Is the ‚Defence‘ Sector an Investment Case?

Much of our understanding of war begins with Sun Tsu’s classic work “The Art of War”¹²³, whose intellectual inheritance leads us to discuss armed conflicts in political, psychological, tactical, technical and ethical terms. Here, however, we will set those considerations aside and instead ask whether there is an investment case for defence.

That framing may sound cynical, but that is not the intention. The goal is to shed light on an aspect that tend to be overseen during emotionally charged debates surrounding armed conflicts. To focus on one aspect is not to deny the others exist, but to examine it more fully, just as we would if we were setting aside economic factors to look at war solely from an ethical standpoint.

Before the outbreak of an armed conflict

The mere possibility of war can motivate a nation's government to allocate state funding for the development of defence technologies over extended periods. Such research carried out by government bodies or private companies may result in outcomes and innovations that are unrelated to weapons systems. These then serve as stimuli for economic effects outside the defence economy. In turn, this may create investment opportunities.

Even when armed conflicts exist in specific regions, the potential that they may escalate is enough to trigger a reorientation of domestic capital markets outside those regions. This initially affects commodity markets (particularly the energy sector), foreign exchange markets, bond markets, and equity markets. Companies whose share prices have long been considered unattractive are suddenly in the spotlight. We see this effect plainly in our own era, with defence sector companies' economic valuations, as reflected in stock market indices, showing strong growth for some time now. This orientation has significant effects across the financial world.

In the world of the stock market, Exchange Traded Funds that invest in defence sector stocks are thus becoming increasingly popular.

There is also a rapidly expanding defence start-up sector which opens the doors for investors looking to get in on the ground floor.

Venture Capital companies have begun specialising in defence technology.

Recently, there have been efforts in the banking sector to establish public institutions that focus on defence financing. Such measures will further boost the sector.

We are also seeing capital flowing out of long-standing favourites (e.g. renewable energy) and into the defence sector.

Investors are not driven by fear of war or patriotism, but by the expectation that they will benefit from rising share prices in anticipation of armed conflict. It is essential here to recognise that portfolio managers are under a professional obligation to generate profits.

Therefore, sustained, strong trends towards investment in the defence sector in the capital markets will see investor’s investments increase in value. Should armed conflicts subsequently break out, this trend may continue for some time.

During an armed conflict

War economies are usually characterised by governments taking increasing control of national economies. They typically direct the reallocation of resources towards the rapidly expanding defence industry, at the expense of consumer goods production.

Economic figures for a country embroiled in an armed conflict are likely to show strong GDP growth, as a great deal of capital flows into the defence industry. The numbers create the impression that the economy is expanding strongly. However, the GDP statistics do not distinguish between goods produced for combat operations, which are likely to be destroyed soon (e.g. tanks), and goods that provide societal benefits over many years (e.g. combine harvesters). In fact, during these times, the national economy may be slowly bleeding.

During wartime, wages also rise across the board as people are recruited into the armed forces, and companies in all sectors are forced to compete for staff. The defence industry attracts human resources, people who previously found it difficult to enter the labour market or who were not in work at all.

These trends are exacerbated by young men of military age leaving the country out of fear, and by citizens losing their lives or suffering serious injuries because of hostilities.

Thus, while a government may boast about falling unemployment, behind this lies a depletion of human resources. Furthermore, a decline in production and exports and a fall in imports can cause a growing shortage of consumer goods, which in turn fuels inflation.

Tax revenue falls. Purchasing power declines.

Governments setting prices for consumer goods does nothing to alleviate the shortage.

The transfer of assets abroad is restricted or prohibited.

The central bank’s assets dwindle, assets held abroad may be inaccessible, and public debt rises.

Economies that are not involved directly in war also experience contractions due to the disruption of international trade.

Although investments in the defence sector may initially have yielded capital gains, that trend will ultimately reverse.

Can a nation state make a profit?

Even if a country has 'won' a war, it is highly unlikely that it can derive any significant economic benefit from the territories it has conquered. The first reason for this is that since the time of the First World War, economic systems which rely on the exploitation of occupied foreign territories, have ceased to be profitable. Ian Morris aptly coined the term 'The FiveHundred Years' War' to describe colonialism. There are still remnants of the colonial system today, but their days are numbered. While the reasons given for abandoning the old model may be legal or humanitarian, such arguments were previously also used to justify conquests. They do not hold water. The real reason is the lack of economic feasibility.

The second reason why conquests are economically pointless today is modern warfare. Following the outbreak of the First World War, wars of attrition became commonplace, rendering vast territories economically useless or even permanently uninhabitable. If even a nation state cannot identify the economic opportunities arising from conquests, then its citizens/investors will not benefit from them.

The third reason that may stop an aggressor from looking for conquest is the chance of later asymmetric warfare. The prospect of being exposed to constant, unpredictable attacks after a 'victory' is a strong argument against occupation.

After an armed conflict

In his 1940 essay 'How to Pay for the War' John Maynard Keynes outlined the impact of returning to peacetime on the economy. He used the term 'financial repression' to describe what was and is inevitable:

Following the end of an armed conflict, the government cancels or renegotiates contracts that had sustained the defence industry. This leads to a decline in turnover, and the financially weakened state attempts to tax 'excess profits'. Consequently investors in the defence sector incur losses⁴⁵.

Lowering interest rates on government debt and increasing income taxes while allowing inflation to rise, combined with restrictions on access to other currency areas, enables governments to reduce their financial burden. This affects pension funds, banks and insurance companies alike. They and their clients cannot escape the vice-like grip. Savers, pensioners, and of course investors become gradually dispossessed.

The defence industry tries its utmost not to disappear and may survive by merging with and shaping other companies, for instance in the aircraft manufacturing sector. In his farewell address in 1961, President Eisenhower warned against the dynamics of the resulting industrial structures, famously labelling it the 'military-industrial complex'.

The demographic trends that follow the end of an armed conflict are the result of a combination of diverse factors. Conscription, wartime mortality and post-war fertility interact with each other, making it difficult to draw general conclusions.

What does all this mean for the 'investment case'?

From an economic perspective, profits can only be made in the period leading up to an armed conflict, provided investors can sell in time and find a way to stash their money away. After that, investors find themselves between a rock and a hard place.

The conclusion is that the investment case for the “defence sector” is not convincing.

In 1795, Immanuel Kant wrote his treatise “Perpetual Peace”. In Section 3 of the First Supplement he did not rely on ethical arguments against armed conflict. Instead, he argued that economic spirit (“Handelsgeist”) combined with international law is the adequate promotor of prosperity.

Kant’s approach is closer to the truth than the instincts of many modern investors, who latch onto an attractive-seeming trend without giving much thought to the long-term consequences to human life or their bottom line.