Nato and post-Brexit defence catalysts

Nearly three months ago, legislators from the US House of Representatives released details of a $717bn (£520bn) annual defence policy bill, including new efforts to compete with Russia and China on cyber warfare. This underlines a view among defence analysts that an intensifying focus on potential security threats by regional powers such as India, China and Japan will provide the main catalyst for global defence spending in the years ahead.

The annual Jane's Defence Budgets analysis published by IHS Markit (US:INFO) indicates that defence spending will grow for the fifth consecutive year, hitting $1.67 trillion in 2018 – an annual increase of 3.3 per cent and overtaking the previous post-Cold War high of $1.63 trillion recorded in 2010. Parallel analysis from Deloitte suggests a compound annual growth rate (CAGR) of around 3 per cent over 2017–22, crossing the $2 trillion mark by 2022.

Trump presses on the Nato obligation

However, the Deloitte analysis was completed ahead of last week’s Nato summit in Brussels, where Donald Trump claimed victory in his struggle to get US allies to increase their military budgets. As only a handful of member states have complied with the minimum Nato defence spending obligation of 2 per cent of GDP, the only surprising thing is that earlier US administrations hadn’t taken a similarly hard line on the issue. (The region with the fastest-growing defence spending is Eastern Europe, reflecting Baltic states' anxieties about Russia's military activities). Indeed, the International Institute for Strategic Studies claims that if all Nato European countries were to have met the 2 per cent of GDP target, their collective defence spending would have needed to rise by over 40 per cent.

Share prices for industry heavyweights, including leading US contractors Lockheed Martin (US:LMT) and Raytheon (US:RTN), rallied on news of the renewed commitments by Nato partners, although you’re left wondering if some European leaders haven’t simply kicked the issue into the long grass. In aggregate, the governments of France and Germany have committed to an extra €34bn (£30bn) in military spending, but the timeframes are such that the political tenures of both Emmanuel Macron and Angela Merkel will have already been consigned to the history books long before their countries’ defence budgets hit the Nato target rate.

Strategic issues the principal catalyst

That European powers have been coming up short of their ground floor commitments to Nato can be traced back to the ‘peace dividend’ that followed the collapse of the Soviet Union. The term turned out to be something of a misnomer, given that defence cuts across Europe were undertaken with limited co-ordination between state and industry or among governments, with the result that upwards of a third of UK defence jobs were cut in the early part of the 1990s.

Leaving aside the intervention of the US president, it’s conceivable that the pressure to increase European defence spending could also intensify simply because of strategic issues. Nato’s expansion into the Balkans is gathering pace, but has received minimal press coverage considering the geopolitical implications for both Turkey and Russia. So, aside from the Nato imperative, we think the growth of homegrown contractors will be supported by military escalation – or the preservation of strategic parity – in certain regional flash points, such as the South China Sea. But there are other catalysts at work.

Beyond the EU27 – gearing up for a post-Brexit settlement

Obviously, politics will always be a central consideration in defence procurement, and we may already be seeing signs that the UK might be looking to step up industry trade ties beyond the EU27 ahead of any post-Brexit settlement. Airbus recently warned that it could exit the UK if the nation leaves the EU single market and customs union without a transition deal. If, as some reports suggest, that the ultimatum was delivered at the behest of pro-EU members of government, it would have been interesting to note the reaction of Airbus executives a week or so later, when it emerged that the MoD was still intent on awarding a 'sole-source' contract to Boeing (US:BA) – the European group's chief rival – to provide airborne early warning aircraft for the RAF, valued at an estimated $1bn.