The Defence Stimulus

The next major fiscal stimulus will not be described as one.

Presented instead as a national-security imperative: money needed to replenish weapons, expand production, protect allies and prepare for conflicts in Europe, the Middle East and the Indo-Pacific.

While it is true, it is also a way for the spending to be politically easier to pass than any civilian programmes. Any package for welfare or infrastructure would trigger at least surface level arguments over deficits, inflation and government waste. Today, as a result of the White Houses own actions military spending begins from a different assumption: that the money is necessary for national survival.

Opposing it can therefore be portrayed as weakness and national disloyalty rather than fiscal discipline.

The House of Representatives has approved a defence authorisation bill worth about $1.15 trillion, a substantial increase from current spending of roughly $900 billion. The bill still needs to pass the Senate, where the total could change. The administration has also pushed for spending closer to $1.5 trillion, implying a possible increase of almost $600 billion from current levels.

Washington is preparing for a major expansion in military expenditure. I want my readers to prepare for a major fiscal stimulus, much in the same way that the lend/lease bills from the aid to Ukraine came to stimulate US economic growth, this bill will have a similar effect.

For investors, the important question is not only whether the spending is strategically justified. It is how it will affect economic data and whether markets will mistake government-financed demand for evidence that the American economy is structurally healthy.

Most fiscal spending passes through Washington eventually because politicians prefer distributing benefits to imposing immediate costs. Defence spending faces even less resistance because it carries the language of patriotism, readiness and crisis - it is after all one of the primary functions of the institution of any and all Governments.

Republicans who might oppose a civilian spending package are less likely to resist a military expansion backed by a Republican White House. Democrats may criticise particular wars, but they have repeatedly supported defence budgets, military aid and weapons production when these are framed as responses to external threats. I want readers who may think the Democrats will put up a firm fight on this increase in spending to re-visit Trump State of the Union address, where in which he received a bi-partisan standing ovation when talking about confronting the Iranian Government (this was the only bi-partisan applause he received that night).

That does not guarantee an easy vote. The Senate can still alter the bill, and disagreements over the scale or direction of military action may delay it. However, national security changes the political calculation.

Legislators are not simply being asked whether they support another spending package. They are being asked whether they will fund troops, replace missile inventories and prepare for future conflict.

That makes opposition harder.

Whatever its purpose, military spending is also fiscal stimulus.

The government will buy aircraft, ships, missiles, drones, software, vehicles and raw materials. It will finance research, expand factories, hire personnel and award contracts to private companies.

The first effects will appear in defence-company revenues, industrial orders and employment. The second-round effects will spread more widely.

A contractor receiving a large order may hire engineers, expand production and purchase more components. Suppliers may then add staff and investment. Workers with higher incomes will spend more on housing, cars and services. Shareholders may benefit from stronger profits and valuations.

This is the fiscal multiplier: government spending generates further rounds of private income and expenditure.

The size of the multiplier is uncertain. It depends on how quickly the money is spent, whether factories have spare capacity, how much equipment is imported and how the Federal Reserve responds. But the multiplier will still support measured economic activity.

Government expenditure also enters GDP directly. That means a military build-up can raise reported growth before the wider effects on employment and consumption are counted.

It is important to mention, that the data will not be false. A missile produced, an engineer hired and a factory built all represent genuine activity.

The risk lies in interpretation. Misguiding the positive numbers for private sector growth. They are not one and the same.

A large defence programme could improve many of the indicators investors use to judge the economy.

Payroll growth may strengthen as contractors hire. Manufacturing employment may improve in regions receiving military orders. Durable-goods data may rise. Industrial production and capital expenditure may increase. Consumption may remain firm as defence-sector wages and profits flow into the broader economy.

GDP may appear surprisingly resilient.

Investors may then conclude that the economy is more structurally sound than it really is.

Suppose private employers are reducing hiring while defence contractors are adding workers. The national payroll report may look healthy even though large parts of the private labour market are weakening.

