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NATO defence spending to rise, time to invest in the defence sector?

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NATO defence spending to rise, time to invest in the defence sector?

What is NATO?

NATO stands for North Atlantic Treaty Organisation and is a primarily military alliance of several countries. NATO was created in 1949 as a western alliance to counter the Soviet Union. It currently stands at 28 countries strong, with the possibility of other European countries joining in the future. One of the main concepts of NATO is that an attack on any member is considered an attack on them all, thereby using collective defence as a deterrent.

Full list of NATO Members

ALBANIA (2009)

GREECE (1952)

PORTUGAL (1949)

BELGIUM (1949)

HUNGARY (1999)

ROMANIA (2004)

BULGARIA (2004)

ICELAND (1949)

SLOVAKIA (2004)

CANADA (1949)

ITALY (1949)

SLOVENIA (2004)

CROATIA (2009)

LATVIA (2004)

SPAIN (1982)

CZECH REPUBLIC (1999)

LITHUANIA (2004)

TURKEY (1952)

DENMARK (1949)

LUXEMBOURG (1949)

UNITED KINGDOM (1949)

ESTONIA (2004)

NETHERLANDS (1949)

UNITED STATES (1949)

FRANCE (1949)

NORWAY (1949)

 

GERMANY (1955)

POLAND (1999)

 

USA’s criticism of NATO  

One key condition of the NATO agreement is that every country should spend at least 2% of its domestic GDP on defence. The USA is way above this minimum at around 3.6%. Donald Trump has downplayed the importance of NATO and has complained that most members are not pulling their weight. Only Greece (2.4%), Poland (2.2%), Estonia and the UK (2%) are currently above the 2% minimum. Other large economies such as France (1.8%), Germany (1.2%) and Italy (1%) are clearly below the minimum, simply due to choice, or economic struggle.

German Reluctance to Lead Europe

Germany’s history during the 20th century has transformed it into something of a gentle giant. It is the largest economy and the most populous country in Europe and the fourth biggest economy in the world. However Germany is stuck between a rock and a hard place; if they didn’t have their history looming over them they would probably have a far more aggressive stance on the world stage, similar to Japan. However, given their history of conflict, their population is reluctant to support a higher level of military involvement.

Germany will have to lead Europe by default, as no other country in Europe is willing, or able to. While other major European countries are struggling with their economic outlook and levels of debt, Germany is currently running a surplus.

Germany has benefited from its peace dividend for decades; by investing funds into other sectors, they have in turn, boosted their economy. It makes no sense to invest large amounts of public money into a military you don’t need, and instead makes very good sense to invest in sectors such as infrastructure, education and healthcare. However, building up a military takes time and the USA has grown tired of paying the large bill mostly by themselves. Germany’s excuse for not meeting the expected minimum 2% in defence, grows more insignificant to their allies over time. Countries such as Poland for example, would likely welcome a more powerful German military to counter Russia’s military build-up.         

Russia has already started to redraw Europe’s borders by force and is modernising their armed forces, which seems to have already started an arms race between them and the West. The annexation of Crimea has alarmed European nations, particularly the Baltic States (who are members of NATO). The perception of the west is that Russia is trying to regain control of some of the ex-Soviet territories it once ruled. It is not yet clear if Crimea will be the only land grab, Eastern Ukraine could be next on the list and even greater annexations could follow if left unchecked by the west.       

During a recent campaign, German Chancellor Angela Merkel has reiterated the importance of all NATO members committing 2% of their GDP to defence to strengthen the organisation, and has confirmed that Germany will boost its defence spending.

USA – the World Defence Leader to Increase Spending

The largest defence budget in the world is held by the United States of America, which currently stands at about $650 billion or 3.6% of its GDP. Even though this greatly surpasses the 2% NATO requirement, President Donald Trump has recently made remarks about upgrading and extending Americas offensive and defensive military capabilities.

The Defence Industry

There are several ways to invest in defence, but we will cover only a few options from an educational perspective and point out some options within the defence sector. These are not recommendations to buy or sell but a starting point for you to review the industry and then then for you to decide where to invest in.

BAE Systems plc (BA.L)

BAE Systems is Europe’s largest defence company and number three in the world. This defence company is based in the UK but has substantial operations in continental Europe and the USA. This share trades in GBP (which has dropped significantly since BREXIT) and currently has a dividend of 3.6%   

AIRBUS (AIR.DE)

Airbus is a civil and military company focused mainly on aircrafts. Similar to Boeing in the US, Airbus will always give you a mixed result due to its civil division. The civil aircraft, A400 has had many problems in the past, but hopefully these prolonged issues will not continue to overshadow Airbus’s military sector in the future.

