By Michael Jervis, portfolio manager, multi-asset at Sarasin & Partners
For decades, the classic economic trade-off between defence spending (guns) and social investment (butter) felt like a tidy thought experiment for economics undergraduates, not a live political crisis. The trade-off itself is nothing new: economist Paul Samuelson used guns and butter to illustrate opportunity cost, highlighting that resources a state devotes to defence are resources unavailable for everything else.
Fast forward to today, and governments across the Western world are being confronted with competing demands: pour money into missiles, warships, and military readiness in a fragmenting world, or protect the hospitals, housing programmes, and welfare nets that citizens depend upon?
With defence budgets under pressure from a resurgent Russia, an assertive China, a US increasingly reluctant to underwrite European security, and a NATO target of 3.5% of GDP by 2035, defence is surely a must? Cuts to welfare when ageing populations are driving up the structural costs of healthcare and pensions year-on-year? Unpopular to say the least.
Tricky choices, then. Or are they? Many governments are refusing to choose at all – putting public finance under pressure.
Public finances under pressure
Public finances in most major democracies never fully recovered from the double shock of the 2008 financial crisis and the Covid 19 pandemic. Debt loads are historically high, and borrowing costs have risen sharply after a decade of near-zero interest rates, adding to the interest cost. This trend is set to rise, not only in the US, which is the relative leader in defence spending, but in other areas too, where significant shortfalls have accrued after years of underspending. In short, the so-called peace dividend has gone.
Implications for economics
What happens to economies when governments choose both guns and butter, and borrow to pay for them?
First and foremost, more inflation. Persistent fiscal stimulus adds demand to economies that – in a fragmenting world of tariffs, re-shoring and less reliable supply chains – are less able to meet it cheaply. We therefore expect inflation to be both higher and more volatile than we have become used to. Put simply, we believe 2% is likely to prove the floor, not the average in most developed economies.
Second, stronger nominal growth. Government spending has to land somewhere, and it shows up in nominal GDP – which has been strikingly strong in recent years. This provides a particularly favourable backdrop for companies to grow their sales – and therefore profits.
Guns and butter are not the only claims on capital today; a significant third lever exists in the form of semiconductors. The vast capital expenditure flowing into AI infrastructure is leading to huge amounts of spending, with semiconductors at the epicentre. Time will tell whether these investments will be profitable over the long run. But for now, we can say that, unlike some investment booms of the past, spending is accompanied by rapidly growing revenues, albeit from a very low base.
A new market regime
Global fragmentation has been in place since 2021, and the post-pandemic global economy is shifting decisively away from an open, co-operative framework towards a more fragmented system dominated by power politics and heightened geopolitical insecurity.
Governments spending freely on guns and butter alike (with chips laying claim to capital too) sits squarely within this regime. Its key assumptions are that inflation, bond yields and nominal growth will all be higher than we are used to, that economic and market volatility will pick up, that bonds will be a less reliable diversifier of equities, and that fiat currencies will continue to lose value as inflation runs hot.
What does this mean for asset allocation?
High inflation and nominal growth support corporate revenues and profits, and so argue for an overweight to equities most of the time. There will be exceptions, and fundamentals will always play their part, but that is our natural starting point in this regime.
High inflation, elevated term premia, and reduced diversification benefits also argue for an underweight to fixed income, most of the time. Short-dated inflation-linked bonds are held in some portfolios given the heightened inflationary outlook.
In place of bonds, alternatives are playing a growing role. Ongoing debasement of fiat currencies and rising geopolitical risk point to a strategic allocation to gold. Central banks appear to agree, with many steadily adding to their gold reserves even as their appetite for US Treasuries wanes.
Finally, as the world gradually becomes more multipolar, the dollar’s exorbitant privilege should gradually erode, arguing for a medium-term underweight to the greenback.
As an active equity investor, we see how pressures on public spending can impact different sectors and this informs how we invest given our thematic approach. There are profound shifts in the investment landscape to navigate. However, more than ever, an active approach to strategy setting, asset allocation and security selection is key.
