Shield Wealth With Smart Defence
Investors understand how the business cycle and liquidity influence portfolio performance, guiding allocations across the four asset classes of the Permanent Browne Portfolio. Active investors can adjust these allocations dynamically, aiming to exceed the 3%-4% annualized real return the portfolio delivers in peacetime.
As a reminder, each phase of the business cycle favours a specific asset class:
Contracts (government bonds and cash) are the preferred assets during a deflationary boom and bust, respectively.
Properties (equities and physical gold) are favoured during an inflationary boom and bust, respectively.
The business cycle can be assessed using indicators like the equity-to-oil price ratio and the gold-to-domestic bonds ratio relative to their seven-year moving averages. Investors should recognize the triggers causing these ratios to cross their averages. The passive, equal-weighted Browne Portfolio typically delivers a 3%-4% real return during peacetime.
The permanent portfolio reflects real wealth creation and remains stable in peacetime. However, during wartime, it falters as centralized assets like government bonds and cash lose value due to defaults and inflation. For instance, French debt securities lost 97% of their real value between 1914 and 1950. Yet, the portfolio never falls to zero, as the 25% allocation to gold preserves a significant portion of its value.
Unfortunately, as recent events in Eastern Europe and the Middle East demonstrate, just as investors cannot change the course of the business cycle but can prepare for it, they also cannot alter the fate of the war cycle. Historically, war intensifies when an empire feels threatened internally, often initiated to maintain its plutocratic cronies in power. War is frequently orchestrated by the elite to avoid addressing the structural issues plaguing a declining republic.
As we close the fourth year of the decade, the world faces an intensifying war cycle. Historically, wars have triggered shifts in the business cycle, moving from inflationary booms to inflationary busts. However, one sector that thrives during wars is Aerospace & Defence.
According to the Stockholm International Peace Research Institute (SIPRI), global military expenditure reached $2,443 billion in 2023, a 6.8% increase from 2022. This represents about 2.5% of the 2023 global GDP, still well below the 6%+ of global GDP spent on military expenditures during the Cold War of the 1960s and 1970s.
Probably because since World War 2 it has to impose the ‘Pax Americana’ across the world, the United States has long been and remains the largest defence spender, accounting for nearly 40% of global military expenditure. According to SIPRI, China’s defence spending has been growing rapidly, with an annual growth rate of 5.5% from 2014 to 2023. While many countries have increased their defence budgets in recent years due to global tensions, terrorism, and cybersecurity threats, most NATO members still spend less than the 2% of GDP required by the North Atlantic Treaty signed in Washington on April 4, 1949.
Countries with the highest military spending worldwide in 2023 (in billion USD).
Great power competition is driving US defence spending. While past spending focused on wars of terror, it has now shifted to a ‘warmer’ cold war, defined by nations competing for regional and global dominance. For example, the Ukrainian conflict, China's continued expansion, the potential invasion of Taiwan by decade's end, and the Israel–Hamas conflict are recent developments motivating US policymakers to prepare for conflicts on these fronts, contributing to higher defence spending since 2015.
Defence spending in recent decades (% of GDP)
US defence discretionary spending is projected to keep rising even under the 47th US president who is looking via the Department of Government Efficiency (DOGE) to cut $2.0 trillion of federal spending once they take office in January 20th, 2025. The 2025 budget, set under the 45th US president, prioritizes readiness, near-term combat capability, and personnel over modernization, delaying investments in fifth- and sixth-generation fighters, trimming F-35 procurement, and reducing funding for the Air Force's NGAD and the Navy's F/A-XX. Future budgets will need to increase focus on modernization if the US wants to keep spreading ‘Pax Americana’ across the world.
Despite the Pentagon's discretionary budget nearing $1 trillion, defence spending as a percentage of US GDP continues to decline, dropping to 3% in the fiscal 2025 request from 11.4% in 1953. Rising costs for Social Security ($1.55 trillion, 5.3% of GDP), Medicare ($936 billion, 3.2%), and Medicaid ($589 billion, 2%) are squeezing discretionary funding, as tax hikes and debt ceiling increases remain politically difficult. The Office of Management and Budget projects US receipts will average 19.7% of GDP from 2025-34, mostly consumed by mandatory outlays and net interest, leaving little room for defence budget increases without expanding the deficit, unless entitlement reform and national debt management are addressed.
The second Trump administration is likely to renew a US-centric defence strategy, focusing on missile defence, long-range weapons, and strengthening the industrial base, benefiting both existing contractors and new technologies. With increased emphasis on China, calls for European military investment may intensify. Trump's Pentagon budget could outpace inflation over the next four years, with real spending gains supporting modernization, industrial growth, and inventory replenishment. While a wholesale increase is unlikely, a 3% real-term rise seems reasonable. Under Trump's first term, defence discretionary spending grew 13% net of inflation, averaging 3% annually, while Biden's 2022-25 budget saw only 1% real growth due to higher inflation. Under Obama, the budget fell 2% in real terms.