RHEINMETALL AG (RHM.DE)

Rheinmetall AG is an international automotive parts supplier and military technology group, based in Düsseldorf. The company has recently won an ammunition order for the F-35 aircraft and on the 17th February 2017 announced that it has started a memorandum of understanding to cooperate globally on defence technology with US defence contractor Raytheon, which is known for its patriot missile defence system.

Rheinmetall has recently issued positive earnings numbers and could well be on a positive trend. This defence company is widely known in the industry for producing the Leopard 2 main battle tank. Tank orders may become more relevant as Germany will soon start to increase its domestic defence budget, to counter Russia’s army modernisation which includes its modern tank the T-14 Armata.

Looking at the chart provided you will see that Rheinmetall AG has underperformed in comparison to other selected listings. It is for you to decide if this means it is an underperforming defence share or if it is still to rise. Past performance is definitely not a guarantee for future gains but should still be considered.  

US Defence Companies and ETFs

 

Major US Navy Ship Building Companies

President Donald Trump has vowed to increase the number of US ships from 272 to 350. It is not yet clear which type of ships he is planning to build, but during one speech he appealed to increase the US aircraft carrier numbers from 10 to 12.

Below are two defence companies likely to gain if Navy ship numbers do increase. The ship types are also listed so that you can effectively turn news into profit once an official announcement is made, by focusing on the relevant producer once its known which type of ships are going to be build.

Huntington Ingalls Industries Inc. (HII)

This defence company has the Newport News Shipbuilding Shipyard which produces the Ford Class CVN and the Virginia Class SNN. The other shipyard is the Ingalls/Avondale which produces LPD 17 Class, DDG 51 Class and the LHA 6 Class.

General Dynamics Corporation (GD)

General Dynamics is the fifth largest defence company in the world and has major exposure to the US ship building sector. They produce the DDG 51 Class and the DDG 1000 at their Bath Iron Works Shipyard. The Virginia Class SSN is also build at the Electric Boat Shipyard. And finally the NASSCO Shipyard builds the RO-RO Strategic Sealift Ships, TAKE, Auxiliary Ships and MLP.

Investing in the general defence sector

Below are two ETFs, Exchange Traded Funds, they could be an option to trade in if you would like to have a wide range of US Defence company exposure.  

SPDR S&P Aerospace & Defence ETF: (XAR)

Top 10 Holdings (43% of Total Assets)

   
 

   
Company

Symbol

% Assets

Arconic Inc

ARNC

5.08%

Huntington Ingalls Industries Inc

HII

4.63%

BWX Technologies Inc

BWXT

4.58%

Boeing Co

BA

4.43%

General Dynamics Corp

GD

4.16%

Taser International Inc

TASR

4.14%

L3 Technologies Inc

LLL

4.09%

B/E Aerospace Inc

BEAV

4.07%

Raytheon Co

RTN

4.05%

Orbital ATK Inc

OA

4.04%

 

 IShares Dow Jones U.S. Aerospace & Defence Index Fund: (ITA)

Top 10 Holdings (58% of Total Assets)    
     
Company Symbol % Assets
Boeing Co BA 10.01%
United Technologies Corp UTX 8.55%
Lockheed Martin Corp LMT 7.44%
General Dynamics Corp GD 6.88%
Raytheon Co RTN 6.18%
Northrop Grumman Corp NOC 5.96%
Arconic Inc ARNC 3.71%
L3 Technologies Inc LLL 3.29%
TransDigm Group Inc TDG 3.17%
Rockwell Collins Inc COL 3.15%

 

All mentioned Investments

This chart compares all mentioned investments and additionally compares these against the S&P500. You should always remember to check your investments against the average market rise or fall. Only then you are able to judge if you have over or under-performed in the market.

Conclusion

I am not able to predict the future but the likelihood that Europe and the USA will have to spend more money on defence is high. President Donald Trump does have a point that the USA cannot foot the entire bill (or large prepositions) for NATO alone. Another possibility is the formation of a European Army which again means more funds. The primary motivation may not even be America but Russia after annexing Crimea and therefore kick starting Europe’s self-preservation instinct.

 

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