This article first appeared in the January 2, 2019 issue of the Globe & Mail. The version below has been updated as of close of business January 29, 2019.

Headlines attest to the deteriorating global geopolitical environment. The United States has adopted a protectionist trading policy, Brexit is symptomatic of a host of problems facing the European Union, the North Korea nuclear issue remains unresolved, and the United States and China are engaged in a contest for global influence in the 21^st century. These are but a sample of the macro issues that will challenge investors in coming years. However, turbulent times also produce opportunities. The defence sector is one such opportunity as it is well positioned to benefit from two converging influences.

 The anxiety and uncertainty produced by the current geopolitical climate has raised the risk of military conflict.  The United States’ withdrawal from global leadership has produced a multi-polar global order that has increased the number of potential theatres of conflict. China and the United States regularly sabre rattle in the South China Sea.  Iran and Saudi Arabia vie for influence in the Middle East.   Moreover, the Trump administration’s stated reservations about the European Union and NATO suggest a weakened Western coalition to adversaries.  It would not be surprising if Russia was emboldened to test the resolve of the NATO alliance. The United States may eventually tire of the lack of progress with North Korean de-nuclearization and resort to military intervention.  These are the major, though by no means only, areas of concern.

These geopolitical issues are driving military spending higher. The Trump administration authorized the biggest defence budget in American history, worth some U.S. $700 billion, in May. The United States accounts for more than a third of world spending on military equipment. China has also been aggressive in building its military capability and is now the second largest purchaser of weapon systems. Saudi Arabia has become a major buyer of military equipment as well and is now in third place globally. Increased defence spending is really a widespread phenomenon. For example, NATO increased its defence expenditures in 2016 for the first time since 2009 and raised spending again in 2017. This trend in global defence spending is expected to continue for the foreseeable future.

Technology will be the second driver of defence spending in the years ahead. The rapid pace of technological advance in the 21^st century puts unprecedented pressure on all armed forces to both update existing assets and purchase newly developed products to remain combat effective. Artificial intelligence is a major focus of defence contractors in developing a new generation of smart and/or autonomous weapon systems.  In fact, products incorporating artificial intelligence promise to largely replace current weapons systems in coming years. China and Russia are the current leaders in the development of hypersonic weapons. Hypersonic weapons are missiles that travel more than 5 times the speed of sound and to which there is currently no effective response.  Billions of dollars have and will be spent on the development and deployment of hypersonic weapons and countermeasures against them in the coming years.

Two conclusions can be drawn for investment in the defence sector. First, given the undisputed impetus to ever greater use of technology in weapon systems, companies that produce products that incorporate the most sophisticated technology, such as aircraft or missile systems, should be preferred. Candidates for consideration are U.S. based companies such as Lockheed Martin (LMT), Boeing (BA), Raytheon (RTN), L3 Technologies (LLL) and General Dynamics (GD) among others. An alternative to purchasing individual stocks is the iShares U.S. Aerospace and Defense ETF (ITA), which provides broad corporate diversification.

The second investment conclusion is that because of fracturing political unity in the West it may be desirable to diversify holdings in the defence sector geographically. Weakening alliances may prompt shifts in buying patterns. European defence contractors that merit interest include BAE Systems (U.K), Rolls Royce (U.K.), Airbus (France), and Thales (France).

Since being first discussed in the February 2017 issue of the Global Investment letter, defence stocks (using the ITA ETF as an industry proxy) have gained 28% versus a 12% advance for the S&P 500 at time of writing.

The average current trailing price earnings ratio of the stocks mentioned in this article exactly matched the price earnings ratio of 19.7 for the S&P 500 at time of writing, while offering substantially better earnings growth prospects.

The greatest risk to investment in defence contractors would be a lessening of global tensions and a move toward peaceful co-operation, the prospect of which is unfortunately quite dim.