Turning Ploughshares Back into Swords

A New Target

On Tuesday last week (23 April), during a visit to Poland, Prime Minister Sunak announced that the UK would raise expenditure on defence to a new target threshold of 2.5 percent of GDP per annum by 2020. UK defence expenditure is currently running at 2.27 percent per annum, so the uplift equates to an additional 0.23 percent of GDP.

That means by my calculations that, in real terms, the UK defence outlay will rise from the planned budget for 2024-25 of £51.7 billion (according to the House of Commons Library) by around £5.23 billion to something like £56.9 billionⁱ. A cumulative figure of £75 billion in increased spending over five years has been widely touted in the media – but this writer cannot work out where that number comes from. The actual uplift is likely to be half that figure.

My first observation is that that is not really a very significant increase given the challenge of putting our armed forces on a “war footing” (Mr Sunak’s words, not mine). As the prime minister said: “It is imperative that we defend our country, our interests and our values”. I wrote a piece in these pages in early February entitled Why Britain Must Rearm citing the need for more manpower and more high-tech (and expensive) military kit. And the clamour for more military expenditure has only grown louder in the last three months. An increase of £5-6 billion is small beer as compared to the increase in the bill for state retirement pensions and incapacity benefits. And it is nothing as compared with the cost of Mr Sunak’s pandemic furlough scheme of 2020-22 which came in at around £70 billion.

My second observation is that it may very well not happen. Mr Sunak is very unlikely to be prime minister by the end of the year and Labour has not endorsed the proposal.

That said, I quoted Richard (Lord) Dannett, a former head of the British Army, last week to the effect that Labour will have to go along with an increase in defence expenditure of at least this order of magnitude, if not bigger. Almost all of our NATO allies will be increasing defence expenditure over the next five years – and if Mr Trump gets in the pressure to do so from Washington will become even more intense. A poll out on Tuesday (30 April) conducted by Savanta for the Daily Telegraph revealed that nearly half of Labour voters want their party to match the recent Tory pledge to raise defence spending to 2.5 per cent of GDP by 2030. It is therefore reasonable to suppose that even under a Labour government the defence budget will have to rise by around ten percent in real terms.

If that is the case then two questions arise for investors. The first is: How will the government finance this uplift? And the second question is, naturally: Who will benefit?

Financing The Sword

Mr Sunak implied that the increase in defence expenditure could be paid for by cutting the bloated work-from-home civil service – but the details of how he would do this are sparse, and it is not clear how many civil servants would have to be let go to save the additional £6 billion or so required per year.

In times of war, or imminent war, governments adopt a “whatever it takes” approach to finance additional military expenditure. Famously, income tax was introduced by Pitt the Younger in 1799 as a “temporary” measure to finance the wars against Napoleonic France. It was later repealed but then re-introduced by Robert Peel in 1846.

Most wars, however, are financed by large-scale additional borrowing. By the end of the Napoleonic Wars in 1815 the debt of the British state was around 200 percent of GDP. Similarly, the national debt-to-GDP ratio was 186 percent at the end of World War One and 259 percent just after World War Two. But our current debt-to-GDP ratio is already just under 100 percent before we even think about financing a future war. The gilt markets might resist a sudden borrowing spree – just as they resisted the Truss-Kwarteng kamikaze mini-budget.

During all those historic conflicts about half of government spending was dedicated to the military – but of course they were fought before the advent of the National Health Service and the welfare state. When I was born in the late 1950s at the fag-end of the British Empire we were still spending 8-10 percent of GDP on defence; and even at the time of the Falklands War in 1982, under Mrs. Thatcher, we were spending 4.5 percent of GDP. That makes the 2.5 percent target look unambitious.

Given that the tax-take as a proportion of GDP is nearing a 70-year high, voters would not take kindly to a further increase in taxes to pay for increased defence expenditure. That means that the only way forward is to find the money by cutting something else. The problem is that the NHS is considered sacrosanct in Britain and any government that cut its budget in real terms would incur outrage. That essentially leaves the benefits bill and state retirement pensions. It is pretty clear that the “triple lock” on state pensions is unsustainable.

It is significant that the Chancellor, Jeremy Hunt, made no mention of an increase in defence expenditure in his Spring Budget of 15 March. If he had done so he would have been obliged to explain how it would be financed. Mr Sunak’s proposal appears to have been an afterthought brought about by pressure from senior Tory MPs (including Penny Mordaunt, the Leader of the House of Commons) and the defence establishment.

