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Is UK defence a countercyclical safe haven?

Is UK defence a countercyclical safe haven?
September 15, 2022
Is UK defence a countercyclical safe haven?

If Liz Truss does intend to govern like a traditional Tory, it will extend beyond asking her colleagues to stop turning up looking like hobos (the new prime minister is reportedly reintroducing a dress code to Downing Street). Her first policy action, however, would have seemed familiar to members of Harold Wilson’s administration in the mid-1960s. Subsidising energy bills obviously won’t play well with hard-line free marketeers in the Conservative ranks, but Truss was snookered on that decision, and it’s doubtful if the party faithful will take umbrage given the probable cost of inaction.

Subsidies and sartorial edicts aside, the Chancellor of the Exchequer, Kwasi Kwarteng, may also be obliged to prioritise defence spending, and not only because we seem to be shipping so much kit over to Ukraine. If reports are to be believed, Russia’s invasion looks to have gone off the rails in the face of determined, well-armed resistance. Strategists at the Ministry of Defence (MoD) will doubtless be busy interpreting events on the ground, but Russia’s aggression also reminds us that the post-Soviet “peace dividend” was always largely illusory; a term dreamt up by hacks and academics which doesn’t bear scrutiny in view of subsequent events. The world is still riven with conflict, and it would be pure folly to keep paring back our military capabilities, especially in terms of boots on the ground.

Plans for a beefed-up military, and the budgets that come with it, represent a clear opportunity for investors, or at least those who take the view that military spending is largely countercyclical, in that it doesn’t necessarily follow the commercial business cycle. That belief rests on whether you can meaningfully plot the rhythms of the wider economy – and the jury is out on that one. That's worth keeping in mind as we drift towards what could be a lengthy recession.

Still, it wouldn’t be a stretch to imagine that a real term increase in UK defence spending would be wholly beneficial for the likes of BAE Systems (BAE) and QinetiQ (QQ.) and other local contractors, at least those that haven’t already been bought by US private equity interests.

Assuming the PM is serious about cranking-up spending, we shouldn’t sniff at the implied numbers – if fulfilled, they represent a heavy-duty commitment. The UK has the fourth largest defence budget in the world, accounting for around 2.2 per cent of the nation’s GDP. Truss has pledged to increase that to 3 per cent by 2030, representing an extra £24.9bn annually based on 2021 statistics. To put that into perspective, sales for BAE came in at £19.5mn for 2021.

Truss’s determination to up the ante may well have something to do with the fact that she was previously Foreign Secretary and therefore heavily involved in the UK response to the Russian invasion. But it’s also a tacit admission that our forces are too thinly stretched even as things stand.

 Price change (YTD)Price change (5Y)PEGEV/SalesPERDYMarket-cap (£mn)
Babcock International0.56-60.47na0.5nana1,620
BAE Systems42.6730.841.61.515.23.2624,462
Chemring Group1.1868.57.92.215.61.7848
Qinetiq Group25.5647.922.12.816.22.191,933
Rolls-Royce Holdings-36.17-73.520.11.2nana6,564
Source: FactSet

The army, Royal Navy, and Royal Air Force have seen a marked reduction in service personnel since cuts initiated in 2010 by the then Conservative-led coalition government. UK forces are also facing added cost pressures linked to the expansion of electronic warfare technologies, artificial intelligence, and analytics, all central to the modern battlefield. It’s worth remembering that any new plans announced at the next government spending review in November would have to take account of likely inflationary effects, a point that won’t be lost on the contractors themselves.

It has been estimated that the number of service personnel could rise by as many as 42,000, a 27 per cent increase on the current level. All those troops will require specialised training and that should generate opportunities. A company like QinetiQ, once part of the part of the UK government’s Defence Evaluation and Research Agency, and a provider of complex training and mission rehearsal systems, is therefore well placed to derive benefit from the expansion in numbers.

But its broad-based stablemate also presents a positive investment case in view of the rise of asymmetric warfare and a deteriorating geopolitical situation. We shifted BAE to a 'buy' recommendation in July 2021, a point at which the contractor was still grappling with supply chain issues and liquidity risk in this area. The group’s share price has increased by 42 per cent in the intervening period, providing something of a bulwark against wider pressures in the economy, a point further emphasised in a stock screen we published in February. In short, we think that this is one area of the state that won't be shrinking through to the next election.