Is Defense a growth industry in Asia-Pacific?

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When well-known talk show host Charlie Rose sat down with the late Lee Kuan Yew (the first Prime Minister of Singapore) back in early 2009, he asked Mr Lee what he would like to convey or ask the newly-elected US president Barrack Obama.

Mr Lee’s question to President Obama was direct and surreptitiously grim: “How would you defend America’s interests in Asia and the Pacific during your time in office?”

Fast forward to today, we see Singapore’s legendary leader’s concerns materialising across the region. A more assertive China has and is flexing her muscles onto the region, and geopolitical analysts, business leaders as well as politicians and policy-makers worry about its implications on the rest of the world (this post will not comment if the actions of the various players involve is justifiable but will focus on the investment implications of the current situation).

Over the past 5 years, governments across Asia have increased the proportion of their budgets to defense spending, causing fears of an arms race between countries as money is poured into weapons outlay, military upgrades as well as training and deployment. The Stockholm International Peace Research Institute noted that the region of East Asia, South Asia, Central Asia and Oceania has posted a 62% increase in military spending from 2004 to 2014.asean-spendingData from The Economist over the past 2 years has also shown that the rates of defense spending in the Asia-Pacific region has outpaced countries from other regions of the world. In terms of geopolitical implications, this is sparking a rise in tensions, which has implications on inter-regional trade and business.

The US still has a strategic presence across Asia, inheriting the ex-imperial stations of the British Empire by retaining political and military influence there… India, Singapore, Thailand, Taiwan, the Philippines, South Korea and Japan. With the political winds changing back at the home front in the US, her allies in Asia are increasingly concerned. Even Australia is boosting her defense, and spending more on naval forces.

Somehow, knowing their deep sense of history and pride, the Japanese fear that someday the Chinese would get back at them. Although, no one is sure if it would actually materialise since the Chinese know full-scale conflict in our current era would be unacceptable and unjustifiable in the eyes of the international public.

Understanding this, my own suspicion is that Chinese strategists are planning interlocking strategies designed to deceive their rivals… (if they are intending to indeed gain the initiative)

If one recalls your Sun Zi; The Art of War clearly states: “In battle use a direct attack to engage and an indirect attack to win.” Simply put, the sage says that you need to first use a conventional way or method to confront your enemy, and then use a superior and unexpected strategy to totally eliminate your enemy.

A clear example was the Allied invasion of Western Europe (codenamed Operation Overlord) during the dark days of the Second World War. The Allied High Command, led by US General Eisenhower, conceived a deception plan to fool Axis forces on Northern France as to the real point of a full-fledged Allied offensive. It was known as Operation Fortitude. The Allies were successful and the German forces were trounced at the D-Day landings on 6 June 1944, becoming the world’s most ambitious amphibious assault recorded in military history, sealing the fate of Allied victory in the European Theatre of the war.

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If the Chinese are really intending to be more assertive in the region, it’s not entirely impossible that the current ‘arms race’ could be a ‘direct’ attack that the Chinese are employing. Who really knows what their ‘indirect’ attack would be?

Anyhow, as global macro investors, we could leverage on such a trend. All that military spending has caused a boom in the defense industry across the region. And the way things are going (post-The Hague’s ruling), its unlikely that this current trend would go away anytime soon. I will not be discussing whether the ruling is fair or not, but I will explore courses of actions for investors.

How to play it:

A quick glance at 2015’s publicly-available data of the deployment of US forces from Western Europe to the western Pacific and Australia seems to suggest that America’s forces are trying to maintain a policy of containment, especially if the deployment is targeting the Russian and Chinese zones of influence.

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Whether or not that is true, we can simply stick to the facts… the various players would require advancing their abilities of rapid deployment, meaning that they need equipment that will allow them to seize the initiative during a deployment phase. Quicker aircraft, efficient transportation, better naval support as well as missiles (long-range assault capabilities).

Defense-related companies that provide products and services in the above areas would do well, and in fact, they have been booming the past 2 years.

Many defense stocks in the West have seen rising valuation multiples, owing to their perceived-stability and their ability to provide dividends to shareholders. ETFs like the PowerShares Aerospace & Defense Portfolio ETF (PPA), iShares U.S. Aerospace & Defense ETF (ITA) and the SPDR S&P Aerospace & Defense ETF (XAR) track this basket of western defense companies, and have seen continuous price increases and interest by the market. Companies like Lockheed Martin (LMT), Boeing (BA), Raytheon (RTN), Northrop Grumman (NOC) and United Technologies Corp (UTX) are key constituents of these ETFs. At this juncture, I wouldn’t touch them despite their strong fundamentals (uncertain global geopolitics) due to them being a consensus for now.

A direct play on the rise of defense spending in the Asia-Pacific region would require an investor to find appropriate defense stocks that are awarded contracts rolled out by the various governments. Governments may roll out contracts to several companies, depending on the perceived concerns over national security and key trade/industry secrets. European defense companies may also participate in the current trend. Here are some defense-related stocks in Asia:

  • AVIC International Holdings Ltd (161:HK)
  • China Spacesat Co (600118:CH)
  • China Aerospace International Holdings (31:HK)
  • North Navigation Control Technology (600435:CH)
  • Fuji Heavy Industries (7270:JP) – Japanese military aircraft manufacturer
  • Mitsubishi Heavy Industries (7011:JP)
  • Kawasaki Heavy Industries (7012:JP)
  • Fuji Heavy Industries (7270:JP)

China Securities Index Co. have also recently created benchmark indexes to track Chinese companies with links to defense spending. Chinese speculators have been speculating on many of these stocks in the mainland recently, according to Bloomberg.

Carefully picking some for one’s portfolio during a general market sell-off could be an ideal way to ride on this theme. Exposure to this market segment could also act as a natural hedge within a portfolio of financial assets against tail risks associated with this development. A rise in geopolitical tension and a sudden spark that leads to military conflicts could devastate financial markets, but benefit safe-haven assets and the defense industry.

Depending on the whimpers and saber-rattling of politicians in the region, this theme could either lasts for months or years to even decades. Watch closely.

*cover image from https://i.ytimg.com/vi/QBakGfbsM_0/maxresdefault.jpg*


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