by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with more signs that European countries intend to keep boosting their defense spending to counter the rising threat from Russia. We next review several other international and US developments with the potential to affect the financial markets today, including moves by China to cut off the US from its drone exports and a major bond manager’s move to reduce exposure to long-term US government debt.

European Union: The European Commission’s new Defense and Space chief, former Lithuanian Prime Minister Andrius Kubilius, said he will seek about 100 billion EUR ($105 billion) for weaponry in the EU’s next seven-year budget to help prepare the bloc for possible aggression by Russia. That would mark a dramatic increase from the current budget’s 10 billion EUR ($10.5 billion) for defense and defense industry spending. Kubilius also said he would support excluding member states’ own defense outlays from EU limits on fiscal deficits and public debt totals.

• Spread out over seven years, the 100 billion EUR that Kubilius is seeking wouldn’t account for a large share of European defense spending. Most military outlays in the region would still come from EU member states’ own budgets.
• Nevertheless, the statement illustrates how top EU leaders are increasingly looking to boost their defense rebuilding efforts. We continue to think the result will be higher revenues, profits, and stock prices for European defense contractors.
• Now that France has dropped its previous insistence that all common EU defense funds be spent only within the bloc, it is likely that some of the EU’s new spending will also benefit US defense firms. However, the US firms may see relatively weaker stock performance because of the incoming Trump administration’s plan to extend the 2017 tax cuts, rein in government spending, and re-channel some funds toward smaller, cheaper weapons systems such as drones.

Russia-North Korea: During the weekend, the commander of US forces in the Indo-Pacific region, Adm. Samuel Paparo, said he has seen intelligence that Russia plans to send advanced Su-27 and Su-29 fighter jets to North Korea. The jets would presumably be partial payment for North Korea sending some 12,000 troops to Russia to help in its war against Ukraine, along with the cash, food, fuel, and air defense systems that Russia has also reportedly sent. If true, the deal is more evidence of increasing cooperation in the China/Russia geopolitical bloc.

China-Taiwan: Military officials in Taiwan today said they see evidence that China is planning what could be its largest naval exercise in the Western Pacific since 1996. The Chinese military has closed the airspace near Taiwan and is reportedly massing dozens of navy and coastguard vessels to the west and east of the island.

• The impending exercise (if that’s all it is) likely aims to express Beijing’s anger over Taiwanese President Lai Ching-te’s recent visit to Hawaii and Guam as part of his first official international trip.
• The deployment of Chinese navy and coastguard ships to both the east and west of Taiwan is probably a signal to the US and its Western Pacific allies that Beijing has the ability to blockade the island and prevent outside forces from intervening.

Syria: To start forming a transition government, rebel leader Abu Mohammed al-Jawlani, whose HTS fighters led the toppling of dictator Bashar al-Assad over the weekend, has convened a meeting with Assad’s prime minister and Mohammed al-Bashir, the head of a de facto government that HTS backed for years in Syria’s rebel-held northwest. Al-Jawlani’s forces have also reportedly worked to impose order on Damascus. Nevertheless, it will probably still be weeks before the contours of a transition government are laid out.

Brazil: President Lula da Silva, who is 79 years old, this morning is in intensive care after surgery for a brain hemorrhage related to a fall in October. Lula was reportedly complaining of severe headaches, which led doctors to discover the injury. According to doctors, the surgery went “well,” and government officials say Lula is awake, alert, and on the road to recovery.

El Salvador: The government of cryptocurrency supporter President Nayib Bukele is reportedly close to clinching a deal with the International Monetary Fund for a new $1.3-billion loan program. However, the deal will require El Salvador to change its laws so that firms are no longer required to accept cryptocurrency as legal tender. The IMF insists on making acceptance of cryptocurrency voluntary to reduce the risk of financial instability.

China-United States: Less than a week after Beijing banned direct or indirect exports of key minerals with military applications to the US, Bloomberg yesterday said multiple Chinese firms have stopped or limited their sales of aerial drone components to the US and Europe. The firms are reportedly trying to get ahead of formal government curbs on the export of motors, batteries, and flight controllers expected to be in place in 2025.

• The Chinese curbs on drone parts would likely crimp US and European drone production, including both civilian and military drones. Since drones have become a critical new technology for defense, the moves are likely to spur further decoupling from China and stronger efforts to develop complete drone supply chains in the US and Europe.
• On a related note, US lawmakers in the House of Representatives have put language in the annual National Defense Authorization Act that would stop China-based DJI and Autel Robotics from selling new drones in the US unless a national defense agency specifically authorizes the sales. If the provision is still in the bill when it is ultimately signed into law, it would further decouple the US from the Chinese drone industry.

Canada-United States: Canadian Prime Minister Trudeau told a chamber of commerce event in Nova Scotia yesterday that his government would retaliate with its own tariffs on US goods if President-elect Trump follows through with his threat to impose 25% tariffs on imports from Canada. Trudeau reminded his audience that his government also retaliated with tariffs when President Trump imposed duties on Canadian goods during his first administration.

• Trudeau’s statement serves as a reminder that a disruptive US-Canada trade war remains a possibility, despite Trudeau’s recent meeting with Trump to head it off.
• Due to the complexities of how import tariffs can affect an economy, it still isn’t possible to gauge exactly how Trump’s threatened duties would affect the US, although there is probably a high chance that they would boost consumer price inflation, at least temporarily. In contrast, since Canada is so dependent on exporting to the US, the threatened tariffs would almost certainly have a negative impact on Canada’s economy and financial markets.

US Workforce Quality: In the latest International Assessment of Adult Competencies, a test given to 160,000 workers around the world to assess their basic reasoning and problem-solving skills, the US ranked a lowly 14^th in reading, 15^th in adaptive problem solving, and 24^th in numeracy. The countries scoring the highest in the three categories in 2023 included Japan, Norway, Sweden, Finland, Estonia, Belgium, the Netherlands, and Denmark.

• Worryingly, while the best-educated US workers continue to score higher in each iteration of the test, the least-educated have been scoring lower. In 2023, the share of US test-takers whose math skills didn’t surpass those expected of a primary-school student rose to 34% of the population from 29% in 2017, the last time the test was administered.
• The results are consistent with other studies suggesting low workforce skills are likely holding down US productivity, competitiveness, and economic growth prospects.

US Bond Market: Giant bond-fund manager Pimco yesterday said it is cutting its exposure to long-term US debt because of the country’s big fiscal deficit and rising obligations. Instead, the firm said it has begun favoring shorter-term notes “where investors can find attractive yields without taking greater interest rate risk.” Pimco’s stance is consistent with our view that US debt is likely to keep rising, leading to questions about sustainability and increasing the chance of eventual financial repression (government efforts to artificially hold down interest rates).

View PDF