Speaker 1: You're listening to Asia Centric from Bloomberg Intelligence, the podcast
Speaker 1: that pulls back the curtain non global business so you
Speaker 1: can invest better across the Pacific rim. I'm Tom Corbett
Speaker 1: in Hong Kong.
Speaker 2: And I'm John Lee. Equity markets appear to see smell
Speaker 2: and hear no evil. The MSCI China Index is in
Speaker 2: a bull run, up twenty percent from its lows. The
Speaker 2: S and P five hundred is still up nine percent
Speaker 2: this year.
Speaker 1: But Chinese and US stocks could be ignoring a fundamental
Speaker 1: shift in the narrative. Geopolitical risks run fast and thick.
Speaker 1: Global military spending is rising, and investors are shifting their
Speaker 1: priorities accordingly.
Speaker 2: Where do the risks and opportunities lie and how can
Speaker 2: invest this profit from the worldwide increase in defense spending.
Speaker 1: Let's bring in Sean Darby, equity strategist at Miss zu
Speaker 1: Ho Securities. Sean, it's great to have you on Asia centerc.
Speaker 3: Good morning, Tom and John am also very grateful to
Speaker 3: be your participants in this podcast. Thank you, Sean.
Speaker 2: The world's equity markets are on a tier. The geopolitical
Speaker 2: backdrop seems to be fraught with risks, though in the
Speaker 2: US and China as well. Stocks are very strong. What's
Speaker 2: going on? Are the markets ignoring risks? Do they know
Speaker 2: something we don't?
Speaker 3: I suppose equity investors are conditioned to follow growth signals,
Speaker 3: and for the best part of the last twenty five years,
Speaker 3: equity investors had good reason to ignore inflation worries and
Speaker 3: really relied on the growth signals as being the way
Speaker 3: to add or subtract beta to those stock portfolios. And
Speaker 3: put it in the context of just general ass allocation.
Speaker 3: You had a what's called a negative correlation between government
Speaker 3: on prices and equity prices, so when you had bad
Speaker 3: news inequities, it would be a good time for bonds.
Speaker 3: And that correlation started in two thousand when we went
Speaker 3: into this world of low inflation. So it's very different
Speaker 3: dynamics now in the sense that we've not necessarily got
Speaker 3: those deflationary or disinflationary winds, but market participants seem to
Speaker 3: be still conditioned to that one frame of how news
Speaker 3: is taken in terms of growth, and that's generally been
Speaker 3: a good environment for equity investors, and it's no different now.
Speaker 3: In fact, looking across the board, there's very few markets
Speaker 3: globally that are in actually a genuine bear market.
Speaker 2: And when it comes to geopolitical risks, the general playbook
Speaker 2: seems to be that, you know, if there's risks, investors
Speaker 2: head towards safe haven assets. Sometimes oil prices rise, but
Speaker 2: defense docks are usually seen as a great head. Do
Speaker 2: you think geopolitical risks will continue to rise in the
Speaker 2: medium term?
Speaker 3: I do. I'm afraid so. Geopol politics is not an
Speaker 3: easy one for gain equity investors or any asset class
Speaker 3: investors to be able to frame and to measure. There's
Speaker 3: been some work done by some of the Federal Reserve
Speaker 3: Board which produced data going back to the nineteen hundreds,
Speaker 3: and what they do show is that geopolitical events tend
Speaker 3: to occur in clusters, and that you get periods of
Speaker 3: time when geopolitics is a very very strong feature of
Speaker 3: the news headlines, and then it can go away for
Speaker 3: almost two or three decades. And in the context of
Speaker 3: the environment that we've been really talking about, the last
Speaker 3: real period of heightened geopolitics was really around the Cold
Speaker 3: War between America and the Allies and Russia, and really
Speaker 3: from that period from the late nineteen seventies late nineteen eighties,
Speaker 3: we didn't have to incorporate geopolitical risks into our asset
Speaker 3: allocation models because they tended to be either very localized
Speaker 3: affairs or didn't actually infringe upon the developed world at all.
