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Daily Intelligence Briefing

Tuesday, February 21, 2023

Identifying Change-Driven Investment Themes

The Daily Intelligence Briefing is published by McAlinden Research Partners. The report is provided to Hedge Connection blog readers once per week for free. Below is just one of the five sections that delivers Change-Driven Investment Themes everyday.


I. Today’s Thematic Investment Idea

A deep dive into a market driver with alpha generating potential.

Global Defense Spending Continues to Ratchet Up as Russo-Ukrainian War Nears One Year Mark

Summary: Almost one year on from Russia’s formal invasion of Ukraine, all sides seem committed to staying the course and fighting for as long as it may take. Throughout the past 12 months, assistance by Ukrainian allies in the west, particularly NATO member states, has surpassed the $50 billion mark with no limit on future expenditures in sight. For many years, most NATO countries had fallen short of the alliance’s stated goal to spend 2% of their GDP on defense, but that balance appears to be shifting. 18 of 30 member states are now committed to complying with their pledge in 2023, double the share who complied in 2022.

Rising military spending in North America and Europe will be driven by both regions’ need to re-fill weapons and equipment stockpiles that have been heavily drained by their support for the Ukrainian war effort. In 2022, direct commercial sales from US defense contractors to governments surged by almost 50% and, if the Russo-Ukrainian conflict goes on as brutally as it has, contractors could see continually resilient revenue growth for years to come.

Related ETF: SPDR S&P Aerospace & Defense ETF (XAR)

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Friday will mark the first anniversary of the Russo-Ukrainian war, which has permanently altered the geopolitical landscape of the world and is unlikely to end anytime soon. Just this morning, Russian President Vladimir Putin reiterated his commitment to the war as part of the annual State of the Nation address, noting his belief that Western allies providing assistance to Ukraine “intend to transform the local conflict into a global confrontation”. Putin doubled down on the stakes Russia faces, stating that this conflict will ultimately be “a matter our country’s existence”.

On Monday, President Joe Biden made a surprise visit to the Ukrainian capital and gave a set of remarks promising the disbursement of “$500 million” in new security assistance to Ukraine. According to a press release from the Department of Defense, that spend will be closer to $460 million and include supplies of 155mm artillery shells, 120mm mortar rounds, additional ammunition for High Mobility Artillery Rocket Systems (HIMARS), thousands of Javelin and other anti-armor rockets, and several Bradley Infantry Fire Support Team vehicles. These supplies will be provided from Department of Defense (DoD) inventories and constitute the thirty-second drawdown of US military stockpiles for Ukraine since August 2021.

Since the initiation of Russia’s invasion in Ukraine, approximately $29.8 billion has been expended by the US on material assistance to the Ukrainian military effort. Combined North American support is close to the $34 billion mark when you include Canada’s sizeable $4.0 billion in military contributions.

At the same time, Al Jazeera notes that the United Kingdom, Germany, and Poland round out the top 3 among European nations providing military assistance to Ukraine, contributing roughly €7.1 billion, €5.5 billion, and €3.0 billion, respectively. More than 20 other European nations have provided assistance as well. Most recently, MRP covered Europe’s upcoming deployment of a significant number of modern battle tanks, specifically the Leopard 2, to Ukraine throughout the next year.

All of these countries are members of the North Atlantic Treaty Organization (NATO). In 2023,  the cumulative military budget across its 30 member states was set at $2.1 billion, representing a 25.8% increase YoY. Still, only nine NATO countries met the organization’s stated goal for each member state to spend the equivalent of 2.0% of their GDP on defense last year. However, DefenseNews reports 18 have plans to do so in 2023. That is a significant shift from 2018 when former US President Donald Trump publicly scolded fellow NATO member state leaders for failing to meet the 2.0% pledge, referring to those nations as “delinquent” in their defense spending and insisting they increase it “immediately”.

A significant amount of new spending from NATO countries will be focused on simply re-filling their stockpiles of weapons, munitions, and equipment that they’ve expended in the defense of Ukraine. As MRP has repeatedy highlighted, US assistance to Ukraine has been putting a significant strain on its own weapons inventories at much earlier stages of the conflict. As an example, about 7,000 Javelin missiles, equivalent to one-third of the US’s existing stock, had been sent to Ukraine through June, according to an analysis by Mark Cancian, a senior adviser with the Center for Strategic and International Studies international security program, cited by Another 2,000 Javelins had been guaranteed to Ukraine through the month of August.

