The fall of the Berlin Wall in 1989 marked the symbolic end of the Cold War. But it was an economic not a military victory – a realisation in the Soviet Union that communism could never bring the same economic advancement as capitalism.
The following three decades witnessed the fastest pace of globalisation since the “hundred years’ peace” of 1815-1914 and the proclamation of a unipolar “new world order” led by the United States. It also began a 30-year bear market in European defence stocks.
But geopolitical events have now changed course which has significant yet underappreciated implications for investors.
Too much ‘butter’
Without its historic adversary – the Warsaw Pact was officially dissolved in 1991 – Nato suffered a crisis of identity, leading to the axing of defence budgets and an economic “peace dividend”.
From 1950 to 1989, the UK, France and Germany spent 5.5pc, 3.6pc and 3.2pc of GDP respectively on defence, compared to just 2.4pc, 2pc and 1.3pc since. In absolute terms, in 2022, British and French annual military spending was only slightly more (in 2021 dollar terms) as in 1989. Germany spent slightly less.
At the time of the Suez Crisis in 1956, the UK was spending 7.6pc of GDP on defence, accounting for 43pc of government spending (a similar ratio to Russia today).
Since then, spending on day-to-day public services (excluding armed forces) has increased from 18pc of GDP to over 35pc during Covid: 15 times the annual defence budget. Never had the UK spent so little on “guns” relative to “butter”.
Germany’s Kiel Institute has pointed out within its own country and across the whole of the G7 that there has been a “growing disconnect” between low military spending and high and rising geopolitical risk, concluding: “We live in dangerous times, but military budgets in the West have not responded to these developments.”
Russia and, more importantly, China never accepted American hegemony, seeing themselves as great powers, signing in 1997 a joint declaration to promote a “multi polar” world.
Encouraged by Europe’s reluctance to rearm and President Biden’s weak leadership, the “anti-hegemonic” alliance led by China, continues to grow, now including not only Russia, Iran, and North Korea, but also Brazil and South Africa.
Retired US army general and Hoover Institute Fellow HR McMaster recently noted: “The perception of weakness is provocative to this axis of aggressors.”
More ‘guns’ needed
The Russian invasion of Ukraine in 2022 has, along with American pressure for Europe to pay its fair share, been a watershed moment for the defence industry.
All European Nato countries now accept – though are not necessarily enthusiastically implementing – a 2pc of GDP floor on annual defence budgets. But Europe would need to spend 3.5pc of GDP on its military to match the US.
Equally important to the defence industry is how much of the budget is spent on hardware. The Nato average today is 30pc (up from just 10pc in 2014) but countries in the frontline such as Finland and Poland are currently spending 50pc on equipment, which is likely to be the trend elsewhere going forward.
Brussels is determined for European nations to procure at least half of its hardware within the EU.
The entire annual revenues of the quoted European defence industry last year (including the UK) were just $132bn (£106bn). If the $375bn annual spend of Nato European nations increases from 1.75pc to 3pc of GDP, and 50pc of this is spent on equipment exclusively sourced within Europe, then annual industry revenues will double.
After three decades of retrenchment, the biggest problem European defence companies currently have is ramping up manufacturing capabilities to meet demand. To encourage investment, governments are offering defence contractors longer contracts and better payment terms.
But with the Russian annual military budget now thought unofficially to be as high as $160bn (10pc of GDP), a UK defence industry executive told me recently: “Putin is on a war footing today, but we have problems getting planning permission.”
Over the last 30 years, Western Europe has effectively disarmed, with its number of tanks down 80pc, fighter aircraft down 60pc and a halving of naval ships and submarines.
Many European countries have already donated most of their ammunition and useful weapons to Ukraine. Nato is now recommending 30 days of battle inventory (previously five days), but the more urgent Ukrainian conflict has postponed Europe’s ability to rearm.
The nature of combat in Ukraine has demonstrated that the next war is always different, requiring new kit: tanks with 360-degree armour, given vulnerability to loitering munitions; mobile artillery as a more cost-effective solution than precision missiles, for example in defending against drone attacks.
German weaponsmith Rheinmetall, the global leader in the manufacture of Nato-standard artillery and tank shells, is the best performing stock in Europe so far this year.
More generally, space and submarines, where Britain’s biggest and most successful manufacturer BAE Systems is well-placed, are promising growth areas, since these are now the only truly stealth activities. Norway’s Kongsberg has an effective monopoly in next generation anti-ship missiles, the kind of which Taiwan might find useful.
Kurtosis: the risk of extreme events
It is too simplistic for investors to think about the new Cold War simply in terms of defence spending. War also has more profound economic consequences and wider investment implications, leading to greater risk of extreme events. Statisticians call this “excess kurtosis” or “fat tails” relative to a normalised bell-curve distribution.
