Don’t be spooked by the jump in defence spending
The UK is set to make the largest increase in its defence budget since the Cold War. Prime Minister Keir Starmer announced that the government would be upping defence spending from 2.3% of GDP to 2.5%, or just under £60bn. The extra billions will come from the overseas aid budget rather than from extra borrowing or taxation. Though undoubtedly significant, the additional funds required are hardly transformational, only taking the defence budget back to 2009/10 levels in real terms.
The first task of any government is to ensure that the country can defend itself from external threats. There can be no contemplation of Labour Party manifesto commitments to funding the NHS or making “Britain a clean energy superpower” without national sovereignty. Unfortunately, the House of Commons Defence Select Committee has found that the UK armed forces do not have “strategic readiness,” let alone “warfighting readiness” – that is, the ability to identify and utilise the tools to fight a war.
There is also a promise that the UK’s defence spending will increase further, to 3% of GDP “in the life of the next Parliament.” Cutting into aid budgets further is unlikely to be an option to fund this additional expenditure, especially when we consider the consequences the current plan to squeeze aid might have. Any funds the UK withholds for foreign aid could well be replaced by China, which would be happy to fill the void if it meant an extension of its soft power in unstable regions. Additional spending is more likely to come from either spending cuts elsewhere, higher taxes, or more borrowing. No government likes to cut spending or raise taxes, so experience strongly suggests that the money will be borrowed.
We have already seen the impact of cutting our defence budget too low and not acting when Ukraine was initially invaded. In Europe, we had a surge of inflation as food and fuel costs went up, and we saw rising risk premia undermine the value of European stocks. The ability to deter aggression can only really come from increased defence spending and having fully supported, strong allies. However, alliances that have defined the West since the Second World War appear to be waning; the US is in the process of shrugging off responsibility for Europe’s defence, leaving it in the hands of unprepared and underfunded European militaries. With Germany’s government likely to be divided post-election, a coherent response to aggression in Europe will need at least some US backing for the foreseeable future.
European defence stocks have shot up in the first few weeks of 2025 in anticipation of increased spending, but it is by no means clear that they will receive the full benefit of this. Only about a third of the defence budget goes on equipment, and of that, about 65% of European equipment is purchased from American defence contractors. American defence contractors’ shares, though, have been lacklustre as they are facing President Trump’s demand that 8% be cut from the American defence budget.
In the worst case, increased borrowing, increased budget deficits, and the diversion of peacetime resources to arms could reignite inflation. The experience of the 1930s is informative. In 1932, Britain’s defence budget was only 2.2% of GDP, a similar level to today, but inflation was minus 2.0%, very unlike today. Rearmament in the 1930s was gradual at first, but by 1939 we were spending 16% of GDP, pushing inflation up to 17% by 1940, despite rationing and price controls. Any spike in inflation caused by extra defence spending is unlikely to sit well with the electorate if the UK slides into a recession.
Government bonds may be viewed as “risk-free” in some quarters, but inflation has the effect of a Blitzkrieg on the value of fixed-interest government bonds. If you had put £100 into government war loans in 1940 for your grandchildren, their purchasing power would only be £31 by their 21st birthday in 1961.
This is not to suggest that you should buy a hard hat and start stockpiling tins of spam. The increase in defence spending in the UK is very small compared to the 1930s, and Trump may be able to bring peace to Ukraine and de-escalate the stand-off with Russia. If he is successful, we could have lower fuel prices and a de-risked international situation, which will be good for all our investment portfolios.
As ever, in the face of uncertainty, we prefer to stay invested, as one is rewarded for accepting volatility, and stay diversified across different currencies, different bond markets, and different equity markets.
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
This document contains general information only and does not provide any advice or guidance specific to your personal circumstances.
Callanish Capital is authorised and regulated by the Financial Conduct Authority to manage investments but does not provide Financial Planning or Investment Advice. Please refer any such queries to your Financial Advisor.
This email and any accompanying attachment is issued by Callanish Capital Ltd, a company registered in England and Wales under company number 13182424. Registered Office: 45 Pont Street, London, SW1X 0BD.
Callanish Capital Ltd is a Discretionary Fund Manager, directly authorised and regulated by the Financial Conduct Authority (“FCA”) under registration number 955992.