The artillery situation is perhaps the most dire. Ukraine can fire tens of thousands of rounds of artillery munitions per day fighting the highly mechanized Russian military, which is nearly equivalent to what the US can produce in a month. The US Army has pledged to triple its monthly output of shells from the prewar total of about 14,000 per month to up to 90,000 per month by 2025 to accommodate the Ukrainians’ needs, which will require a significant amount of investment on the US government’s part. from March to October, the United States supplied Ukraine with more than 900,000 155mm artillery rounds, which has undoubtedly exceeded the 1 million mark by now. The exact size of the DoD’s US munition inventories is not publicly known, but the government has begun digging into its international caches in South Korea and Israel to provide uninterrupted support to Ukraine.

Ukrainian allies in Europe are facing similar struggles with their domestic supplies after sending so much weaponry and equipment to the battlefields of eastern Europe. This has spurred a wave of new orders from defense contractors, particularly US-based manufacturers. DefenseNews notes that direct commercial sales of defense equipment ― from contractors to governments ― grew rapidly in 2022, reaching $153.7 billion, up 48.6% from $103.4 billion the year before.

As far as the conflict on the ground goes, the Institute for the Study of War (ISW) noted early this month that Russia had regained the initiative in the war, following offensive successes in the Donetsk Oblast and the mounting of a resilient defense against Ukrainian momentum in the Kharkiv and Luhansk Oblasts. As MRP previously noted, Russia’s November withdrawal from the northern part of the Kherson Oblast (located in the Southwest of Ukraine) to the left bank of the Dnieper River freed up a significant amount of manpower for both sides, leading to heavier clashes in the east.

Rumors have been swirling for some time now regarding the opening up of a new front, or the concentration of forces on an existing frontline, somewhere in Ukraine, as the Russians are currently holding up to 150,000 mobilized troops (about half of the total that was mobilized between September and October) in reserve outside of the special military operation (SMO) zone. Most of these troops have been stationed in training grounds and bases throughout the Belgorod, Kursk, and Rostov-on-Don regions, while around 10,000 have reportedly been deployed to Belarus to expand the two nations’ joint military groupings.

At the start of the war, on February 24, 2022, the Russians embarked on a failed blitz attack toward Kiev, advancing south through Belarus and west through Ukraine’s Sumy and Chernihiv Oblasts. This offensive included as many as 30,000 soldiers (as well as heavily extended supply lines and various logistical failures), and some have speculated Russia may try a similar path of attack once again, but with a much larger number of troops this time. Other axes of attack include a potential incursion west of the Oskil River in the northeastern part of the Kharkiv Oblast, or from the South in the Zaporizhzhia Oblast where Russia appeared to initiate a large wave of probing attacks and small-scale offensives late last month.

THEME ALERT – LONG Aerospace & Defense

We view rising defense spending, as well as increasing grants, loans, and sales to the US’s international allies, as a trend that is unlikely to abate any time soon. As President Biden said back in December, assistance from the US to Ukraine in its war against Russia will continue for “as long as it takes”. The Russo-Ukrainian war has had, and will continue to have, significant implications for the earnings of defense contractors who are perpetually receiving a stream of direct orders for new equipment bound for Ukraine, as well as contracts meant to re-fill increasingly depleted US stockpiles.

The US seems to be handing missiles and other equipment over to Ukraine faster than they can be produced, and that is creating significant order traffic with other allies. A backlog of orders meant for Taiwan, which was already in excess of $14 billion last December, has recently grown to $18.7 billion, according to congressional officials and others cited by the Wall Street Journal.

Axios has reported that rising defense expenditures have become a worldwide phenomenon with global military spending topping $2 trillion in 2021 for the first time. With nations across Europe and Asia preparing to beef up their armies throughout the next several years, we are likely on the precipice of an economic boom for defense contractors. 

MRP added Long Aerospace & Defense to our list of themes on June 18, 2021. Since the initiation of this theme, the SPDR S&P Aerospace & Defense ETF (XAR) has returned -7%, thus far underperforming an S&P 500 decline of -2% over the same period.


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