You're listening to Asia Centric from Bloomberg Intelligence, the podcast that pulls back the curtain non global business so you can invest better across the Pacific rim. I'm Tom Corbett in Hong Kong.
And I'm John Lee. Equity markets appear to see smell and hear no evil. The MSCI China Index is in a bull run, up twenty percent from its lows. The S and P five hundred is still up nine percent this year.
But Chinese and US stocks could be ignoring a fundamental shift in the narrative. Geopolitical risks run fast and thick. Global military spending is rising, and investors are shifting their priorities accordingly.
Where do the risks and opportunities lie and how can invest this profit from the worldwide increase in defense spending.
Let's bring in Sean Darby, equity strategist at Miss zu Ho Securities. Sean, it's great to have you on Asia centerc.
Good morning, Tom and John am also very grateful to be your participants in this podcast. Thank you, Sean.
The world's equity markets are on a tier. The geopolitical backdrop seems to be fraught with risks, though in the US and China as well. Stocks are very strong. What's going on? Are the markets ignoring risks? Do they know something we don't?
I suppose equity investors are conditioned to follow growth signals, and for the best part of the last twenty five years, equity investors had good reason to ignore inflation worries and really relied on the growth signals as being the way to add or subtract beta to those stock portfolios. And put it in the context of just general ass allocation.
You had a what's called a negative correlation between government on prices and equity prices, so when you had bad news inequities, it would be a good time for bonds. And that correlation started in two thousand when we went
into this world of low inflation. So it's very different dynamics now in the sense that we've not necessarily got those deflationary or disinflationary winds, but market participants seem to be still conditioned to that one frame of how news is taken in terms of growth, and that's generally been a good environment for equity investors, and it's no different now. In fact, looking across the board, there's very few markets globally that are in actually a genuine bear market.
And when it comes to geopolitical risks, the general playbook seems to be that, you know, if there's risks, investors head towards safe haven assets. Sometimes oil prices rise, but defense docks are usually seen as a great head. Do you think geopolitical risks will continue to rise in the medium term?
I do. I'm afraid so. Geopol politics is not an easy one for gain equity investors or any asset class investors to be able to frame and to measure. There's been some work done by some of the Federal Reserve Board which produced data going back to the nineteen hundreds, and what they do show is that geopolitical events tend to occur in clusters, and that you get periods of time when geopolitics is a very very strong feature of the news headlines, and then it can go away for
almost two or three decades. And in the context of the environment that we've been really talking about, the last real period of heightened geopolitics was really around the Cold War between America and the Allies and Russia, and really from that period from the late nineteen seventies late nineteen eighties, we didn't have to incorporate geopolitical risks into our asset allocation models because they tended to be either very localized
affairs or didn't actually infringe upon the developed world at all. So I think the takeaway really is that none of us in the current investment environment have the experience of dealing with geopolitical events, which may mean that we're not very good at accommodating that information. And secondly, genuinely, the last time we've had a real rise in geopolitical risk has been really almost thirty to forty years ago, So again, most of us would not have been investing around that period of time.
So, Sean Darby, you're looking at a generation of investors that may not have seen this narrative in the past. How would you characterize the change we're undergoing? Would you describe it as a paradigm shift? Is that too much of an overstatement?
No, you're right, Tom, I think it is a paradigm shift. And the way to think about it is that from the response function of governments, for the best part of the last thirty years, they've been cutting military budgets as a percentage of GDP. So irrespective of some of the news headlines and against some of the localized military conflicts or tensions. The real trend line has been for governments
to cut military expenditure as a percent of GDP. So if you were looking at this in terms of profits for the global economy and all for the major benchmarks, the profits coming from the aerospace and defense indices was actually diminishing and diminishing very rapidly against that against health
care and tech. So, again coming back to that earlier question, the narrative for investors has been one of which these sectors did not necessarily produce outsized profit cycles because the government is by and largely the biggest expend purchaser of this equipment, and they were actually cutting defense for the last thirty years.
And Sean, which Asian countries and companies do you think most exposed to this boom in defense spending?
