Money and Might — Financing the Future of Defense

A reshaping of defense spending over the last decade has bolstered the outlook for legacy defense contractors while letting venture-backed companies begin changing the face of the industrial base ecosystem. In this Must C report we look at the outlook for defense spending and offer insights about Western allies’ priorities.

A new report from a team led by U.S. Aerospace & Defense analyst Jason Gursky looks at the state of global defense spending, which has been rising since Russia’s 2015 invasion of Crimea. Since then, new factors at play have bolstered the outlook for legacy defense contractors and let venture-backed companies begin changing the face of the industrial base ecosystem. At the same time, deficits and debt have continued growing for most Western economies, spurring questions about the sustainability and prioritization of government spending. The report, which draws on views from Citi Research economists and equity analysts, looks at the outlook for defense spending and offers insights about the spending priorities of Western allies in this evolving landscape.

Here are seven takeaways from the report:

Defense-spending scenarios: We consider three scenarios. In the first, spending steps down as the Ukraine conflict is resolved and national security concerns take a step back given other priorities. In the second scenario (our base case), defense spending continues at current levels amid geopolitical concerns, with the composition of that spending shifting from personnel and material to equipment and countries seeking to make spending smarter, including by integrating AI. And in the third scenario, spending increases in both the EU and the U.S., driven by either the onset of some broader or more pronounced conflict or a reframing of the “great power” competition with China in more military terms.

The great power competition and U.S. spending: The U.S. updates its National Security and National Defense doctrine every four years, with the most recent update in 2022. Doctrine has shifted away from a focus on the war on terror to a seemingly warmer cold war in which nations actively compete for regional and global dominance. The Ukrainian conflict, China–Taiwan tensions and the Israel–Hamas conflict are all recent developments motivating U.S. policymakers to prepare to deter and if necessary, fight conflicts on three fronts.

Europe’s NATO commitments: NATO member states spending less on defense than their commitments sparked friction in the late 2010s and early 2020s between Europe and the U.S., which consistently spends a greater percentage of its GDP on defense. U.S. criticism of European underspending looked prescient following Russia’s 2022 invasion of Ukraine; European countries are now reassessing their capabilities and reinforcing the need for a much stronger European Defense Industrial base, with their spending moving to higher levels.

New spending priorities: Recent conflicts in the Ukraine and the Middle East, as well as China’s rise, have brought lessons that have informed spending priorities. In addition to recapitalizing nuclear deterrence capabilities, allies are prioritizing areas including Space, Unmanned Aerial Vehicles and Attritable Aircraft (the latter are unmanned craft that can be reused but are affordable enough to risk losing), AI and Missile Defense. All of these areas are growing more quickly than overall defense spending, and in many cases they’re being addressed by both legacy contractors and new entrants, which are often backed by venture capital.

An evolving industrial base: Large defense primes still dominate such well-known platforms as fighter jets, tanks and aircraft carriers. But the Department of Defense (DoD) has been pursuing alternatives as it looks to acquire innovative technologies that could position the U.S. to stay ahead of its peers. New companies have emerged as alternatives to traditional suppliers for the rapid development and deployment of “next generation” capabilities.

A new catalyst of change: The Defense Innovation Unit (DIU) was created in 2015 as the DoD looked to reengage Silicon Valley and other technology hubs. Its mission focuses on identify technologies that can support DoD efforts and keep those technologies out of adversaries’ hands. As part of this effort, the DIU provides contracts to keep companies out of the “valley of death” while awaiting the often-slow contracting process and helps tech companies partner with larger primes.

Venture capital and the ecosystem: DIU successes and a more menacing geopolitical environment have helped drive a resurgence of venture investing in the defense tech sector, with more than $70 billion deployed in the past two years. Most of the large defense primes have established and funded corporate venture arms, allowing them to invest either on their own or together with institutional backers.