Likely Beneficiaries

Mr Sunak’s announcement was accompanied by a “joint statement” issued by HM Treasury and the Investment Association, the trade body for Britain’s still very significant fund management industry. Members of the Investment Association have combined assets under management of £8.8 trillion, according to its website.

The statement averred that investing in Britain’s defence industry is both good news for the country and for investors. In the past, some fund managers have been shy about buying the shares of companies which manufacture arms because it offended their ESG (environmental, social and governance) agendas. But there is some evidence that the grip of the ESG zealots is weakening. It is now widely understood that, much as we prefer peace to war, if we are to be able to defend ourselves against any potential foreign aggression we shall need to invest in weapons. The statement concluded that:

“Investing in good, high-quality, well-run defence companies is compatible with ESG considerations”.

In practice, all major defence contractors are global in scope with extensive cross-border operations. BAE Systems, Britain’s leading defence contractor, is pre-eminent. It manufactures fighter jets, including the Eurofighter Typhoon, submarines, tanks and even provides software to promote cyber-security. Its order book amounted to £37.7 billion of contracts last year. Some 40 percent of its sales go to the USA. BAE Systems’ share price is up over 15 percent this year.

The other major British player in the sector is Rolls-Royce. This is a key strategic British company which is a world leader in aero-engines, marine propulsion and nuclear power. Under the leadership of CEO Tufan Erginbilgic, who took the reins at the beginning of last year, the company’s share price has surged by around 170. Like BAE Systems, Rolls-Royce has a bulging order book. The company reported net profits of £2.4 billion last year. RR even produces the engines for the US Air Force’s fleet of B-52 bombers.

Then there is Babcock which services, amongst other things, the UK’s fleet of nuclear powered submarines. Other companies which provide key services to the Ministry of Defence include Compass, the catering to cleaning outsourcer which feeds much of the British Army, and Chemring which provides heat-shields for aircraft and ships.

And don’t forget the vital minnows such as Colchester-based Concurrent Technologies, which provides equipment which enables battle tanks to communicate with one another. Founded in 1985, the company originally supplied software to the telecoms sector. But these days 70 percent of its revenues comes from the defence sector. Concurrent supplies the UK and the US defence ministries as well as the governments of India, Malaysia and South Korea.

Overseas companies in friendly nations which will also benefit from increased UK and European defence expenditure include France’s Thales which is considered a leader in the defence against cyber-warfare. Thales bought out Cobham’s aerospace communications subsidiary in an £850 million deal last summer. Amongst the USA’s defence giants Lockheed Martin stands out as dominant. Also, Italy’s Leonardo (formerly Finmeccanica) is impressive.

It is a matter of regret that Cobham which provided in-flight refuelling equipment for RAF Typhoons was allowed to fall prey to the private equity firm Advent International for £4 billion in 2019. The Johnson government failed to invoke the National Investment and Securities Act which could have blocked the deal.

There is a small number of investment funds which specifically allocate to the defence sector. One is the HAN Future of Defence ETF which invests in about 50 defence contractors within NATO countries as well as Australia, New Zealand, Japan, Israel and South Korea. Launched in July last year, it has £266 million of assets. BAE Systems and Thales rank amongst its top ten holdings, as well as German equipment supplier Rheinmetall and the French aircraft equipment supplier Safran. Rheinmetall’s share price has soared this year, as has those of Bavarian supplier Renk, which makes components for battle tanks.

Other publicly available investment funds which have significant exposures to the defence sector include Ninety One UK Special Situations, JP Morgan Claverhouse and Law Debenture. Goldman Sachs’ basket of European defence stocks has risen by over 40 percent this year. The only other European sector that has powered ahead similarly of late is luxury goods (of which LVMH in particular).

Expensive Projects

Last weekend it was reported that Britain plans to develop its own hypersonic missile by the end of this decade. China, Russia and the USA already possess such missiles which can travel at up to five times the speed of sound or 4,000 miles per hour. These weapons are designed to hit their targets before the enemy even knows that they are coming. US President Joe Biden has described these weapons, which have already been used by the Russians against targets in Ukraine, as being “almost impossible to stop”.

This project is evidently at a very early stage. It is not yet known whether Britain’s hypersonic missiles would be launched from land, sea or air. Reportedly, since late last year, the MoD has working with about 80 private companies to come up with designs. The Hypersonic Technologies And Capability Framework Agreement was signed last December. Some signatories are working on a scramjet engine which uses compressed air moving at supersonic speeds to combust either liquid or solid fuel. One design involves a glide vehicle whereby the engines cut out and the missile glides down to its target.

