The tone of Europe’s political debate on defence expenditure has shifted markedly this year. And as former Netherlands defence minister Kajsa Ollongren, put it in a Chatham House Q&A in early March: “The mindset should be ‘war economy’.”
Big budgetary guns have been blazing. Germany’s new coalition partners plan to increase defence and infrastructure spending in a €500bn fund and to release defence spending above 1% of GDP from the so-called debt brake restrictions. Both the UK and France are set to increase defence expenditure significantly, and EU leaders have agreed measures that could release €800bn in spending for defence and other purposes.
But how will this extra resource be allocated? Some politicians, including in the UK, will want to allocate a slice of increased defence to personnel rather than materiel in order to boost social mobility – as well as troop numbers. Political rhetoric has been about boosting domestic manufacturing capability. Heavy military equipment – from artillery to aircraft to naval vessels – will doubtless be on defence chiefs’ wish lists.
State or European defence funds and associated bond issuance, as the Danish pension association IPD has called for, could offer a straightforward core fixed income defence play, with echoes of the war bonds of the twentieth century.
Europe, of course, has a swathe of listed defence companies, including manufacturers and contractors, that are likely to benefit from the upturn in budgets. These include the likes of France’s Dassault, the UK’s BAE and Italy’s Leonardo, among many others.
Rheinmetall, a banner stock for European defence, is certainly on a war economy footing, having just reported record operating results and a €55bn order backlog.
For investors, however, a good opportunity lies outside these traditional defence suppliers, bearing in mind that capacity in the traditional defence sector is limited. There isn’t going to be a new Rheinmetall any time soon, and Europe can’t easily produce more heavy artillery more quickly.
Assuming a sizeable slice of increased defence budgets makes its way to defence technology, pension funds might instead look to small and mid-caps, where a swathe of innovative tech-focused companies offers nuanced opportunities both for public and private equity investors, but also private credit players.
In Denmark, an example is Terma, a high-tech defence firm based close to Aarhus, a specialist and self-described world leader in radar, which makes components for the Danish F-35 fighter jet. Or OMT – an Odense-based manufacturer of “smart naval technologies”.
Denmark, for the record, is increasing its defence expenditure to exceed 3% of GDP this year. As reported by Reuters, prime minister Mette Frederiksen told a press conference the message to the defence chief is “Buy, buy, buy”.
Some, if not all, pension funds are keen to participate. Last year, Long-Term Danish Capital, managed by the labour market pension giant ATP, took a minority stake in Terma, an unlisted company controlled by a private foundation, and supplied a loan facility.
ATP’s undisclosed “single-digit billion” Danish kronor stake will support Terma’s long-term growth and acquisition strategy. A key point is that the firm’s technology has both military and civilian uses, making it hard to classify this entirely as a defence play.
Two years ago, PensionDanmark announced its participation to take part in a consortium to develop patrol ships for the Royal Danish Navy together with Terma and OMT.
In the UK, more than 100 MPs signed an open letter backing investment in defence companies.
A few pension funds have adopted a wholesale exclusion of defence stocks; a fair number, European public entities in particular, have understandable (sometimes statutory) exclusions centred on controversial weapons, such as anti-personnel mines.
A pretty mainstream view, however, is that national security underpins our freedom and our democratic societies – something that is pretty compatible with the guiding principles of most investors.
It is important for private-sector pension funds to assert, as they continually do, that they hold private capital that they invest on behalf of members. Investing in the defence sector should be seen as a secular opportunity that will suit the investment objectives of many. It should not be seen as a mark of good citizenship or patriotism, doubtless though many will see it that way.
Putting Europe on a war economy footing will be a hefty strategic endeavour and will not be easy. It will be state directed, certainly, and will need knowhow. But it is an endeavour that needs patient, private long-term capital as well if Europe is to maintain the security and long-term prosperity of its citizens.
Liam Kennedy
Editorial Director, IPE
+liam.kennedy@ipe.com
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