In February, Defense Secretary Chuck Hagel delivered the Obama administration’s proposed 2015 defense budget. It was notable for the reduction of the U.S. Army to its lowest force level since World War II. It envisions “a military capable of defeating any adversary, but too small for protracted foreign occupations.” (Forces could be reduced still further if the sequester makes another appearance in 2016.)
Critics said that it would create a U.S. military incapable of engaging in two wars simultaneously, scuppering a longstanding piece of military doctrine. Mr. Hagel described armed forces that were “agile, capable, and modern,” and the proposed budget protects spending (for example) on special forces and cyberwarfare.
The ideal of a more austere, agile, and effective U.S. military is attractive. And given the experience of the wars in Iraq and Afghanistan, most voters hope that there are no more “protracted foreign occupations” on the horizon. Of course it would be a happier world if we only needed a military capable of defending the homeland from invasion.
However, there are geopolitical realities that make the world something other than we wish. Those realities have been coming ever more to the fore during President Obama’s second term.
Keeping the Global Peace and Creating Global Economic Success
Today, wherever we look, we see countries where internal warfare and conflict create a lack of security and thus industry and commerce are crippled. Without entrepreneurs and workers feeling secure in their rights and possessions, they have no motivation to work and build wealth. As these countries exemplify, the critical factor in permitting the buildup of capital is the rule of law.
On an international level, the situation is not so different. What’s true for a nation is also true for the international community. Economic globalization has had tremendous benefits; in the past 20 years, the global poverty rate halved (from 43 percent to 21 percent) even as population soared. Globalization was made possible by a stable international order in which countries could trade, and gained strength dramatically after the fall of the Soviet Union and the birth of a world with just one dominant global power. The international order has its problems; but the Pax Americana had the effect of making the world safer than ever for trade — and the world’s people benefited from it, with billions being lifted out of poverty.
The past decade and a half has seen two dramatic shifts in the role of the U.S. within the international order, in our opinion. First, the U.S. squandered a great deal of its international prestige and goodwill in its wars in Iraq and Afghanistan. And second, the Obama administration has retreated from the military dimension of the U.S. role as primary supporter of the global order. We are not supporting or criticizing these shifts; we are however noting that they will make the world a more challenging place for investors.
Perhaps it was the American public’s exhaustion with war; perhaps President Obama believes that order can be maintained by dialogue and consensus without a “big stick” to back them up. Whatever the case, we see the contraction of U.S. defense capability happening just at a time when global tensions are on the rise in new and dangerous ways.
Global Shift: China
As we’ve commented in this letter before, China’s rise as an economic power is now complemented by China’s rise as a military power striving to be dominant in its region. During his visit to China a little over a week ago, U.S. Defense Secretary Chuck Hagel was met by the defiance of his Chinese counterpart. Speaking about its new territorial claims in the South and East China seas, Chang Wanquan stated: “On this issue, we will make no compromise, no concession — not even a tiny violation is allowed… We are prepared at any time to cope with any type of threats and challenges.”
During the trip, Secretary Hagel was given a tour of China’s first aircraft carrier. So as the U.S. is reducing its defense posture, China is preparing to fill the vacuum in its own neighborhood. This is the path to a global order where not the U.S., but other powers — often with values very different from those of the west — make the order and set the rules.
Global Shift: Syria and Iran
Hopes for a self-sustaining democratic order in the Middle East were dashed after the Arab Spring led not to democracy, but to instability and civil war. Syria has been the worst example. Vladimir Putin’s Russia stepped in to protect Syria’s dictator, Bashar al Assad (and to prevent the construction of an inconvenient pipeline that might eventually connect Saudi and Qatari natural gas to Europe).
Meanwhile, Iran continues to drag out negotiations with the west while it pursues its nuclear ambitions, and U.S. allies Israel and Saudi Arabia are growing increasingly unhappy. Even though they have not been friends, these two nations may cooperate to do something about Iran without the help of the U.S.
So in the Middle East, too, new tensions and dangers are arising.
Global Shift: Russia
And the most recent example, of course, is Russia’s re-emergence as a threat to its neighbors in Europe. Vladimir Putin has shown in Ukraine that he is willing to use all the tricks of the trade — military confrontation, energy blackmail, and covert destabilization — to grow Russia’s sphere of influence back to its imperial glory. With the U.S. talking about reducing its ability to project force around the world, Europe’s leaders are looking nervously at their own defense capabilities — since the U.S. has been pulling most of the spending weight in NATO for decades. Many new NATO members (the Baltic states, for example) may be in Moscow’s crosshairs.
Implications for Investors
With the U.S. retreat from its role as global policeman, we see the greater likelihood of regional instability as other countries step in to fill the vacuum and assert their role as local powers. This means the greater likelihood of geopolitical events which cause market volatility. More conflicts, more local wars, and more destabilizing threats — these seem to be the future we’re headed towards.
Investors will also have to do more legwork to keep themselves informed about the political and business cultures of the world’s new regionally dominant powers. Without western dominance, very different cultures (such as Islamists, Russians, and Chinese) will have more sway, and investors in the global economy will need to be even more savvy about the implications of those cultural and political differences.
[See Also: Marc Chandler: Military Expenditures on the Rise]
We continue to believe that the macro environment is supportive of stocks and of corporate profits in the U.S., Europe, and possibly Japan, and we are keeping our eye on certain emerging markets that may become promising near-term. But we must be prepared for volatility driven by geopolitical events.
There also may be opportunities for investors, as we’ve noted before, in particular defense areas. While the U.S. may be decreasing its spending on big weapons systems and on the equipment that its soldiers have needed for the recent wars, it will probably be increasing its spending on ISR (intelligence, surveillance, and reconnaissance) and cyberwarfare. Defense contractors more heavily weighted in those areas may stand to benefit, while others will continue to face the stress of budget cuts.
Pure-play cybersecurity firms could also benefit in this environment, since global threats will be increasingly common in that sphere. For example, Russia’s lightning-quick takeover of the Crimean peninsula may have been aided and abetted by Russian hackers; NATO’s website was hit by a distributed denial of service (DDoS) attack on March 17.
Though much of the incremental ISR and cyberwarfare spend may go to U.S. defense companies, European contractors may also benefit. In order for NATO’s European members to reach their defense spending obligations under the treaty (2 percent of GDP), they would have to increase defense spending by 25 percent.
Should the European Central Bank act decisively to counter Eurozone deflation, a prospect which seems to be growing more likely, the growth shot might also positively affect these European aerospace and defense companies (though investors must always evaluate downside currency risks).
For more commentary or information on Guild Investment Management, please go to guildinvestment.com.