NATO Membership Is Swelling, With Neutral Sweden And Finland Joining Soon
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One: Who are the winners?
In this environment, we believe one set of winners is the countries that can benefit from the recalibration of supply chains. They could be established, like Mexico, where unit labor costs are relatively low, the transport infrastructure is good, and there is a sizable pool of experienced maquiladora workforce as well as agile companies that can adapt to requirements quickly. Another will be those countries that have significant access to specific raw materials that are critical for semiconductors or electric vehicle (EV) batteries, as well as the ability to offer a stable base for manufacturing or processing. Mexico also benefits here, from having valuable resources. The United States Government Accountability Office (USGAO) has compiled a list of “critical” minerals. Mexico is a top three supplier for 14 of them and has potential to offer more, like lithium (EV batteries), bismuth (pharmaceuticals), graphite (semiconductors), lead and selenium—the last three of which are particularly valuable as they can replace supplies from China.
Another obvious contender to us would be Indonesia, which has the added advantage of a significant consumer market and a strategic location in the Association of Southeast Asian Nations (ASEAN). Jakarta has an additional attraction for foreign investors—it has the fourth biggest population in the world at 275 million. This implies that it is attractive for foreign direct investment (FDI), as the consumer market is growing fast. Furthermore, with 15–24 year olds representing nearly 16% of the population,14 there is a demographic dividend in place.
At the company and sector level, those companies that can address existing and priority shortcomings in specialist infrastructure are clearly in a privileged position. The construction of LNG terminals, short distance pipelines and industrial machinery modernization for energy efficiency are some examples. Along with this group are the enablers or beneficiaries of an acceleration in green-energy transformation. Together, these companies could boost economic growth and lay the foundations for longer-term structural and productivity improvements, in our analysis. In any case, defense companies stand to benefit in the coming decade. In part, this is down to the lessons of the Russia-Ukraine war. Full-scale land wars consume enormous amounts of plain-vanilla ammunition, and the use of relatively “dumb” munitions or unsophisticated drones can still be very effective. This efficacy is partly in their destructive capacity, but also in the economics of war. An effective antiaircraft and antimissile battery uses extremely expensive ammunition to stop very cheap drones.
All of this has implications for how the NATO procurement and planning process is organized, and ultimately how war is likely to be waged in the future. And for the companies involved in the military-industrial complex, the top priority will probably be to invest in capacity expansion, providing even more scope for revenue growth in the specialist-engineering subsector. In commodities, the clear beneficiaries are the “good” producers, since their client base represents over 60% of world GDP. However, we may see some “neutral” producers migrate to the “good” list to benefit from the decrease in competitive pressures, as the “bad” producers get excluded from lucrative markets.
Two: Governments need to issue more debt—inflationary pressures abound
Inflation has put a temporary ceiling on debt issuance, as interest costs have been rising fast. The global debt pile stood at around US$294 trillion in the third quarter of 2022, putting the world’s GDP ratio at an estimated 343%.16 Nevertheless, we expect debt issuance to climb again this year, as governments seek to implement pro-growth policies and boost investment in defense, as well as deal with higher-interest costs. For many, currency weakness presents additional headwinds. The traditional taboo around high debt-to-GDP ratios is only relevant for those countries that cannot easily refinance. Japan can sustain a ratio of 250% of GDP, the United States could go to 150%, and so on. The key point here is that the high-income countries will be better able to deal with the service costs and continue to find a market for its issuance. By default, this trajectory leads to increased polarization between the high-income and low-income countries. Developing countries tend to have lower sovereign debt/GDP than in the past, so for China the bulk of the debt is in the non-financial corporate sector (159% of GDP), while Indonesia’s equivalent ratio is a relatively modest 24%. The squeeze is being felt across low-income countries, such as Sri Lanka and Zambia. According to the World Bank, “as many as a dozen developing economies could prove unable to service their debt.
One of the biggest long-term impacts for the world is the European attitude to defense. Until the Second World War, Europe had a war every 20 years. Except for the breakup of Yugoslavia in the 1990s, Europe has been a continent that believed that creating close economic relationships can take the sting out of geopolitical rivalries. No longer. We believe the German word Zeitenwende meaning “change of eras” captures the moment perfectly.
NATO membership is swelling, with neutral Sweden and Finland joining soon, and an energized political class is prioritizing at least 2% of GDP to be dedicated to defense. This is not possible without issuing significant debt and, given the small production capacity in the military-industrial complex on both sides of the Atlantic, it is likely to be inflationary. Add to this the turbo-charged drive to accelerate the green-energy transition, the wave of industrial company capital expenditure to modernize industrial plants, and we see a series of inflationary waves coming over the next decade that would seem to question the validity of historic inflation targets of 2%. In practical terms, it doesn’t matter too much if it’s 3% or 4%, the markets will adjust accordingly. What the markets will struggle with is volatility of inflation and consequently of interest rates.
Three: It’s all different now
It seems to us that the good times of freewheeling globalization and converging economies in a higher-growth trajectory are ending, with national security interests and ideology now taking priority over economic logic. The result is a fragmented world, with trade barriers and increasingly regionalized trade zones, underpinned by ideology, geopolitical alignment, and perceived national security considerations.
We believe we need a massive reallocation of resources, which implies a need for positive real interest rates. This is because there will be so much issuance from both governments and the private sector, that there will be competition for investors’ cash. The traditional sources of long-term savings might be squeezed or even reduced over time, as the working populations in mostly high-income countries shrink and their social costs increase. A striking illustration is provided by the National Pension Service (NPS) of Republic of Korea, which is set to run out of money by 205519 because of the country’s aging demographics. There will be increasing government intervention in most western countries—not always efficiently or even usefully.
In the short term, it seems that asset prices have generally adjusted downwards, and there is optimism for economic growth. Fixed income is attractive again, but equity markets may have to temper earnings growth expectations, and inflation may remain higher than the traditional target of 2% for several years.
In summary, we believe we are at a global Zeitenwende, with implications that range from structurally higher debt, inflation and interest rates to a requirement for higher investment returns at a time of economic fracturing of the world. In our opinion, this scenario makes every investment decision loaded with implicit factor weights that are not currently mainstream.
