‘Abrupt reversal of the peace’: Geopolitical tensions reshaping defence investment

An escalation in geopolitical tensions and in some cases outright conflict, an abrupt reversal to decades of uneasy peace between the great powers, is not only fundamentally re-shaping policy decisions but also the investment landscape, a new research paper from the Franklin Templeton Institute (FTI) argues.

Global defence spending hit its ninth successive annual record in 2023, peaking at $2.4 trillion, fueled by a confluence of increased military conflict between states and rapidly emerging innovations in defence technologies. As a result, defence-aligned assets have presented investors with a growing diversity of opportunities for capital appreciation, both directly and indirectly.

“The abrupt reversal of the ‘peace dividend’ has brought us back to the era of large-scale kinetic warfare and urban combat – scenarios not seen in Europe since World War II,” writes Kim Catechis, Investment Strategist at the Franklin Templeton Institute and lead author of the Deep waves: the paradoxical trinity of defence paper.

“This shock has driven a rapid acceleration in defence investment, from modernising equipment and training to recalibrating supply chains and boosting domestic industrial production capacity.”

Defence stocks have rallied to new highs in recent years (with the S&P Aerospace & Defense Select Industry Index up 16.5% over the three years to the end of November 2024), as conflict heats up around the world.

Among the top performing defence stocks include law enforcement and military tech developer Axon Enterprises, which has grown 150.4% in the year to date, while aerospace engineering firm Howmet rose 118.7%, featured among the top 10 performers of the S&P 500 Index.

As FTI noted, the last time a defence stock was among the top 10 was in the 1980s.

“These new developments have reopened an investment opportunity in the defence sector.”

In Europe, the Russian war on Ukraine has compelled the continent and the broader global community to build “a credible deterrent supported by robust logistics and manufacturing”.

This includes, for instance, the European Commission’s launch of its first-ever European Defence Industrial Strategy (EDIS) to strengthen the EU’s defence readiness and industrial base, as well as a commitment from European NATO members to invest more than US$400 billion annually for at least the next decade, according to NATO data.

Over the next six years, NATO spending alone is estimated to reach US$8.9 trillion, more than one-third of which (US$3.2 trillion) will be contributed by European NATO members and Canada, according to figures from the IMF, NATO, and FTI.

“Unless the various belligerent powers around the world can find accommodation, this industry is set for a multi-year trend of high expenditure,” Catechis wrote.

Opportunities for investors

As part of his FTI paper, Catechis underlined the three formative trends shaping defence investment:

• Magnitude of investment: Many countries are rethinking their defence architectures, notes Catechis, resulting in a new set of priorities and requirements to suit modern warfare. “It seems prudent to assume that the amount of capital investment will be significantly higher than currently expected.”
• Longevity of the theme: For Catechis, the longevity of this investment theme appears underappreciated. “The transformation of military capabilities required for modern asymmetric warfare ensures that this investment theme has a decades-long runway,” he said.
• Diverse opportunities: The evolution of defence has expanded investible opportunities, which encompass both traditional armaments and emerging technologies such as low-Earth orbit (LEO) satellite communications, AI-driven data systems and unmanned vehicles for surveillance and reconnaissance. These innovations, often dual-use in nature, are expected to drive productivity in civilian sectors over time.

Catechis also highlighted the growing fortunes of non-traditional players like Anduril and Shield AI, “which are disrupting the defence sector by focusing on high-speed, multi-domain coordination”.

“These companies, much like SpaceX and Palantir before them, are rapidly achieving unicorn status, reflecting their impact on the sector.”

Data suggests approximately 850 funding rounds for such companies in the United States alone since 2018, signalling growing investor interest in these niches.

For FTI, asset owners and professional investors can achieve exposure to some of the highest-priority defence spending by investing in dual-use technologies which – noting the rise of asymmetric-style warfare – reflect the real transformation of the new defence industry.

They include cybersecurity, low-Earth-orbit satellite communications, and unmanned drones for air, surface and underwater surveillance, reconnaissance and mine clearing, to name but a few.

As well, FTI sees high potential in the fast-growing, higher-value segment of the sector, singling out other ‘dual-use’ technologies, including communications resilience, innovative unmanned vehicles, and high-specification missile defence.

These dual-use tech companies (those that do not produce weaponry but will likely benefit from the enor­mous waves of military-focused investment over the next decades) have also drawn the eye of ESG-conscious investors, who otherwise may regard military stocks as being at odds with the fundamental principle of ‘do no harm’, Catechis said.

“All asset owners and professional investors can achieve exposure to some of the highest-priority defence spending by investing in the dual-use technologies which reflect the real transformation of the ‘new’ defence industry,” he said.