Afghanistan, but that is spilt milk under the bridge now. It is what comes next that is the interesting part, and later today at 14:00 CET (UTC + 2) our CIO Steen Jakobsen will take part in an interesting conversation together with the former US Ambassador, Hugo Llorens, to Afghanistan under Presidents Obama and Trump; sign up for the conversation here. This conversation will undoubtedly give some good answers and perspectives on what comes next for the world.

Many opinion pieces have already been written on what comes next and below is a small subset of pieces worth reading. The main points are that Europe is not seeing the US in the same light any longer as the US is finishing the “Nixon Doctrine” of leaving the world scene to more players reducing its military presence in especially Middle East in favour of more focus on the Asia Pacific region. In the EU there are already now discussions along two fault lines. One, the situation in Afghanistan will likely cause many more refugees coming to Europe adding another period of political discussions and disagreement inside the EU on how to handle the biggest refugee situation since the Syrian civil war. Two, Europe has to be more self-reliant militarily and focus on its own continent instead of engaging in never-ending nation building.

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%.

For investors that means that the defence sector has the potential to become an area with considerable growth. In these times of ESG focus we know it is not politically correct to highlight defence contractors, but some investors put less emphasis on ESG and the US military doctrine that started under Nixon has come full circle creating a different future for Europe and defence contractors as spending will likely go up. The list below highlights the 25 defence contractors that provide the most pure expression of European defence spending going up. To enter the list a company has to have more than 50% of its revenue coming from defence, but we have made two exceptions in terms of Airbus and Rolls-Royce as these two companies are in the top 10 in terms of European defence contractor revenue. We have also aimed at getting a tilt towards European defence contractors as we believe they will benefit more than American contractors in the new world of a more nationalistic agenda.

The defence sector had some good years between 2017-2019 under the Trump agenda but the pandemic has lifted global equities through growth and technology stocks to an extent where defence stocks have underperformed. The list on an equal-weighted basis (monthly rebalanced) has generated 88% total return over the past five years compared to 99% for the MSCI World. In many ways military spending is planned many years in advance providing great clarity of future growth for defence contractors.

Key risks for investors investing in defence stocks are the growing importance of ESG which could lead to a bigger valuation discount over time despite the potential growth opportunities. Lack of cohesion in Europe might lead to a slower path towards 1.6% or 2% military spending of GDP lowering the expected returns of defence stocks. An economic recession may slow down military spending as welfare benefits will be prioritized.

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