National Security and Capital Markets
Article from Beat Wittmann, Chief Investment Strategist at Key Family Partners
Geopolitics – The Paradigm Shift to National Security
The Washington Spring Meetings 2024 of the International Monetary Fund (IMF) and the World Bank Group (WBG) were strong testimony that the national security agendas have taken the lead to the now subordinated economics in Western policymaking.
The global economy adhered to a framework of organizations and regulations that minimized tariffs and subsidies to advance international trade following the end of the Cold War in 1989, China’s entry into the World Trade Organization (WTO) in 2001 and the global financial crisis (GFC) in 2008. That era of stability is over, the final blow being Russia’s invasion and the subsequent Western decoupling and sanction regime.
In this context Europe is particularly challenged and has started to embark on a journey towards overdue reforms and investments in areas of critical infrastructure and defense against the ongoing de-globalization in the context of the US China great power competition and the hard power conflict with Russia in Ukraine.
Strategically Autonomous US and Lagging Europe
The US with its infrastructure investment and job-, chips-, and science and inflation reduction acts encompass all areas of critical infrastructure and have already started to impact and explain the US extraordinary strategic and economic performance and resilience.
Particularly important for Europe is to acknowledge that it has to meet the challenges and develop its full long term potential regardless of the election outcome in the US, its Western partner.
The US economic environment is significantly more flexible and business friendly and there is superior and broader access to specialist and funding opportunities with deeper pools of liquidity at more attractive enterprise valuations.
Europe is in much need to follow suit but is clearly lagging those developments, mainly due to economic, financial and industrial fragmentation as well as more nation-specific, decentralized decision making.
Europe in Need of Reforms and Investment
Expect widening fault lines in European politics caused by rising polarization between inflammatory nationalist populism on one hand and weak incumbent governments on the other. Just think of recent political developments in countries as different as Spain, Portugal, France, Germany, Netherlands and Switzerland.
It is a Hercules task, on the economic side, to progress and lift off towards the potential in output and increase in productivity. Lifting economic growth in any significant way can only be achieved by improving competitiveness, promoting and incentivizing innovation, embracing the fundamental geo-economic transformation and fast advances in technology as opportunities. The need for multi-year and enormous investments in green technologies, transportation, communications, science and higher education and defense and security is evident.
In addition, overdue and crucial fiscal reforms are necessary to secure debt, budgetary and financial sustainability in societal welfare, health and pension systems. All against the obvious backdrop of unfavorable demographics, powerful lobby groups such as farmers, unions and pensioners to be confronted with cuts in social spending, wasteful and competition-distorting subsidies and increases in pension age – France has shown the way having faced months of street protests.
For a valuable and insightful read on European needs for reforms and investment I highly recommend ‘Mario Draghi: Radical Change-Is What Is Needed’ at www.geopolitique.eu.
Prioritize Leading US and Undervalued Europe
The global economic and capital market trends will not only continue to diverge but are set to sharpen. 2024 is the biggest election year on record with the EU, US and India holding elections. However, we don’t expect the global economy nor the capital markets to be affected in a relevant way.
The key driver of positive investment returns is the gradual normalization of the US monetary and credit cycle. We expect that equities remain the asset class of choice with the still leading US leading and attractively valued European companies being the main beneficiaries.
Europe has been lagging the US in economic performance and productivity. A closing of the relative performance gap will be very much dependent on European reforms that would create exceptional entrepreneurial and investment opportunities. The good news for Europe is that the bad news seems to be priced in by significantly lower asset price valuations and negative investors’ sentiment.
Active Asset Allocation to Preserve and Grow
Cash is attractive again from a yield and ‘dry powder’ optionality point of view. Markets have strongly performed and as a result have become increasingly vulnerable to profit taking.
This could be triggered by negative news from the armed conflicts in either the Middle East or Ukraine, by higher-for-longer interest and inflation rates or some large corporate distress or default event.
Equities, listed and private markets alike, remain the risk asset class of choice as we have entered a medium- to longterm favorable growth&productivity cycle carried by advances in technology and artificial intelligence.
We advise to be defensive about investments in fixed income, particularly regarding credit and duration risk. The worst case scenario would be a stagflation environment.
European Security&Defense&Industry – Strategically Favored Sector
Europe has to secure its own collective defense and sovereign protection. The ability to defend itself has to be and become a top priority and its financing is simply a matter of the political will and resolve.
The fragmentation of the European defense industry is a reflection of the political landscape along national borders and can no longer be afforded as such. Crucially, there is no time to be wasted as the European defense industry is in dire need of a lasting boost to replenish ammunition and weaponry stocks and to be prepared to face all potential threats while fully enabling Ukraine to defeat Russia.
It is essential to consolidate and create European military-industrial leaders across space, cyber, air, sea and land through cooperation, joint procurement, research and development and projects of common European interest. Importantly, the focus should be on geographic Europe rather than the EU as for instance the UK could and should be an important contributor from a political and defense industry point of view. Just think of Airbus and BAE Systems, both publicly traded globally leading European aerospace and defense group that have been the result of international mergers and acquisitions.
The publicly listed European defense firms have already strongly performed, however this is still the beginning of a long-term uprise as public defense budgets are being steadily and strongly increased and orders signed. Investors’ fund flows are also set to increase over time as ESG criteria have kept a large majority of potential investors away from this sector. However, it can be expected that those criteria will be differentiated and softened, thus facilitating investors’ demand.
We expect that there will be sharply increased corporate financial deal activity, IPOs and spin-offs across security, defense, industrial and technology sub-sectors. Over time investors will focus on pure-play defense firms such as listed German Rheinmetall (www.rheinmetall.com), a leading international systems supplier and will seek to invest in firms such as Europe’s leading missile maker MBDA (www.mbda-systems.com), that is not listed yet.