Speaker 3: So I think the takeaway really is that none of
Speaker 3: us in the current investment environment have the experience of
Speaker 3: dealing with geopolitical events, which may mean that we're not
Speaker 3: very good at accommodating that information. And secondly, genuinely, the
Speaker 3: last time we've had a real rise in geopolitical risk
Speaker 3: has been really almost thirty to forty years ago, So again,
Speaker 3: most of us would not have been investing around that
Speaker 3: period of time.
Speaker 1: So, Sean Darby, you're looking at a generation of investors
Speaker 1: that may not have seen this narrative in the past.
Speaker 1: How would you characterize the change we're undergoing? Would you
Speaker 1: describe it as a paradigm shift? Is that too much
Speaker 1: of an overstatement?
Speaker 3: No, you're right, Tom, I think it is a paradigm shift.
Speaker 3: And the way to think about it is that from
Speaker 3: the response function of governments, for the best part of
Speaker 3: the last thirty years, they've been cutting military budgets as
Speaker 3: a percentage of GDP. So irrespective of some of the
Speaker 3: news headlines and against some of the localized military conflicts
Speaker 3: or tensions. The real trend line has been for governments
Speaker 3: to cut military expenditure as a percent of GDP. So
Speaker 3: if you were looking at this in terms of profits
Speaker 3: for the global economy and all for the major benchmarks,
Speaker 3: the profits coming from the aerospace and defense indices was
Speaker 3: actually diminishing and diminishing very rapidly against that against health
Speaker 3: care and tech. So, again coming back to that earlier question,
Speaker 3: the narrative for investors has been one of which these
Speaker 3: sectors did not necessarily produce outsized profit cycles because the
Speaker 3: government is by and largely the biggest expend purchaser of
Speaker 3: this equipment, and they were actually cutting defense for the
Speaker 3: last thirty years.
Speaker 2: And Sean, which Asian countries and companies do you think
Speaker 2: most exposed to this boom in defense spending?
Speaker 3: That's a very good question. So first of all, to
Speaker 3: put it into a global context, the aerospace and defense
Speaker 3: indices have done relatively well. Now, so as that expenditure
Speaker 3: has started to pick up with the conflict in Ukraine
Speaker 3: and other geopolitical tensions in perhaps the South China seas,
Speaker 3: the aerospace and defense in diseees have started to see
Speaker 3: a profit shift back to them, and that's possibly the
Speaker 3: most pronounced has actually been in the European in decease.
Speaker 3: They've been dramatically out for performed the eurostop first of all.
Speaker 3: In this time zone. What's been interesting is that there's
Speaker 3: been pressure on countries to increase their military expenditure, and
Speaker 3: the most notable has actually been in Japan. Japan has
Speaker 3: come out with the headline numbers which are very, very
Speaker 3: significantly above anything that they've ever done in terms of expenditure,
Speaker 3: and certainly that narrative has been one feature of the
Speaker 3: last five to six years as China's maritime prowess has gained,
Speaker 3: so certainly in Japan has been a very significant change
Speaker 3: in the defense spending. Just to put it into context,
Speaker 3: the average military expenditure globally, if you use twenty twenty
Speaker 3: two to twenty three figures, was close to around just
Speaker 3: two percent of GDP. At the peak of the Cold War,
Speaker 3: it was over six percent. So just to get a
Speaker 3: framing of where we're starting from, we're only just beginning
Speaker 3: to see those numbers change, and for a country like Japan,
Speaker 3: the numbers have actually been extremely low, again below two
Speaker 3: percent of GDP. For the best part of the last
Speaker 3: twenty five thirty years. So Japan has been one of
Speaker 3: those economies which is broken away in terms of expenditure
Speaker 3: of GDP, and because the index tops or the nick
Speaker 3: as a large amount of defense related companies that tend
Speaker 3: to be industrials. That's been shown up in some of
Speaker 3: those numbers. The second economy that's actually benefited quite dramatically
Speaker 3: from the turnaround and expenditure has been South Korea. South
Speaker 3: Korea has always had a very large expenditure of military
Speaker 3: costs to GDP, and because they've also had the in
Speaker 3: situ factories and munitions, they've been able to benefit from
Speaker 3: this sweeping change of orders as the war in the
Speaker 3: Ukraine has intensified. So South Korea, strangely enough, has benefited
Speaker 3: from what has been an external conflict, are not necessarily
Speaker 3: one which they've been sort of perhaps we say, been
Speaker 3: set for, or the conflict that they've imagined that they
Speaker 3: would have with North Korea. Just two other points to note.