With a Trump White House and Republicans controlling Congress, the upcoming debt-ceiling negotiations may be less contentious, giving Trump more flexibility to increase defence spending. The US debt ceiling will be reinstated on January 2, after being suspended by the 2023 Fiscal Responsibility Act, which capped defence budgets at $842 billion (3% growth) in fiscal 2024 and $850 billion (1%) in 2025. The Congressional Budget Office projects rising deficits could push public debt to 116% of GDP by 2034, up from 99% at the end of 2024. The Trump administration's approach could include lower social spending, but tax cuts and increased military spending may raise deficits.
President-elect Trump has consistently urged NATO members to increase defence spending, advocating for a 3% GDP contribution, up from the previous 2%. While NATO countries have begun raising their defence budgets, Trump is likely to continue pushing for 3%, though he will not advocate for the US to leave NATO due to vital international partnerships, co-development projects, and military collaborations. Despite potential trade tensions, Trump's primary focus will remain on influencing China's role in global markets, rather than engaging with NATO partners.
The election of Trump as the 47th US president, despite his pledge to stop wars in less than 24 hours, will lead to higher defence spending, with a shift towards a more US-centric strategy. Key areas may include strengthening domestic defence capabilities, such as missile-defence systems, interceptors, and hypersonic missiles, with increased focus on the Pacific. This could benefit Navy vessels and Air Force long-range missile systems, as well as boost investment in the US defence manufacturing base for munitions, missiles, and new technologies.
While some are still expecting the Washington swamp to be drained by the DOGE, the Pentagon has failed its seventh consecutive audit, revealing deep financial mismanagement issues. Since audits began in 2018, the Department of Defence has yet to pass, with the latest review citing 28 material weaknesses. Chief Financial Officer Michael McCord admits significant progress is needed to meet the 2028 congressional mandate for a clean audit under the National Defence Authorization Act (NDAA). Critics highlight the Pentagon's inability to account for trillions in untracked funds, an issue dating back to a whistleblower’s claim of $2.3 trillion missing before 9/11. The destruction of WTC7, allegedly housing key audit materials. WTC7, the only building not struck by a plane on 9/11, collapsed in what the government attributed to fire melting steel beams. Notably, it housed the Pentagon audit system. While government employees were evacuated before the attack, civilians in other towers were not as fortunate.
Regardless of who occupies the White House, investors have recognized that the world has shifted from celebrating the ‘peace dividend’, the economic benefits of reduced defence spending, to countries increasing military expenditure. Research shows more NATO members are meeting the 2% of GDP defence spending commitment, with 18 out of 31 countries now meeting this target, up from 7 last year. A 2023 JPMorgan study projects NATO spending could rise by 21% in the near future. European nations like Germany are also pushing toward the 2% threshold. If there is government spending that is agnostic to the state of the business cycle, it is defence spending, which has historically been resilient, often rising during recessions, and is increasingly viewed as a key sector that thrives across the business cycle.
World Defence Spending in USD & US Recessions since 1992.
Since investors cannot control war cycles any more than they can control business cycles, their best option is to understand how war cycles impact the business cycle and adapt their portfolios accordingly. Wars drive capital out of conflict zones into safer environments, creating investment opportunities elsewhere. For example, without World Wars I and II, capital might never have shifted from Europe to America, making New York the global financial capital instead of London. In addition to geopolitical tensions that may intensify inflation pressures, investors should also be wary of the looming great wall of debt. The need to refinance existing debt by issuing new debt in a tightening liquidity environment would ultimately trigger a sovereign debt crisis and capital controls in the economic zone dealing with wars directly like Europe and the Middle East seems to be inevitable.
In a nutshell, the world is on the verge of two sequential crises:
Geopolitical Crisis: This will drive capital out of unstable regions in Europe and the Middle first and Asia later, strengthening the USD and USD assets as investors seek safety.
Sovereign Debt Crisis: Likely beginning in Japan once another proxy war starts on the Korean peninsula and then in Europe as the Ukraine Russia Special Operation spreads outside the current battlefield. This will culminate in a US government default as American citizens realize that the overseas wars have just been a pretext to hold the current plutocracy on life support for much longer while the separation between the blue and the red states are increasingly unable to live together. This means that by the end of the decade the US government will become unable to issue new debt to refinance existing obligations.
Given the combination of wars and the ensuing debt crisis, investors should prepare for capital controls being implemented sooner rather than later, especially in regions already embroiled in proxy wars, such as Europe and the Middle East.