That's a very good question. So first of all, to put it into a global context, the aerospace and defense indices have done relatively well. Now, so as that expenditure has started to pick up with the conflict in Ukraine and other geopolitical tensions in perhaps the South China seas, the aerospace and defense in diseees have started to see a profit shift back to them, and that's possibly the most pronounced has actually been in the European in decease.
They've been dramatically out for performed the eurostop first of all. In this time zone. What's been interesting is that there's been pressure on countries to increase their military expenditure, and
the most notable has actually been in Japan. Japan has come out with the headline numbers which are very, very significantly above anything that they've ever done in terms of expenditure, and certainly that narrative has been one feature of the last five to six years as China's maritime prowess has gained, so certainly in Japan has been a very significant change
in the defense spending. Just to put it into context, the average military expenditure globally, if you use twenty twenty two to twenty three figures, was close to around just two percent of GDP. At the peak of the Cold War, it was over six percent. So just to get a framing of where we're starting from, we're only just beginning to see those numbers change, and for a country like Japan, the numbers have actually been extremely low, again below two percent of GDP. For the best part of the last
twenty five thirty years. So Japan has been one of those economies which is broken away in terms of expenditure of GDP, and because the index tops or the nick as a large amount of defense related companies that tend to be industrials. That's been shown up in some of those numbers. The second economy that's actually benefited quite dramatically
from the turnaround and expenditure has been South Korea. South Korea has always had a very large expenditure of military costs to GDP, and because they've also had the in situ factories and munitions, they've been able to benefit from this sweeping change of orders as the war in the
Ukraine has intensified. So South Korea, strangely enough, has benefited from what has been an external conflict, are not necessarily one which they've been sort of perhaps we say, been set for, or the conflict that they've imagined that they would have with North Korea. Just two other points to note.
The multipliers on military expenders are extremely high, So when you look at governments around the world when they want to stimulate an economy, most will turn to some form of fixed acid investment building some roads, building some airports and so forth. But the multipliers from defense equipment expenditure is very very significant because you're involve in very large ticket items which have to be built over long periods
of time. So in terms of the impact from the expenditure on GDP and on profits, they can last a very very long time. And again I think this is something very different from what equity investors would normally be looking for, where you build a fab plant in eighteen months and in thirty six months you've got profits generating orders for ships, aircraft, tanks, large defense items. They can go on for six seven years, and the maintenance costs and upgrades can be quite dramatic. So this is not
a short run impact on profits. It's going to have a very very long one as we go forward into this sort of new dimension, sort of new era in terms of defense spending.
So how can investors reposition themselves to align themselves with the opportunity if you want to call it that, and these shifted national priorities should they look at it? Is this a case of glass half full or glass half outdy Well, that's.
A very good question, Tom. The first is that the type of expenditure now that we're going to have come under the defense bracket won't just be hard IT ticket items. It'll be things such as abilities to use drones, specialized navigational equipment. There'll be measures to counteract, as we say, computer malware. All of these type of new threats to
economic systems are becoming increasingly important. And just as a maunter of interest in Europe and Europe and the UK, they've had to start to spend money on protecting their underwater pipelines and cable networks. So again, the threats to the system have become very different to what we would
have expected thirty or forty years ago. So even though the aerospace and defense industry sees are defined by this type of big ticket items, you're going to see a trickle down effect into a lot of other sectors, potentially in the software industry, as people have to also protect their IT integrity far more from government. So that's the
first thing to say. The second is quite interestingly, and it's something that's afflicted the energy sector, is that because of the ESG overlay from many equity investors, they can't actually participate in the defense industry. It's a sort of off the ground, off the territory area. So if you're an equity investor at the moment and you've been out of energy in the last three years, defense in the last two or three years, you've had some pretty difficult narrative.
You're forced into very very concentrated bets in very concentrated companies. So that's the second thing is that the ESG framework, which didn't exist of course thirty or forty years ago, has made defense area a sort of very difficult one
in which they can run their portfolios around. I think the last thing to say is that in contrast to what we saw in the sixties or seventies, when most military equipment companies were actually nationalized or semi nationalized idea were under the government, these companies now are listed, So there's a lot more choice for portfolio managers in terms of the companies that they can select, whereas in the past most of them were actually held under the national
government and there was not the same impact on profits as it would potentially be going forward. So I think from my side, the portfolio choices are much wider and much more internationalized. And again we're talking about a relative
profit shift from very very low levels. Even now. You think you look at the aerospace and defense and disease in some of these countries, like in Korea Europe, they look quite well, what a extreme move, But actually we're probably only in the beginning of this cycle in many respects, given the long duration of the orders that are going to have to be initiated.