Speaker 3: The multipliers on military expenders are extremely high, So when
Speaker 3: you look at governments around the world when they want
Speaker 3: to stimulate an economy, most will turn to some form
Speaker 3: of fixed acid investment building some roads, building some airports
Speaker 3: and so forth. But the multipliers from defense equipment expenditure
Speaker 3: is very very significant because you're involve in very large
Speaker 3: ticket items which have to be built over long periods
Speaker 3: of time. So in terms of the impact from the
Speaker 3: expenditure on GDP and on profits, they can last a
Speaker 3: very very long time. And again I think this is
Speaker 3: something very different from what equity investors would normally be
Speaker 3: looking for, where you build a fab plant in eighteen
Speaker 3: months and in thirty six months you've got profits generating
Speaker 3: orders for ships, aircraft, tanks, large defense items. They can
Speaker 3: go on for six seven years, and the maintenance costs
Speaker 3: and upgrades can be quite dramatic. So this is not
Speaker 3: a short run impact on profits. It's going to have
Speaker 3: a very very long one as we go forward into
Speaker 3: this sort of new dimension, sort of new era in
Speaker 3: terms of defense spending.
Speaker 1: So how can investors reposition themselves to align themselves with
Speaker 1: the opportunity if you want to call it that, and
Speaker 1: these shifted national priorities should they look at it? Is
Speaker 1: this a case of glass half full or glass half
Speaker 1: outdy Well, that's.
Speaker 3: A very good question, Tom. The first is that the
Speaker 3: type of expenditure now that we're going to have come
Speaker 3: under the defense bracket won't just be hard IT ticket items.
Speaker 3: It'll be things such as abilities to use drones, specialized
Speaker 3: navigational equipment. There'll be measures to counteract, as we say,
Speaker 3: computer malware. All of these type of new threats to
Speaker 3: economic systems are becoming increasingly important. And just as a
Speaker 3: maunter of interest in Europe and Europe and the UK,
Speaker 3: they've had to start to spend money on protecting their
Speaker 3: underwater pipelines and cable networks. So again, the threats to
Speaker 3: the system have become very different to what we would
Speaker 3: have expected thirty or forty years ago. So even though
Speaker 3: the aerospace and defense industry sees are defined by this
Speaker 3: type of big ticket items, you're going to see a
Speaker 3: trickle down effect into a lot of other sectors, potentially
Speaker 3: in the software industry, as people have to also protect
Speaker 3: their IT integrity far more from government. So that's the
Speaker 3: first thing to say. The second is quite interestingly, and
Speaker 3: it's something that's afflicted the energy sector, is that because
Speaker 3: of the ESG overlay from many equity investors, they can't
Speaker 3: actually participate in the defense industry. It's a sort of
Speaker 3: off the ground, off the territory area. So if you're
Speaker 3: an equity investor at the moment and you've been out
Speaker 3: of energy in the last three years, defense in the
Speaker 3: last two or three years, you've had some pretty difficult narrative.
Speaker 3: You're forced into very very concentrated bets in very concentrated companies.
Speaker 3: So that's the second thing is that the ESG framework,
Speaker 3: which didn't exist of course thirty or forty years ago,
Speaker 3: has made defense area a sort of very difficult one
Speaker 3: in which they can run their portfolios around. I think
Speaker 3: the last thing to say is that in contrast to
Speaker 3: what we saw in the sixties or seventies, when most
Speaker 3: military equipment companies were actually nationalized or semi nationalized idea
Speaker 3: were under the government, these companies now are listed, So
Speaker 3: there's a lot more choice for portfolio managers in terms
Speaker 3: of the companies that they can select, whereas in the
Speaker 3: past most of them were actually held under the national
Speaker 3: government and there was not the same impact on profits
Speaker 3: as it would potentially be going forward. So I think
Speaker 3: from my side, the portfolio choices are much wider and
Speaker 3: much more internationalized. And again we're talking about a relative
Speaker 3: profit shift from very very low levels. Even now. You
Speaker 3: think you look at the aerospace and defense and disease
Speaker 3: in some of these countries, like in Korea Europe, they
Speaker 3: look quite well, what a extreme move, But actually we're
Speaker 3: probably only in the beginning of this cycle in many respects,
Speaker 3: given the long duration of the orders that are going
Speaker 3: to have to be initiated.