Grover Cleveland was elected as the 22nd and 24th US president, being the only previous president who, like Trump, was elected to non-consecutive terms. Like Donald Trump, he also stood against his own party, expressing this best during the Panic of 1893: capital can flee and move offshore, but it is the middle class that cannot hoard their labour nor move it offshore.
As investors seek to understand how the war cycle impacts the business cycle and recognize that capital flows often precede events, they naturally look for the best investment opportunities. Examining the performance of the S&P 500 and the S&P Aerospace and Defence Sector reveals that exposure to this sector has consistently been a source of alpha for portfolios over the past 25 years.
Performance of $100 invested in S&P 500 index (blue line); S&P Aerospace and Defence Sector (red line) since 31st December 1999; S&P Aerospace and Defence Sector 12-month Rate of Change (yellow histogram); S&P 500 12-months rate of change (green histogram).
In the short term, while largely overlooked by many Wall Street bankers and their media parrots, the S&P Aerospace and Defence sector has outperformed the IT sector since the tragic events of October 7, 2023, which triggered the current war in the Middle East. Notably, it has achieved this with significantly less volatility and drawdown, while substantially outperforming both the S&P 500 and the S&P 500 Energy sector during this period.
Performance of $100 invested in the S&P 500 index (blue line); the S&P Aerospace & Defence Index (red line); the S&P IT sector index (green line) & S&P Energy sector (purple line) since October 7th, 2023.
The impact of the war cycle on the business cycle will largely depend on its influence on oil prices and how economic actors adapt to profit from these changes. Over the past 25 years, whenever the 12-month rate of change in the S&P 500 Index relative to the S&P Aerospace and Defence Sector Index turned negative, it preceded the S&P 500 to oil ratio—a measure of the energy efficiency of the US economy, falling below its 7-year moving average within 6 to 9 months. Although less consistent than the S&P to gold ratio crossing below its 7-year moving average, the 12-month outperformance of the Aerospace and Defence sector relative to the S&P 500 can act as an early warning signal, indicating that the US economy shifts from an economic boom to a bust. As of November 29, 2024, the 12-month rate of change in the S&P 500 relative to the Aerospace and Defence sector has turned negative, adding to other market indicators suggesting that the US economy may soon transition from the current inflationary boom to an inflationary bust.
Upper Panel: S&P 500 to oil ratio (blue line); 84 months Moving Average of the S&P 500 to oil ratio (red line); Middle Panel: 12-months rate of change of the S&P to Aerospace Defence Sector (yellow histogram); Lower Panel: S&P 500 to Gold ratio (green line); 84 months Moving Average of the S&P 500 to Gold ratio (red line)
Savvy equity investors are well aware that since the COVID pandemic, a barbell passive equity portfolio equally weighted in the Tech and Energy sectors would have significantly outperformed the S&P 500 with much lower volatility. As wars continue to shape the investment landscape, investors are now encouraged to enhance this strategy by adding the Aerospace & Defence sector, creating a ‘Smart Defence Equity Portfolio.’ Since the tragic event of October 7th, a moment that may ultimately be regarded as the effective start of World War III, as it served as an additional catalyst to the Special Operation in Ukraine and the emergence of a multipolar world, this portfolio has not only outperformed the S&P 500 index and the traditional Barbell Equity Portfolio (50% IT, 50% Energy) but has also delivered superior returns with much lower volatility.
Performance of $100 invested in the S&P 500 index (blue line); the old Barbell Equity Portfolio (50% IT & 50% Energy) (red line); the Smart Defence Portfolio (33.33% IT; 33.33% Energy; 33.33% Aerospace & Defence) (green line) since October 7th, 2023.
Over the past 25 years, the Smart Defence Equity portfolio has been on average historically negatively correlated with the return in the S&P 500 to Oil ratio which means that it is also well equipped to help investors navigating the upcoming transition of the US economy from an inflationary boom into an inflationary bust.
In a nutshell, while the US is still in an inflationary boom, there are increasing risk from the weaponization of the liquidity to the heating up of the war cycle to see the US moving into an inflationary bust in the next 6 to 9 months. Indeed, investors should be increasingly concerned that, despite expected deregulations under the 47th US president and his supposed wishes to stop the wars started under the 46th US president, he could be impotent to deliver on his campaign promises on both the economic and geopolitical fronts as the current inflationary boom could quickly turn into a bust.
If the banking system fails to operate profitably for the benefit of US citizens under tighter, weaponized liquidity, and those pulling the strings behind the scenes stage a false flag to push the US and the rest of the world into inevitable battlefield escalation, it will ultimately lead to GLOBAL STAGFLATION. This stagflation will also be fuelled by a trade war centred on what the 47th US president elect has described as the ‘nicest word ‘in the English dictionary: TARIFFS
Read more and discover how to position your portfolio here: https://themacrobutler.substack.com/p/shield-wealth-with-smart-defence
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