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Global Top Cat

Pivoting Defense Spending

By Yiannis G. Mostrous, on Dec. 17, 2016

As the Trump administration prepares to take office, trends in military spending over the past eight years resemble what transpired from the mid-1970s to the late 1980s, when the government reduced the defense budget consistently.

President Ronald Reagan’s budget called for a 25 percent increase in defense spending relative to the previous proposal. Reagan’s four-year target of $224 billion in military expenditures was so immense that the Dept of Defense found itself at a loss as to how to spend the money.

Defense stocks rallied significantly in 1980, but pulled back when reality set in that spending would fall short of Reagan’s initial proposal. Although defense budgets during the Reagan era were below the initial plan, the industry still outperformed for much of the decade, suggesting that dramatic take a backseat to a steadily growing stream of money.

Today, the military-industrial complex has closer ties to the US government than ever before.

The defense industry’s financial performance historically exhibits limited correlation with to the rest of the economy because demand for its products doesn’t depend on the consumer. And because the military-industrial complex remains one of the country’s major employers, Congress often struggles to refuse budget increases.

If the new administration lives up to its promises and increases the defense budget during its time in office, current equity valuations in the industry should be sustainable.

But prospective investors should remember that the new administration’s first proposed budget will be for 2018, so the defense industry’s financial results won’t receive a bump until 2019. And not all companies will benefit to the same degree.

Be patient and focus on bottom-up analysis to maximize your returns. The Global Top Cat series, available to Capitalist Times Premium subscribers, does just this with recent articles on European infrastructure plays, mining and resource plays, and defense industry picks positioned for a Reagan-like expansion in military spending. If you’re not a subscriber, consider becoming one now.

The Japanese Goldmine

For US-based defense companies, Japan potentially represents a key growth market. Last year, Japan spent $41 billion on its military—about 1 percent of its GDP, the budgetary limit. Meeting NATO’s 2-percent rule would require the country to allocate another $40 billion to military spending.

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And there could be upside to this target. Prime Minister Shinzo Abe has pushed changes to Japan’s constitution that would allow for increased defense spending.

The appointment of Tomomi Inada as Japan’s defense minister last summer likewise signals a commitment to further investment in the military’s capabilities. A hardline nationalist, Mrs. Inada rose to prominence in 2005, when she argued that the Tokyo Trials led to misperceptions about Japan’s responsibility for World War II.

Inada has also highlighted the Abe government’s aim to regain some of the “Japanese-ness” that the country lost during the postwar occupation. These hardline views don’t preclude purchasing equipment from US defense companies; the country can recover some of its Japanese-ness and do business at the same time.

Political observers in the country have suggested that, as one of Abe’s discoveries, Inada eventually could succeed her mentor as prime minister.

Over the longer term, military spending trends in Japan will depend on how the country views China’s rise and its threat to Japan. China has increased its defense spending to about $146 billion, or 1.3 percent of GDP. That’s good for No. 2 in the world, behind the US. And all signs point to China continuing to invest in its military capabilities.

How Japan ultimately decides to respond to China’s ambitions depends on how the global balance of power evolves. Become a Capitalist Times Premium subscriber today for access to our favorite global stocks in addition to our portfolio coverage.

Yiannis G. Mostrous contributes his expertise in emerging markets and international equities to Capitalist Times in his Global Top Cat columns.

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