Speaker 2: For the benefit of the listener, some of these defense
Speaker 2: docks have really been on a tear Mitsubishi Heavy is
Speaker 2: up over seventy percent year to date. I think Hanwa
Speaker 2: Aerospace in Korea is also up over seventy percent. So yeah,
Speaker 2: they have been really strong. If I could just talk,
Speaker 2: you did mention Japan. At Japan's in a quite intriguing situation.
Speaker 2: They're not allowed to actually export their weapons. There seems
Speaker 2: to be some potential for changes to the constitution allowing
Speaker 2: them to export some weapons. I think there's been something
Speaker 2: US on the jet fire planes. Do you see this
Speaker 2: happening and could this be a catalyst?
Speaker 3: That's a very good question. So at the moment, there
Speaker 3: are very few countries that, for example, can build planes,
Speaker 3: put together missile systems and do the hardware, and Japan
Speaker 3: is one of those that can do that. Now, there
Speaker 3: is a precedent because as the Ukraine War developed, the
Speaker 3: German government did a u turn on exports of military equipment,
Speaker 3: particularly the Leopard tanks. So the first thing to say
Speaker 3: is that when there is an immediate need for demand
Speaker 3: for military equipment to be moved overseas or into other jurisdictions,
Speaker 3: the German government did show within Europe that it could
Speaker 3: do that. I think the issue for Japan is that
Speaker 3: it certainly can change parts of the constitution and also
Speaker 3: change certain rules. One of the things that's interesting about
Speaker 3: Japan is a lot of the military that is actually
Speaker 3: built domestically is under license from America and from other countries.
Speaker 3: So in a sense, they've got the physical capacity to
Speaker 3: build domestically, but they're actually doing it under international licenses,
Speaker 3: and that's something again very different from what we saw
Speaker 3: in the last thirty or forty years. Companies like Boeing, Array,
Speaker 3: cal and on, all of these type of military companies
Speaker 3: would normally build the equipment domestically and export it. Now
Speaker 3: a lot of it's done unlicense agreements, and I think
Speaker 3: that's very much the case for Japan. So they would
Speaker 3: also need to be mindful of the fact that some
Speaker 3: of us would need to get approved from the US
Speaker 3: or whoever they've licensed those production schedules from.
Speaker 1: Sean Darby, it's difficult to talk about this without bringing
Speaker 1: in America's fiscal situation. In the United States, debt has ballooned.
Speaker 1: In nineteen ninety two, it was what forty six percent
Speaker 1: of GDP Today it's ninety six percent. Politicians tut about it,
Speaker 1: but a handful of voices former Treasury Secretary Larry's summers,
Speaker 1: for one, it shows some sense of urgency about it.
Speaker 1: Is it time to worry? How is America's fiscal situation
Speaker 1: stacking up on your list of concerns? How is it
Speaker 1: shaping the entire geopolitical setting as it's changing.
Speaker 3: One thing about conflicts and wars is that they tend
Speaker 3: to be very inflationary. You're forced into spending whether you
Speaker 3: like it or not. So talking about paradigm shifts, the
Speaker 3: reality is that the defense budgets are going to have
Speaker 3: to go up one way or the other. There's a
Speaker 3: number of threats for these are countries, and they've been
Speaker 3: spending way below what would normally be considered to be
Speaker 3: a baseline case of something like three percent of GDP.