For the benefit of the listener, some of these defense docks have really been on a tear Mitsubishi Heavy is up over seventy percent year to date. I think Hanwa Aerospace in Korea is also up over seventy percent. So yeah, they have been really strong. If I could just talk, you did mention Japan. At Japan's in a quite intriguing situation. They're not allowed to actually export their weapons. There seems to be some potential for changes to the constitution allowing
them to export some weapons. I think there's been something US on the jet fire planes. Do you see this happening and could this be a catalyst?
That's a very good question. So at the moment, there are very few countries that, for example, can build planes, put together missile systems and do the hardware, and Japan is one of those that can do that. Now, there is a precedent because as the Ukraine War developed, the German government did a u turn on exports of military equipment,
particularly the Leopard tanks. So the first thing to say is that when there is an immediate need for demand for military equipment to be moved overseas or into other jurisdictions, the German government did show within Europe that it could do that. I think the issue for Japan is that it certainly can change parts of the constitution and also
change certain rules. One of the things that's interesting about Japan is a lot of the military that is actually built domestically is under license from America and from other countries. So in a sense, they've got the physical capacity to build domestically, but they're actually doing it under international licenses, and that's something again very different from what we saw in the last thirty or forty years. Companies like Boeing, Array, cal and on, all of these type of military companies
would normally build the equipment domestically and export it. Now a lot of it's done unlicense agreements, and I think that's very much the case for Japan. So they would also need to be mindful of the fact that some of us would need to get approved from the US or whoever they've licensed those production schedules from.
Sean Darby, it's difficult to talk about this without bringing in America's fiscal situation. In the United States, debt has ballooned. In nineteen ninety two, it was what forty six percent of GDP Today it's ninety six percent. Politicians tut about it, but a handful of voices former Treasury Secretary Larry's summers, for one, it shows some sense of urgency about it. Is it time to worry? How is America's fiscal situation
stacking up on your list of concerns? How is it shaping the entire geopolitical setting as it's changing.
One thing about conflicts and wars is that they tend to be very inflationary. You're forced into spending whether you like it or not. So talking about paradigm shifts, the reality is that the defense budgets are going to have to go up one way or the other. There's a number of threats for these are countries, and they've been spending way below what would normally be considered to be a baseline case of something like three percent of GDP. So the first thing is you're not going to get
away from that rise in the military budgets. Maybe we don't go back to where we were in the nineteen sixties, but certainly as a proportion of GDP, it's going to go up. So the debt financing for this is only going to increase. I think the odd thing about this is that it's got to be seen in the context that governments are spending an awful lot of money in other areas. At the same time, you have a huge renewables program, You've got subsidies to bring plants back on
shore in the United States as well. You've got the.
Chips entitlement programs in the US.
Chips Acts entitlement program, subsidies for building plants. So in the whole context of expenditure by governments within the economy, the share of government spending in the economy is going to go up as well, which means much more levels of debt issurance. And that's inevitable not just in the United States but elsewhere as well. So again from an investor point of view, we've had governments generally globally, and I would say which would resonate in Europe, which were
very mindful of their fiscal positions after twenty eleven. You know, there was a very conscious awareness that they would not go and similarly in Asia, countries would not go on heavy expenditures in terms of the budgets. But they're almost now forced into this, you know, coming into the COVID period with renewables program during COVID to offset the huge deflationary shock, and now post COVID where you have geopolitical
pressures coming through. So to answer your question very succently, I'm afraid to say that the debt levels are going to go up, and unfortunately, debt issuance is going to be a very significant overhang for asset markets going.
Forward, and then factor in inflation the impact on interest rates. It doesn't sound like a very pretty picture.
