TL; DR

Authored by GoldFix ZH Edit

The Ukraine war brings to light three problems militarily.

• The face of war has changed again and we are unprepared for it
• Right now, there is a shortage of shells for conducting the war we are in.
• Going forward we likely have more of these type wars to fight

Warfare: From Shock and Awe to Muck and Mire

The July 31st TS Lombard report entitled Rearmament- A Lasting Investment Theme  assesses the geopolitical implications of the Ukraine war and the implications for investors. Their report first discusses the smart hindsight trade of hedging against the early 2022 "no-Russian invasion" consensus with long positions in leading defense sector stocks. This has shown significant outperformance over the past 18 months. It then contemplates whether this outperformance is a temporary trade or a fully-fledged investment theme.

Contents (1100 words, 6 min. read):

1. War: Urgency, Justification, and Sustainability Bullets
2. Investment Thesis
3. War is Both Chronic and Acute Now
4. Cold War 2.0: Current and Future War Duration Risk
5. Rearmament Headwinds
6. Bottom Line Geopolitically…
7. ….and for Investors.

• Related: Zoltan’s 3 Spending Themes Rearming, Reshoring, Energy Transition.

1- War: Urgency, Justification, and Sustainability Bullets

The key points in Christopher Granville's TS Lombard analysis that sit at the intersection of Geopolitics and Portfolio Management are:

• Military Unpreparedness: The Ukraine war has revealed that the defense industrial base of the US and its military allies is unfit for high-intensity territorial warfare against peer adversaries.

• Shell Shortage: Biden saying: “We’re running low [on shells]” ensures the necessary political impulse for sustained increases in defense spending1

• Humanitarian Need: The rearmament investment theme is supported along the way by the humanitarian disaster of the war’s protractedness2

• Cold War 2.0: The mindset created from this experience will take on a life of its own. In doing so, the legacy of persistent threat fresh in everyone's minds will serve as a driver of policy for years to come.3 Skirmish wars and tests of opponent resolve are part of a deglobalization process under mercantilistic rules.

   

2- Investment Thesis

The ongoing conflict in Ukraine, combined with the US-China rivalry, provides a robust rationale for structurally overweighting defense stocks in portfolios.

For passive exposure purposes, the tide-lifts-all-boats prospect looks safe. On the active side, a key question is whether the prime contractors will be the main relative beneficiaries of incremental demand or offer less upside than smaller players. The answer may depend on investment horizons, with diversification more likely to outperform over longer holding periods.

In short: We need to restock now for the Ukraine War, and we need to rearm for future preparedness in a Cold War 2.0 Environment. That means military spending in the *now* and ongoing for years.

• TS Lombard Twitter

3- War Drivers Will Outlive The War

The rationale for overweighting defense stocks in equity portfolios is driven by adversarial geopolitics, particularly the US-China rivalry, and the potential for periodic stagflation shocks resulting from geopolitical tensions. Moreover, the ongoing war in Ukraine and the urgent need for rearmament have further bolstered the investment thesis.

Lombard’s Granville highlights the urgency of rearmament, particularly due to the recent intense fighting. From the report:

The past eight weeks of intense Ukrainian counter-offensive has brought the rearmament urgency into sharp public view

US National Security Advisor Jake Sullivan's statements on addressing the 155mm shell supply problem underscore the seriousness of the situation.

4- Cold War 2.0: Current and Future War Duration Risk

They drill down into the duration of the war and its impact on defense spending. While the war's duration may affect overall risk factors, the rearmament theme is expected to continue due to the persistent post-war threat from Russia, necessitating the expansion of military industrial capacity.

The author emphasizes that the key driver of the rearmament theme is the geopolitical environment that will emerge and be sustained by the war's experience. This environment will continue to support the demand for rearmament, providing an attractive risk-reward opportunity for defense companies.

5- Rearmament Headwinds

There are potential challenges and nuances to consider in this investment theme. Incremental spending may raise questions about the effectiveness of increased investments in relatively inexpensive areas like artillery shells. But from the report, Granville believes Russia’s Ukraine war was just icing on an already baked cake.