Great power competition: The unlikeable, but undeniable, mega theme

Global defence spending has jumped 18 per cent this year and is on track to reach as high as $3 trillion per annum by 2030, as the globe grapples with the largest number of active conflicts since World War II and a record number of forcibly displaced people.

Governments are preparing for a decades-long battle for power that will impact trade, economic policy, and military and defence strategy, according to Simon Henry, managing director and portfolio manager at Wellington Management.

The fragmentation of global power, alongside climate change and the rise of AI, has been identified by Wellington as major generational changes that will impact markets for decades to come.

“Geopolitical friction and great power competition will lead to a much higher prioritisation of national security, and one clear knock-on effect is going to be the structural rise in global defence spending,” Henry told the Fiduciary Investors Symposium at Oxford, UK.

“Governments around the world are recognising these tensions, and the burden is increasingly on individual countries to defend their borders.”

While defence ticks a lot of boxes for investors, given the sector’s strong medium-to-long term growth outlook and favourable political tailwinds, Henry acknowledged the challenges of investing in defence from an ethical and sustainability perspective.

“In an ideal world, this wouldn’t be a theme that is compelling. No one wishes for war. In our discussions with investors however, there is an increasing recognition that it is essential to modernise defence capabilities to protect national interests and, hopefully, reduce the likelihood of conflicts in the future.”

In addition to war and geopolitics, climate change also poses a major threat to long-term national security. According to Wellington, the number of people displaced by climate change, particularly in the equatorial band, could outweigh the number of people forcibly displaced by conflict.

The consequences of this trend include mass migration, driven by, or leading to, greater levels of water stress and more extreme heat events.

Henry said action on climate change needed to extend beyond the energy transition to include adaptation.

“We talk a lot about slowing down climate change, but there isn’t much discussion about how to live in the new reality,” he said.  “Human beings will need to adapt. Economies need to prepare for much more volatile and extreme conditions.”

A greater focus on adaptation also provides some protection against the risk of governments and corporates failing to hit their emission reduction targets.

To achieve targets contained in the 2015 Paris Agreement, global greenhouse gas (GHG) emissions need to almost halve by 2030 and hit net-zero by 2050.

“Decarbonisation is going to take time. Renewables come with an intermittency that is very challenging from a grid perspective and the supply chain, particularly the solar supply chain, is heavily dominated by China, which is challenging from a geopolitical perspective,” Henry said.

“The longer the transition gets delayed, the more money must be spent on adaptation and resilience. The numbers are staggering.”

With climate-related risks, global conflict and technological advancement here to stay, investors needed to step back, think long-term and build targeted exposures into their portfolios, he added.

“The next 25 years will be full of disruption as we all navigate a changing world order, the impact of climate change, and the explosion of AI,” Henry said. In relation to this trend of continual change, Wellington’s Thematics Platform has identified around 20 investable themes. One theme includes investing in defence stocks. “There are about 50 pure play defence stocks, and they are underrepresented in broad market exposures, and they can come with quite interesting return opportunities and characteristics, particularly during periods of heightened geopolitical risk,” Henry said. Climate resilience is also a key theme, given the strength of the team’s conviction and how structurally underrepresented the theme is in investment portfolios.

“These changes sound like existential problems and somewhat dystopian at times, but they can provide compelling return opportunities, particularly in areas where traditional benchmarks and exposures are very light.”