Geopolitical risk and the returns and volatility of global defense companies: A new race to arms?
The end of the Cold War in 1991 was met with jubilation. No longer did the world have to live in the shadow of fear that a large-scale conflict would break out between the USA and the Soviet Union. Geopolitical risk, it appeared, had receded. Governments responded to this new outlook with large-scale cuts to defence budgets. This reduction of defence spending was called the “peace dividend”.
Those days, however, are long gone. Instead, there is a growing sense of geopolitical risk, from the ongoing war in Ukraine to growing tensions in the South China Sea. Both geopolitical risk and defence budgets are back on the rise. From Europe to Asia, new, big spending packages have been announced, while national defence strategies have been rewritten.
As a result, it may be opportune for investors to consider their exposure to defence.
Structural shift to higher spending in Europe
One particular area of focus is European NATO members. The declines in European defence spending post-Cold War resulted in many European NATO members falling short of the 2% of GDP defence spending target set by the alliance. These cuts have left European inventories troublingly low. European nations have alarmingly less tanks, aircraft, combat ships, and submarines compared to 1992, immediately after the Cold War ended.
Following the 2022 invasion of Ukraine, the need to address this has become apparent to governments across the continent. Germany has announced a €100 billion spending package, equivalent to double the annual defence budget, to jumpstart the modernisation of its military. Meanwhile, Poland has committed itself to spending over 4% of GDP on defence.
The key beneficiaries of this uptick in spending may be the big European defence firms such as Rheinmetall, Leonardo, and BAE Systems.
Geopolitical hedge
But defence exposure may have appeal beyond expected growth. It can also serve as a hedge in a world vulnerable to “geopolitical shocks”.
Defence sector firms typically see price rises following a “geopolitical shock”. This is well known but we can see it documented in an article from the International Review of Financial Analysis, titled ‘Geopolitical risk and the returns and volatility of global defence companies’. The paper looked at the returns of 36 defence companies and their co-movement with the Geopolitical Risk (GPR) Index of Caldara and Iacoviello. It was noted that while returns of defence companies were rather detached from GPR before the Russian invasion of Ukraine, they became heavily correlated in the period from February to early April 2022 as conflict broke out.[1]
So, while investors often hold safe-haven assets such as gold as a hedge against such “shocks” in a multi-asset portfolio, we can also point to defence stocks as playing a similar role. Just as certain events lead to a “flight-to-safety” in the form of buying safe-haven assets, we can call the buying of defence stocks a “flight-to-arms”.
But what about ESG?
The outbreak of war in Ukraine prompted a re-evaluation of the automatic exclusion of defence sector stocks from investment portfolios on an ESG basis. Within a month of the conflict’s onset, Swedish bank SEB announced a significant policy reversal, permitting some of its funds to hold defence companies—a stark departure from its position less than a year prior.
Moreover, recent data from Morningstar indicates a shifting tide, with growing acceptance of defence stocks in ESG-labelled funds. By the end of the third quarter of 2023, over 1200 ESG funds included stocks from the Aerospace & Defense sector—a 25% increase from March 2022. Surprisingly, a YouGov poll cited by analysts from Citi Group showed that defence stocks faced less negativity from an ESG perspective compared to sectors traditionally considered less in tension with ESG principles, such as luxury fashion, banking, and media.
The European Union’s recognition of the pivotal role played by Europe’s defence sector in safeguarding the continent’s security further underscores the changing sentiment. The recently announced European Defense Industrial Strategy emphasises the necessity of financing the rebuild of Europe’s defence sector and supply chains, hinting at a potential momentum towards greater acceptance of defence stocks.
Using a NATO+ screen for responsible exposure
One approach adopted by the EQM Future of Defence Index involves employing two distinct screens, which is tracked by the Future of Defence UCITS ETF (NATO). Firstly, a standard ESG-type screen is used to exclude firms not compliant with the United Nations Global Compact (UNGC) principles and Organisation for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises, thus addressing risks related to labour rights, human rights, taxation, and corruption practices.
More uniquely, though, the index employs its NATO screen. Companies considered for addition to the index must be headquartered in NATO and NATO+ countries. Part of the reason for this screen is to provide exposure to the expected growth of NATO defence spending, particularly among European NATO members. But the screens also attempt to provide risk mitigation in the same way classic ESG screens do. Chiefly, by ensuring NATO and NATO+ headquartered firms are included, meaning the likelihood of exposure to geopolitically irresponsible actors is reduced. With this screen, the index aims to avoid exposure to the weapons suppliers of nations that may act in a hostile manner to the USA or NATO-aligned European nations.
The other consideration is that NATO’s rationale as a military alliance is defensive. That is, to prevent the resumption of large-scale war on the continent and safeguard European members from invasion through collective alliance.
