The rise of global defense spending

As the news headlines remind us almost daily, we live in an age of rising geopolitical temperatures that almost seem to envelop the globe.

“The military threat environment is at a level that is incredibly high,” says Clayton Pfannenstiel, manager of Fidelity^® Select Defense and Aerospace Portfolio ().

These rising tensions have been fueling new commitments to defense spending around the globe—as nations look to strengthen their abilities to deter any would-be aggressors and restock their armaments that have been depleted by recent conflicts.

United by rising spending

Stunned and alarmed by the Russian invasion of Ukraine, European members of NATO have been making significant increases to their defense budgets. In 2024, an estimated 23 NATO members will spend at least 2% of gross domestic product (GDP) on defense.¹ Poland, on the front line with Belarus and Ukraine, is estimated to spend 4% of GDP this year and has called for NATO to raise its defense-spending minimum target to 3%.²

In the Asia-Pacific theater, US allies are concerned by the expansion of China’s naval, air force, and defense budgets. In response to growing Chinese influence and ambitions, Australia’s defense spending has surpassed 2% of GDP and is rising.³ Japan, which by constitution is a pacifist nation, is in the process of increasing its defense budget to 2% of GDP by 2027, up from 1.6% now. That would make Japan—already the world’s third-largest economy—also the world’s third-largest military spender.⁴

“I believe that Europe and East Asia are where defense spending is most likely to increase,” says Pfannenstiel.

At home: Defense demand but fiscal reality

And what about the US, whose more than $800 billion defense budget dwarfs those of other nations?

It’s complicated, due to fiscal politics in Washington. Under the 2023 budget agreement, spending on defense is capped at a 1% increase—i.e., less than the rate of inflation—for the current and following fiscal year. “The willingness of Congress to spend is uncertain,” says Pfannenstiel. However, there are also supplemental US budgets to provide armaments to certain nations at war, and export opportunities for US defense contractors.

In a time of elevated security risk but tight budget constraints, Pfannenstiel thinks it makes sense as an investor to focus on clear priorities within the US defense budget, such as Columbia- and Virginia-class submarines, along with other shipbuilding projects.

“Shipbuilding has been an area of focus during tight budget times,” he says.

Two contractors, General Dynamics () and HII (),⁵ also known as Huntington Ingalls Industries, have been poised to potentially benefit from orders for the nuclear-powered, ballistic-missile-armed Columbia subs and the fast-attack Virginia submarine. Due to factors including general deindustrialization and dramatic consolidation in the defense industry during the past generation, there is a shortage of shipyard capacity in the US.

General Dynamics’ Electric Boat division in Groton, Connecticut, has been the dominant contractor for Columbia subs, which are a critical component of the US military’s 3-legged nuclear triad (the B-21 bomber and land-based ballistic missiles comprise the other 2 legs). Ballistic-missile submarines located in the deep seas are difficult for adversaries to locate and track, thus providing vital deterrence and second-strike capabilities.

Defense contracting accounted for about 75% of sales for Virginia-based GD as of the first quarter of the year.⁷ The company also provides the bulk of content for Virginia-class subs. GD has also been a major supplier of ordnance such as tank and 155mm howitzer shells, as well as land-based vehicles like Abrams tanks and Stryker armored fighting vehicles—armaments that are in demand due to restocking from the Ukraine war and the European military buildout.

HII, with shipyards in Newport News, Virginia, and Pascagoula, Mississippi, derives all its revenues from defense contracting, about 80% of which is related to shipbuilding. Apart from major work in submarine-building, the contractor also builds destroyers and aircraft carriers. Aircraft carriers hold a particularly protected position in the defense budget. That's because the military is required by federal law to maintain at least 11 aircraft carriers—the sturdiest projector of power of any naval vessel—at any one time. The US is also in the process of retiring and replacing the dated Enterprise-class aircraft carriers.

In Europe: Contractors with strategic exposures

Defense is very much a global industry in terms of sales, profits, and publicly traded securities. Pfannenstiel says that Europe is an attractive region for investors to consider due to the presence of globally active contractors with important US ties and expanding markets in Europe (including in Ukraine) and East Asia. Two outfits based in NATO-member nations that may be poised to see an impact from growing defense budgets are BAE Systems ()⁸ of Britain and France’s Thales ().⁹

Coming off its acquisition earlier this year of Ball Aerospace, BAE has recently generated about half of its revenues in the US. Pfannenstiel notes that some of the British firm’s main areas of focus—such as electronic warfare and space systems—have been favored in recent US defense budgets. BAE has been a contractor on the F-35, a technologically advanced US fighter aircraft, and, in partnership with Japan and Italy, is developing and building a so-called 6th generation fighter aircraft to replace aging jets in Japan, Britain, and other European nations. BAE also supplies important land-based systems including Combat Vehicle 90, an armored combat vehicle being used by Ukraine’s military.

Thales has had a particularly strong presence in defense electronics, such as radar-jamming and electronic-warfare systems, anti-tank and surface-to-air missile systems, and avionics and radar. Customers for such products have included France’s Dassault Aviation, maker of the Rafale fighter.

Making commitments in an uncertain world

More than many industries, defense policies and spending are subject to political vagaries. Voting outcomes for President and Congress at the polls this November may influence the size, growth, and focus of future defense budgets. And the US is not the only military power heading to the polls this year.

While election outcomes are unknown, many nations may continue to respond to rising global uncertainty and risk by controlling what they can—by continuing to invest in their abilities to defend themselves.