Well, it wasn't one during the nineteen seventies, so that's the first thing to say. And again there wasn't the type of globalization that we had back then. Most countries were running some form of capital controls and most the debt was owned by the domestic institutions. But the reality is that this implicit policy shift between what the government wants and how central bankers want to finance. It has
been going on. You know. Really once we started QI, they bought the government bonds, put it onto the balance sheet, and there was an implicit monetization of government debts anyway. So we've been in this, but not to the degree that we've ever really felt thought about that actually, this is going to be the game going forward. I think again coming back to experience levels, you have a shortage of people in Japan who've never seen interest rates go up.
People are desperate to find people who know how to trade rates now. And similarly in the aerospace sectors, there's very very few analysts who actually cover these stocks have seen the type of changes going forward. And the companies, those heavy industrialized companies that John Lee mentioned would not necessarily get the same front page coverages as your tech companies, but that's profit shift is going to be very different. So the context of this and an investment framework is
a much more difficult one. And as I said, it's going to be against the backdrop of much much higher yields than we anticipated nearly five or six years ago.
And sure, just sticking with the US, there seems to be some growing concerns about America's manufacturing base. Now one of the biggest suppliers is Boeing. Now they've had a lot of problems on their commercial jet engine side. But there's also some news articles talking about how the US Navy is worried that their supplies are not building submarines quick enough. I think that someone seenior in the US Navy visited South Korea and Japan to see if these
countries could actually supply navy vessels going forward. Is this a big issue?
Yes, it is. I think again, there's been a huge hollowing out of these industries, and one of the features of the aerospace and defense industries has been like a large amount of M and A activity over the last thirty years because to survive, these companies had to scale themselves for reduced budgets, and across the board in the United States, in Europe, the number of defense and companies have been reduced and there's been quite a significant scaling
and hollowing out. So in the context of trying to expand quickly, what you're finding is that not everybody has got the physical capacity to meet this level of demand. And you know, it comes back to the fact that suddenly South Korea found its export profile for defense equipment improving purely because they're one of the few countries that still produce munitions on the scale that can provide that
very rapidly. So quite right, John, I think in the short term there's a skill shortage in this particular area. It's one where there's not enough in situ physical capacity. And thirdly, you're going to rely on global allies to pick up any shortfall in the production of components and items, because again, this is just not being the level of demand out there for companies to anticipate putting in any
physical capacity. So yes, there's going to be quite a significant sea change in a way we sort of buy and sell equipment from each other because there's just not enough of the companies around that can do it.
Sean Darby, let me paraphrase something that Bloomberg opinion columnist Thomas Black recently wrote. He wrote, the flare up of Middle East violence, Russia's war in Ukraine, China's stance on Taiwan have all shattered the illusion of a peaceful world that had taken hold after the Berlin Wall fell in nineteen eighty nine and the collapse of the Soviet Union two years later. Is that an overstatement or is that a realistic take on where we stand today in geopolitics.
I think it's a very good summary, Tom, and I think it was basically summarized being the peace dividend. And this peace dividend came through in a number of different levels. As you cut the military expenditure in countries, you were given tax cuts as consumers, so we all benefited from a low tax rate, both income and on purchases. So that's the first thing. It was a very big shift
to the consumer in terms of their spending power. Secondly, of course, we benefited from waves of disinflation of goods and services because a lot of these countries came into the global economy, came through WTO and were trading partners, so you benefited from a very big drop in in the inflation rate. Thirdly, if you look at, for example, the profile of China's purchases of US treasuries, there were very big purchases of foreign debt. That's all going to change.
So I think that summary, Tom is a very good one because it works on so many levels. And it comes back to this that nobody has the variance of dealing managing through the nineteen seventies and governments themselves are just trying to reorientate their economic structures. So yes, it's a very difficult world in the sense that unless you frame it in the nineteen seventies sort of backdrop, is very hard to make adjustments that quickly as to how people will manage portfolios.
Our guest has been Sean Darby, equity strategist at Miss zoo Ho Securities. It's been a fascinating, engaging and eye opening conversation about japan defense spending and the investment risks and opportunities in our very rapidly changing world. Sean, it has been a pleasure.
Thank you very much, Tom and John, and being very privileged to be able to participate in the podcast. Thank you very much.
I'm Tom Corbett in Hong Kong.
And I'm John Lee. This podcast was produced by Clara Chen and you've been listening to the Asia Centric podcast