You might not have noticed amid the holiday frenzy and cheer but the US Senate passed a major defense policy bill this past week.

• Senators voted in a bipartisan manner (!) 83-11 to pass the annual National Defense Authorization Act that came in at a cool $858 billion.​

Who says bipartisanship is dead?!

The only thing that might bring very divided Americans (and their politicians) together like voting for the troops and the financial health of the good old fashioned military industrial complex.​

This would increase America’s total national security budget by just over 10% from last year’s $778 billion authorization bill.

This convenient headline speaks to one of our last year themes that could continue into 2023 and beyond.

• Namely, that defense stocks are a rare bright spot in a generally difficult landscape for publicly traded equities.

​We have argued before that the vast changes occurring - especially but not limited to Europe - in terms of how many developed nations view the need to arm and protect themselves is leading to a sea change for military spending around the world.

The war in Ukraine gets a lot of attention and deservedly so. The conflict is acting as a forcing mechanism for rearmament across Europe. More regrettably, it is also using up billions of dollars of arms that will need to be quickly replenished by major arms manufacturers both for the ongoing conflict and to restock stores.

But that isn't all that is going on. It is true that there is one perspective that says that 2023 might not have another major land war in Europe (or elsewhere) and so a lot of this spending is either behind us or already priced in by eager investors front running.

The idea being that defense stocks were yesterday's trade.

• That could always be the case but we don't think so.

Here is why:

There are three reasons:

1. The real action when it comes to defense spending is in Asia, not Europe.

2. The war in Ukraine is both ongoing and becoming ever more brutal. Governments are often slow but are nonetheless implementing massive shifts in their plans.

3. The focus has been on countries other than the US, which spends well above 2% of GDP on defense, but this may be the other shoe to drop.

Let us deal with each in turn:

On the first argument, it is difficult to properly grasp the arms race that is occurring in Asia as countries become increasingly alarmed at China's aggressive behavior and military plans and spending.

The era of Deng Xieopeng's famous advice to "hide your strength, bide your time” as a way to avoid conflicts and build up their capabilities is clearly well and truly over under Xi Jinping.

The knock on effects of this shift are unsurprising but just getting started. They are also nothing short of incredible. Just this week, previously pacifist Japan announced its largest military build up since World War II with a $320 billion plan to nearly double defense spending.

Japan's spending will not be alone.

In terms of the second point, this newsletter has been deeply critical of both the scope and the speed of the German "Zeitenwende" or turning towards a more assertive approach of defense spending and policy.

However, there is no denying that slowly and often kicking and screaming the Germans are shifting. In Europe, they are also not alone. One of the incredible trends this autumn and into the winter has been the slate of orders for the F-35. Germany was among them (this past week) but so was Finland, Poland and, a new country, Czechia.

Country after country are either signing up to order, increasing their orders or simply deciding that, yes, they want to stand behind their previous commitments after all.

Germany was one such country. Denmark is another.

Denmark's new government is remarkably considering abandoning a holiday that has been around since 1686 in order to increase its economic productivity and growth.

Getting rid of "Great Prayer Day" may not actually occur and it is certainly a pretty odd move for any government. But when a country like Denmark is explicitly linking getting rid of a holiday so that it can reach its NATO target of 2% of GDP on its military, you know Europe has changed.

Lastly, the US already spends quite a bit on defense (~2.7% of GDP) but in a multipolar world full of large and aggressive authoritarian regimes set on explicitly overthrowing the international order, it may have to do quite a bit more.

The US, as the "indispensable nation" is the only country that has both the means and the interest to protect some of the values the West has come to take for granted. As a result its commitments will, in the new age of great power competition, have to be that much bigger.

The problem is the American military isn't really in a position to do the job.

​A recent report by the Heritage Foundation argues that, on current course, the US military might not even be able to successfully win “a single major regional conflict” in the years ahead.

The problems are:

• The budget is not keeping up with inflation.

• The amount of military spending as a % of GDP is falling steadily.

• The national security commitments are rapidly growing.

• The branches of the military are losing the capacity to even spend the money effectively.

This will likely be a new shoe to drop in the next few years and an unpleasant discovery for US taxpayers, policymakers and bondholders. To focus just on the US Navy, the current fleet will have to be both entirely revamped and also expanded. Congress authorized a Navy of 355 vessels back in 2018 and yet the current force hasn't grown and is only 296 ships.

The former number is barely adequate to police today's seas let alone deal with a rapidly militarizing and aggressive China. Many of the Navy's vessels are also past their planned service times or are no longer suited to modern warfare conditions.

We may be moving beyond the age of the large aircraft carrier platforms....

But the real problem may come with reduced capacity and expertise after decades of lost expertise and declining quality in manufacturing, maintenance and overall competence. It isn't great when a major branch of the armed forces shows a “persistent inability to arrest and reverse the continued diminution of its fleet.” According to one quoted count, the Navy is consistently missing their shipbuilding by 10 ships a year for the last half decade.... That isn't good and the report argues the Air Force is even worse.

Add it all up and just the US Navy will require tens of billions of dollars over the next few decades to radically rethink and reinvest in their ships, their sailors and their strategic priorities.

Above all, as with so many other elements of our society, economy and government, the US Armed Forces will have to work hard to get back to actually executing well rather than just pretending. Military-as-theater is as bad as "public health policy-as-theater."

In conclusion, we think that defense stocks could continue to outperform. They might stand along Industrials and Energy companies as the few sectors of the economy that are doing very well in these inflationary and volatile times. Also, unlike both of the other sectors, they may hold up in the 2023 recession scenario as well.

They would struggle only if perhaps the Ukraine war comes to a quick and peaceful end and we decide that today's China isn't such a revisionist power.

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