In the unipolar post-Cold War world, investors’ prime concern was the economic cycle, which could be managed by central banks providing liquidity at moments of extreme stress, most notably in 2008 and 2020.
But central banks can’t resolve supply side problems, prevent deglobalisation, or fight geopolitical conflicts. This means investors must think about extreme “unpredictable” outcomes, structurally higher inflation, and higher volatility.
We are already witnessing a reshaping of the global economy. The generally low inflation of the post-Cold War era, which has allowed for historically low interest rates, has been facilitated by the deflationary impulse of Russian commodities and Chinese manufactured goods. This is now changing.
Eminent economist Charles Kindleberger wrote that “war both cuts off old connections in trade and finance and is likely to require the fashioning of the new”.
Russian crude oil now gets sold at a discount to India and China, who – since we have destroyed our own indigenous fossil fuel industry – often export it back to Europe as a refined product.
This disruption of optimal economic trade routes – deglobalisation – by geopolitics, as seen with the Houthi attacks on merchant vessels in the Red Sea, ironically requires more rather than fewer ships for longer voyages, particularly crude (see Norway’s Frontline) and product tankers (see Norway’s Hafnia and Denmark’s Torm).
The American and Chinese economies continue to ‘decouple’
Chinese exports to the US are now down 25pc from peak. China’s foreign direct investment has now turned negative, with Western corporations instead looking to “friend-shore” manufacturing to Malaysia, India, Vietnam, or Mexico instead.
The US government has provided $280bn in subsidies via its Chips Act to “re-shore” semiconductor manufacturing from Asia, while also seeking to prevent the export of high-performance semiconductors and manufacturing equipment to China. What is politically logical comes with economic cost.
The projection of geopolitical power is also changing the unipolar global financial system based around the hegemony of the US dollar.
There is currently $300bn of Russian financial assets frozen (mostly in Belgium’s Euroclear), which the US wants to give to Ukraine – but Europe, fearing retaliation, is resisting, instead considering using the accumulating interest as war reparations.
Russia has responded by freezing the assets of investors from “non-friendly” countries. This should be a shot across the bows for any UK investors in the Chinese stock market.
Equally, the “anti-hegemonic” alliance is highly incentivised to diversify their assets “outside” the Western banking system to avoid political default risk.
Chinese holdings of US Treasuries are now down to just $800bn (from $1.2 trillion at the peak in 2016). Gold – with a market value of $15 trillion – is the most liquid alternative as a store of value. The People’s Bank of China has emerged as its current biggest buyer.
The “Axis” powers must also “de-dollarise” their financial systems since transacting in the greenback results in the risk of accumulating assets which could be confiscated. It also incurs the risk of being frozen out of international trade by sanctions via the dollar-based SWIFT payments system.
The new Cold War increases the attractiveness of “outside” money in all its forms: cash, gold, crypto and, for the Axis, their own currencies.
Russia, Iran, and Venezuela have already adopted China’s CIPS payment system to evade sanctions. China continues to explore a jointly issued central bank digital currency (CBDC) and migrate its commodity transactions from US dollars to renminbi. However, the renminbi share of global transactions is currently less than 3pc.
But rather than pay its friends in an arguably over-valued currency that is not fully convertible and could therefore only buy reciprocal Chinese goods and services, China has instead allowed convertibility into gold, which if done at scale, would require it to further ramp up its gold purchases. But it is not clear whether China can really afford to fulfil its reserve currency ambitions.
America has enjoyed the “exorbitant privilege” of the greenback being the world’s reserve currency, whereby Middle Eastern “petrodollars” and subsequently Asian manufacturing trade surpluses were recycled back into its own assets, particularly government debt, which in turn kept its interest rates low and stimulated the global economy through demand for imports.
But as the British experience of the early 20th century demonstrated, this privilege can be forfeited.
America is already running unprecedented fiscal stimulus at a time of full employment. War increases demand for commodities, which is inflationary, particularly when their supply is not indigenous.
The economic history of war suggests that rather than risk losing geopolitical conflicts, central banks of nations at war will backstop government debt, resorting to the printing press. In fact, the green ink on the new paper currency was the Civil War origin of the dollar’s “greenback” nickname.
The inflationary nature of war and the attractiveness of “outside” money means that gold – and its more volatile peer silver – should replace government bonds as a portfolio risk diversifier.
Having significantly underperformed the physical commodity, blue-chip gold miners such as Barrick and Newmont are a more geared play, now looking cheap perhaps for the first time in my investment career.
To all investors in the new Cold War era: welcome to the jungle and think about both guns n’ Kurtosis.
Barry Norris is founder of Argonaut Capital and manager of the Argonaut Absolute Return fund
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