- Geopolitical instability, rising cross-continental tensions and global fragmentation have placed defense spending at the forefront of national priorities. This has led to a significant increase in defense budgets across a number of countries and we expect this trend to continue in the near future. We believe that the rising uncertainty stemming from the geopolitical landscape present long-term macro and market opportunities for investors.
- Following Russia’s annexation of Crimea in 2014, NATO urged member countries to allocate 2% of their GDP annually to defense by 2024. This target is expected to rise over the next few years, reflecting a broader shift in global defense priorities. The subsequent increase in defense spending is evident across many NATO nations, particularly in the UK and Germany. More recently, the war in Ukraine has served as a profound wake-up call for Europe, prompting a reassessment of security strategies and a renewed commitment to improving defense capabilities. This has translated into further increases in military spending across the continent, with nations like Germany making historic shifts in their defense budgets to address emerging threats. However, this surge in defense expenditure is poised to place considerable strain on government finances, especially at a time when many countries are already dealing with substantial debt burdens.
- The surge in defense spending offers diverse investment opportunities across various asset classes. Defense and defense-related sectors (eg. Materials, Industrials, etc.) are likely to benefit from this increased demand. Additionally, raw materials needed for defense equipment production (eg. industrial metals and rare earth minerals) also present attractive investment avenues as defense manufacturing scales up globally. As governments issue more debt to finance military spending, government bond yields may rise, putting downward pressure on prices. Infrastructure upgrades related to military facilities offer further investment prospects on both the public and private side.
Elevated policy uncertainty warrants a more cautious asset allocation, in our view, with government bonds reasserting themselves as a good hedge against growth risk. That said, we remain moderately constructive on equities through year-end given resilient global growth, healthy earnings prospects and ongoing easing by major central banks.
US Growth Deceleration
After four years of above-trend growth, investors have re-calibrated for a slower US economy as elevated trade uncertainty may delay domestic investment and weigh on consumer sentiment. US equity markets now reflect some slowdown in economic growth but remain vulnerable if activity data continue to surprise to the downside.
Key Implications
Investors that are concerned about a more severe growth deceleration may consider pivoting to more defensive and dividend-paying stocks, extending duration by increasing exposure to long-dated bonds and adding alternatives, such as multi-strategy hedge funds or gold, which have historically offered some protection against those episodes.
Inflation Re-Acceleration
The odds of inflation staying above 2% in both the US and the Euro area have risen, although for different reasons. In the US, the prospects of higher tariffs, slower immigration and a rise in inflation expectations may lead to more rapid growth in consumer prices, at least in the short term. In the Euro area, the newly announced fiscal package may create renewed inflationary pressures in the medium term if not accompanied by a productivity boost.
Key Implications
In our view, the best tactical inflation hedges are non-traditional diversifiers like gold, trend-following hedge funds or private assets. That said, investors can also adjust their core exposure by favoring the short-end of the curve within fixed income and high-dividend stocks within equities.
Ukraine Ceasefire
A potential ceasefire in Ukraine could have important repercussions for the European economy. The geopolitical relief could boost business and consumer sentiment and benefit Euro area growth as a result. While European energy prices may move somewhat lower, full resumption of Russian gas flow through Ukraine now seems less likely reducing the potential disinflationary effect.
Key Implications
European equities (DM and EM) may outperform on the back of a valuation boost. Given the extent of the reconstruction job, infrastructure would also probably benefit.
Large China Stimulus
Chinese authorities have become incrementally more supportive of the economy recently, and we think that fiscal and monetary policy stimulus might be ramped up in the event of a further tariff escalation.
Key Implications
Chinese equities would be the biggest beneficiaries of a large stimulus package, especially A shares which have lagged H shares so far this year. Stronger growth and consumption in China would also support Asia credit and European equities, in our view.
OUTLOOK
Mapping the Growth in Active ETFs
Actively managed exchange-traded funds have gained increasing investors’ interest in recent years. Flows into active ETFs in 2024 have more than doubled from the previous year and we think that this trend will continue. Increased appetite for active management suggests that investors are finding it valuable to allocate part of their portfolios into this space in order to achieve desired outcomes that might not be possible by having beta exposure only. While passive ETFs are mandated to closely track the performance of the index, active strategies are designed to achieve specific goals like generating alpha over relevant benchmarks, enhancing income, or positioning the portfolios to capture dislocations related to duration and credit quality of issuers. We believe active ETFs can complement pure passive plays by offering better risk and return characteristics for investors’ portfolios.
The Case for Going Active Has Strengthened
Indeed, active ETF strategies have outperformed across all asset classes over the past year or so, and in relatively inefficient markets, like small caps and fixed income, active ETFs have delivered consistently superior returns for the last 10 years. The main exception is in the large cap space, where excessive concentration and extended valuations make it difficult to generate alpha in excess of benchmarks. But even there, active exposure has delivered better returns in the past couple of years as market volatility has increased. Given ongoing policy uncertainty, heightened geopolitical risks, and macro volatility, we believe the case for active exposure has strengthened.
SOLUTIONS