Most hi-tech defence projects such as the development of new fighter jets are conducted in partnership with two or more friendly nations. For example, the Eurofighter Typhoon was developed by a European consortium which included BAE Systems, Airbus and Leonardo. The accession of Sweden and Finland to the NATO alliance now means that British defence contractors will be able to collaborate with some of the world-class defence companies in those two countries. Sweden’s SAAB is a case in point. With these two new Scandinavian members the focus has turned to the Baltic – described as a “NATO lake” but with two critical Russian naval bases in Saint Petersburg and Kaliningrad.

It is understood that once the UK has developed this technology we shall share it with our AUKUS partners – the USA and Australia – as part of a technology sharing agreement which embraces AI, quantum computing, hypersonics and undersea drones. The initial price tag on the current project is thought to be £1 billion – but it is easy to imagine that it could balloon to many times that figure.

There is also much debate about the future direction of the Royal Navy. The Chinese launched this week a huge new aircraft carrier, the 80,000-tonne Fujian, which could change the balance of power on the high seas. But there is a controversy about the effectiveness of aircraft carriers. Some military strategists believe that they are an essential way to project power when operating far from home; others believe that they are vulnerable targets which drain resources from elsewhere.

Britain has two new aircraft carriers, HMS Queen Elizabeth and HMS Prince of Wales – which cost ££3.5 billion each – but they have been beset by technical and mechanical problems since they were launched. They do not have sufficient combat aircraft nor are there enough supply and escort ships to support them. There was talk earlier this year of either mothballing or even selling one of them (possibly to Australia).

According to naval expert Tom Sharpe, the elite club of nations which operate aircraft carriers consists of the USA (with 11), China (2, and one more on trials this week), Britain (2), India (2), Japan (2), Italy (2), Russia (1), France (1), Thailand (1 – but it can only carry helicopters), Spain (1), Turkey (1) and South Korea (2 planned). The US Navy is by far and away the most potent navy in the world – the Chinese navy has more vessels, but the Americans command greater tonnage and firepower. For now, the USS Gerald R Ford, which can carry 80 aircraft, is the biggest and deadliest carrier ever. The two British carriers accommodate 40 aircraft. Tom Sharpe believes that there is only one non-American aircraft carrier which comes close to this behemoth and that is France’s Charles de Gaulle.

Only the US carriers, the Charles de Gaulle and now the Fujian have catapults which can hurl fully-fuelled and armed fighter jets into the air. Jetties have already been constructed to accommodate the Fujian in Djibouti and Cambodia. But the Chinese aim to have six carriers by 2035. A global naval arms race is already underway.

The other pressing need, especially in view of the unsuccessful Iranian drone attack on Israel on 13 April, is for an “Iron Dome” missile defence shield. Former US National Security Advisor General HR McMaster was asked by Andrew Marr on LBC yesterday whether the UK should have an Iron Dome system. He replied: “I think that every country is going to have to develop these kinds of defences and long-range missiles…I think it’s quite urgent for the United Kingdom, the United States, for all nations to invest more in defence.”

Clearly, pressure to increase defence spending beyond the 2.5 percent of GDP threshold will only increase over time. Poland, which is quite literally on the front line, is now spending four percent of its GDP on defence. General McMaster believes that Britain should follow suit with four percent. The question is where the money will come from.

Listed companies cited in this article which merit analysis:

• BAE Systems PLC (LON:BA)
• Rolls-Royce Holdings PLC (LON:RR)
• Babcock International Group PLC (LON:BAB)
• Compass Group PLC (LON:CPG)
• Chemring Group PLC (LON:CHG)
• Concurrent Technologies PLC (AIM:CNC)
• Thales SA (EPA:HO)
• Lockheed Martin Corporation (NYSE:LM)
• Leonardo SpA (BIT:LDA)
• Rheinmetall AG (ETR:RHM)
• Safran SA (EPA:SAF)
• Renk Group AG (VIE:RENK)
• SAAB AB (STO:SAAB-B)

Investment Funds

• HAN Future of Defence ETF (LON:NATP)
• Ninety One UK Special Situations Fund (ISIN: GB0033063636)
• JP Morgan Claverhouse Investment Trust PLC (SEDOL:0342218)
• Law Debenture Investment Trust (LON: LWDB)

i^ These figures are from my spreadsheet which I am happy to share with readers. Any errors are my own.