Defense Budgets and Markets & Japan
David R Kotok
Cumberland, July 18, 2016
The United States tops the charts tracking the world’s defense expenditures, at approximately $570 billion (Ashley Kirk, “What are the biggest defence budgets in the world?”). The list continues with China in second at $191 billion, followed by the United Kingdom ($67 billion), Russia ($53 billion), France ($53 billion), and India ($50 billion). There is some variation among nations as to what is included in the defense budget and what is not, what is security spending and what is defense spending, and how much is devoted to foreign grants or other allocations abroad. But as a practical matter, this is the list of the six largest defense budgets.
The seventh largest is Japan’s. Japan’s defense budget is limited to approximately of 1% of its GDP, a constraint imposed by the Japanese constitution drafted at the conclusion of World War II by General Douglas MacArthur’s staff. Japan adopted the constitution in 1946, agreeing in Article 9 to renounce war as a means to settle international disputes. Thus defense expenditures were limited to internal, purely self-defensive purposes only. Article 9 has remained in effect since – even with some judicial and legislative decisions that have broadened the definition of self-defense to include coming to the aid of Japan’s allies in time of war.
With the reelection of Prime Minister Shinzō Abe and the overwhelming vote for his program of economic growth, change – including constitutional change – is expected to come to Japan. The implications are huge, not only for Japanese society but also for markets, defense technology and spending, and all of the related second derivatives.
Essentially, Prime Minister Abe now has the votes to change the constitution to allow Japan to become more aggressive in its military operations. Japan’s military posture has long been a major issue for Abe. There has been intense discussion and division in Japan between those who hold to the pacifist approach that grew out of World War II and the pragmatists who would directly confront China in the South China Sea and elsewhere in Asia.
Meanwhile the ancient enmity between China and Japan is heating up. China has developed territories on islands in the South China Sea, building airstrips and other facilities and claiming they are for civilian purposes. The territories are disputed by other nations bordering the South China Sea, including Japan, the Philippines, Vietnam, and South Korea. China has defined its boundaries aggressively. The other nations have defined them according to their own aspirations. Now maritime freedom of transit has become a contentious issue. An international tribunal in The Hague recently declared that China had failed to comply with obligations to which it had voluntarily agreed. The decision has escalated the South China Sea conflict.
Think of it in the following way. You are in Japan, and after an overwhelming electoral victory, you are the prime minister. You feel threatened by an ancient enemy that is occupying disputed territory and building and reinforcing airstrips; and then a rocket is fired over your head from North Korea. Your instinct is to protect your country. That is what we expect Prime Minister Abe to do.
Implications for Japan’s budget include an increase in defense expenditures, from 1% of GDP to upwards of 2 or 2½% of GDP. That increase would vault Japan’s military spending ahead of the United Kingdom’s, Russia’s, France’s, and India’s, giving it the third largest defense expenditures in the world.
How should the funds be spent, given Japan’s aging population and the limited cadre of young men and women who can serve in the military? We expect a change in the character of war fighting with the development and deployment of the first modern Star Wars army in Japan. Japan is a major technological innovator and the world leader in the development of robots. Find an automobile that was built at an advanced facility anywhere in Europe and look closely at the robots that assembled it. Those robots were made in Japan. Now, the Japanese are motivated and they have the political will to protect their country from a perceived and perhaps actual threat. We can expect Japan to be in the forefront as the world enters the era of robotic warfare.
On the economic front, take the third largest economy in the world and raise its defense allocation from 1% of GDP to 2½% of GDP. Based on a Japanese GDP in excess of $4 trillion, that 1½% increase amounts to some $60 billion, on top of present defense spending of $41.4 billion, for a total that tops $100 billion a year – that’s a very substantial economic boost to Japan and secondarily to the world. We expect that increase to kick in within the next year. The major Japanese industrial conglomerates function in a keiretsu system that amounts to an interlocking corporate directorate with close ties to the government. They will be the primary beneficiaries of the expansion of the Japanese defense budget, and their stock prices will appreciate.
Look at Japan today from a market valuation perspective. The earnings yield of Japanese companies is two full percentage points higher than that of companies in the United States. Think of it as a 7% earnings yield in Japan and a 5% earnings yield in the US. Add to that the embedded interest rate of zero in Japan, which provides a no-cost source of additional fiscal financing for the ramping up of Japanese defense expenditures. Imagine a structure in which a government can finance itself for a long period of time at no interest cost. That’s Japan.
As we see it, the list of the world’s major defense budgets is going to change. A few years from now the United States will still be the largest, and China will still follow in second. However, there is a very good chance that Japan will rise to number three.
Japan’s remilitarization is a disturbing topic for those who would prefer a peaceful direction for the world rather than expanding militarism. However, the world remains a combative place. China’s aggressiveness in the South China Sea, North Korea’s rogue behavior, and China’s tolerance of North Korea are heating up the East Asia region. Asian defense budgets are rising, and the pace is accelerating. Asia is changing.
In this unpleasant, higher-risk environment, we continue to apply discipline to our market investments. In our view, Japan offers an opportunity for American investors and our clients. We are overweight Japanese stocks and use a variety of ETFs to access that market. Some of those ETFs are currency-hedged, and some are not. The combination of the two types allows us to be approximately 30% above the index weight in Japan. We believe the evolution of the Japanese defense budget over the next two years will validate that decision.
We continue to expect the Japanese currency to weaken. That has been our position for some time now. Policy shifts in Japan and the surprise outcome of the Brexit referendum have favored the yen over the pound. At the same time, the euro weakened because of monetary-policy and banking-system troubles in some Eurozone member countries, such as Italy. That combination brought the yen to about 100 to the dollar. We believe that era is now over. We think the prospect of the yen going under 100 is unlikely. We think Japanese policy changes and the political validation of Prime Minister Abe are sea-change political events of the same magnitude globally as Brexit is for the UK and Europe.
At Cumberland Advisors, we are bearish on the UK and think it will face a recession. Market conditions require an investment shift in favor of Tokyo over London. For that and other reasons, however unsettling those reasons are, we are bullish on Japan.
David R Kotok, Chairman and Chief Investment Officer