Speaker 3: So the first thing is you're not going to get
Speaker 3: away from that rise in the military budgets. Maybe we
Speaker 3: don't go back to where we were in the nineteen sixties,
Speaker 3: but certainly as a proportion of GDP, it's going to
Speaker 3: go up. So the debt financing for this is only
Speaker 3: going to increase. I think the odd thing about this
Speaker 3: is that it's got to be seen in the context
Speaker 3: that governments are spending an awful lot of money in
Speaker 3: other areas. At the same time, you have a huge
Speaker 3: renewables program, You've got subsidies to bring plants back on
Speaker 3: shore in the United States as well. You've got the.
Speaker 1: Chips entitlement programs in the US.
Speaker 3: Chips Acts entitlement program, subsidies for building plants. So in
Speaker 3: the whole context of expenditure by governments within the economy,
Speaker 3: the share of government spending in the economy is going
Speaker 3: to go up as well, which means much more levels
Speaker 3: of debt issurance. And that's inevitable not just in the
Speaker 3: United States but elsewhere as well. So again from an
Speaker 3: investor point of view, we've had governments generally globally, and
Speaker 3: I would say which would resonate in Europe, which were
Speaker 3: very mindful of their fiscal positions after twenty eleven. You know,
Speaker 3: there was a very conscious awareness that they would not
Speaker 3: go and similarly in Asia, countries would not go on
Speaker 3: heavy expenditures in terms of the budgets. But they're almost
Speaker 3: now forced into this, you know, coming into the COVID
Speaker 3: period with renewables program during COVID to offset the huge
Speaker 3: deflationary shock, and now post COVID where you have geopolitical
Speaker 3: pressures coming through. So to answer your question very succently,
Speaker 3: I'm afraid to say that the debt levels are going
Speaker 3: to go up, and unfortunately, debt issuance is going to
Speaker 3: be a very significant overhang for asset markets going.
Speaker 1: Forward, and then factor in inflation the impact on interest rates.
Speaker 1: It doesn't sound like a very pretty picture.
Speaker 3: Well, it wasn't one during the nineteen seventies, so that's
Speaker 3: the first thing to say. And again there wasn't the
Speaker 3: type of globalization that we had back then. Most countries
Speaker 3: were running some form of capital controls and most the
Speaker 3: debt was owned by the domestic institutions. But the reality
Speaker 3: is that this implicit policy shift between what the government
Speaker 3: wants and how central bankers want to finance. It has
Speaker 3: been going on. You know. Really once we started QI,
Speaker 3: they bought the government bonds, put it onto the balance sheet,
Speaker 3: and there was an implicit monetization of government debts anyway.
Speaker 3: So we've been in this, but not to the degree
Speaker 3: that we've ever really felt thought about that actually, this
Speaker 3: is going to be the game going forward. I think
Speaker 3: again coming back to experience levels, you have a shortage
Speaker 3: of people in Japan who've never seen interest rates go up.
Speaker 3: People are desperate to find people who know how to
Speaker 3: trade rates now. And similarly in the aerospace sectors, there's
Speaker 3: very very few analysts who actually cover these stocks have
Speaker 3: seen the type of changes going forward. And the companies,
Speaker 3: those heavy industrialized companies that John Lee mentioned would not
Speaker 3: necessarily get the same front page coverages as your tech companies,
Speaker 3: but that's profit shift is going to be very different.
Speaker 3: So the context of this and an investment framework is
Speaker 3: a much more difficult one. And as I said, it's
Speaker 3: going to be against the backdrop of much much higher
Speaker 3: yields than we anticipated nearly five or six years ago.
Speaker 2: And sure, just sticking with the US, there seems to
Speaker 2: be some growing concerns about America's manufacturing base. Now one
Speaker 2: of the biggest suppliers is Boeing. Now they've had a
Speaker 2: lot of problems on their commercial jet engine side. But
Speaker 2: there's also some news articles talking about how the US
Speaker 2: Navy is worried that their supplies are not building submarines
Speaker 2: quick enough. I think that someone seenior in the US
Speaker 2: Navy visited South Korea and Japan to see if these
Speaker 2: countries could actually supply navy vessels going forward. Is this
Speaker 2: a big issue?
Speaker 3: Yes, it is. I think again, there's been a huge
Speaker 3: hollowing out of these industries, and one of the features
Speaker 3: of the aerospace and defense industries has been like a
Speaker 3: large amount of M and A activity over the last
Speaker 3: thirty years because to survive, these companies had to scale
Speaker 3: themselves for reduced budgets, and across the board in the
Speaker 3: United States, in Europe, the number of defense and companies
Speaker 3: have been reduced and there's been quite a significant scaling
Speaker 3: and hollowing out. So in the context of trying to
Speaker 3: expand quickly, what you're finding is that not everybody has
Speaker 3: got the physical capacity to meet this level of demand.
Speaker 3: And you know, it comes back to the fact that
Speaker 3: suddenly South Korea found its export profile for defense equipment
Speaker 3: improving purely because they're one of the few countries that
Speaker 3: still produce munitions on the scale that can provide that
Speaker 3: very rapidly. So quite right, John, I think in the
Speaker 3: short term there's a skill shortage in this particular area.
Speaker 3: It's one where there's not enough in situ physical capacity.
Speaker 3: And thirdly, you're going to rely on global allies to
Speaker 3: pick up any shortfall in the production of components and items,
Speaker 3: because again, this is just not being the level of
Speaker 3: demand out there for companies to anticipate putting in any
Speaker 3: physical capacity. So yes, there's going to be quite a
Speaker 3: significant sea change in a way we sort of buy
Speaker 3: and sell equipment from each other because there's just not
Speaker 3: enough of the companies around that can do it.
Speaker 1: Sean Darby, let me paraphrase something that Bloomberg opinion columnist
Speaker 1: Thomas Black recently wrote. He wrote, the flare up of
Speaker 1: Middle East violence, Russia's war in Ukraine, China's stance on
Speaker 1: Taiwan have all shattered the illusion of a peaceful world
Speaker 1: that had taken hold after the Berlin Wall fell in
Speaker 1: nineteen eighty nine and the collapse of the Soviet Union
Speaker 1: two years later. Is that an overstatement or is that
Speaker 1: a realistic take on where we stand today in geopolitics.
Speaker 3: I think it's a very good summary, Tom, and I
Speaker 3: think it was basically summarized being the peace dividend. And
Speaker 3: this peace dividend came through in a number of different levels.
Speaker 3: As you cut the military expenditure in countries, you were
Speaker 3: given tax cuts as consumers, so we all benefited from
Speaker 3: a low tax rate, both income and on purchases. So
Speaker 3: that's the first thing. It was a very big shift
Speaker 3: to the consumer in terms of their spending power. Secondly,
Speaker 3: of course, we benefited from waves of disinflation of goods
Speaker 3: and services because a lot of these countries came into
Speaker 3: the global economy, came through WTO and were trading partners,
Speaker 3: so you benefited from a very big drop in in
Speaker 3: the inflation rate. Thirdly, if you look at, for example,
Speaker 3: the profile of China's purchases of US treasuries, there were
Speaker 3: very big purchases of foreign debt. That's all going to change.
Speaker 3: So I think that summary, Tom is a very good
Speaker 3: one because it works on so many levels. And it
Speaker 3: comes back to this that nobody has the variance of
Speaker 3: dealing managing through the nineteen seventies and governments themselves are
Speaker 3: just trying to reorientate their economic structures. So yes, it's
Speaker 3: a very difficult world in the sense that unless you
Speaker 3: frame it in the nineteen seventies sort of backdrop, is
Speaker 3: very hard to make adjustments that quickly as to how
Speaker 3: people will manage portfolios.
Speaker 1: Our guest has been Sean Darby, equity strategist at Miss
Speaker 1: zoo Ho Securities. It's been a fascinating, engaging and eye
Speaker 1: opening conversation about japan defense spending and the investment risks
Speaker 1: and opportunities in our very rapidly changing world. Sean, it
Speaker 1: has been a pleasure.
Speaker 3: Thank you very much, Tom and John, and being very
Speaker 3: privileged to be able to participate in the podcast. Thank
Speaker 3: you very much.
Speaker 1: I'm Tom Corbett in Hong Kong.
Speaker 2: And I'm John Lee. This podcast was produced by Clara
Speaker 2: Chen and you've been listening to the Asia Centric podcast