Suppose households are struggling with rent, debt payments and weak real wage growth, but consumption remains supported by incomes generated through government contracts. The headline spending figure may stay firm while the typical household becomes more fragile.

Suppose industrial production rises because the Pentagon is ordering more missiles, aircraft and ships. This does not necessarily mean civilian manufacturing has become more competitive or that private demand has recovered.

As productivity data will become harder to read. Investors must therefore distinguish between structural growth and fiscally sponsored growth.

Structural growth comes from rising real incomes, competitive private investment and productivity gains that can continue without ever-larger deficits.

Fiscally sponsored growth depends on the government’s willingness to borrow and spend. Both can raise GDP yet only one indicates a healthier, structurally sound economy.

Spending can be financed through higher taxes, spending cuts elsewhere, asset sales, money production or additional borrowing.

Large tax increases appear unlikely, particularly after the administration has reduced taxes in several areas. Congress could cut civilian programmes, but the reductions required to offset an increase of several hundred billion dollars would be politically and economically difficult - not to mention, the Democrats would not allow for this.

Borrowing is therefore the most likely source of finance.

That borrowing would be added to an already weak fiscal position. The United States is running an annual deficit approaching $2 trillion, while public debt is greater than the size of the entire economy.

The full defence budget should not simply be added to the deficit, because most existing military spending is already included in current projections. The relevant cost is the increase above what would otherwise have been spent.

Even so, an increase from roughly $900 billion to $1.15 trillion would add about $250 billion. A rise towards $1.5 trillion would add close to $600 billion.

For a government already borrowing heavily each year, that is a major expansion.

Borrowing avoids an immediate tax bill, but do not mistake it for a free lunch.

The Treasury must issue more debt. Interest payments will rise - unless rates are cut.

Heavy government borrowing should keep interest rates higher by competing with private borrowers for capital.

However, households are likely to experience the brunt of the cost through weaker purchasing power and a higher cost of living, rather than direct taxation.

If spending raises demand faster than the economy can increase the necessary private sector supply, prices will rise. Defence contractors will compete for engineers, metals, chips, fuel and factory space. Those higher costs will spread through the economy.

For all of the productivity gains made in the AI space, such increases in rate of government re-distribution make it difficult for the private sector firms and households to reap the rewards.

Asset prices may also rise. Companies receiving military contracts will report stronger earnings, supporting their share prices. Property and other scarce assets may benefit from stronger nominal demand. For those looking for the asset bubble to pop, they may see a reversal before the true bottom is obtained.

People who own defence shares, property and businesses may benefit from the stimulus. People who rely mainly on wages and cash savings may face higher prices without receiving equivalent asset gains, widening public outcry over wealth inequality and living standard.

Instead of appearing as a military tax, it will appear as a continuation of more expensive housing, higher interest rates, weaker real wages and worsening quality of public services in the future. All of which have government at the root cause, yet have been ascribed to capitalism and the free market. On a social level, the polarising nature of political discourse will increase. With the left focusing on the deteriorating living standards becoming more increasingly socialist and the right focusing on the headline figures and boosts in asset values as an argument for more economic nationalism - rather than a return to free market policies.

The spending mix will depend on the conflicts Washington expects to fight.

A European conflict would favour artillery, armoured vehicles, ground-based air defence, drones, electronic warfare, jammers and ammunition production.

A prolonged confrontation with Iran, which is the stated cause of the increase in spending would place greater emphasis on air superiority, missile defence, naval systems, surveillance, long-range strikes and the protection of bases and shipping routes.

An Indo-Pacific contingency would favour submarines, shipbuilding, anti-ship missiles, long-range aircraft, satellites, logistics and autonomous systems.

Investors should therefore look beyond the broad defence sector. The key questions are which theatre receives priority, which inventories need replenishment and where production bottlenecks exist.

The direct winners will include major contractors, specialist technology firms, component suppliers and skilled workers. Regions with shipyards, aerospace plants, bases and ammunition factories may experience stronger employment and property demand.

Shareholders may benefit early because markets often price future contracts before the government has spent the money.

The gains, however, will be concentrated. A defence worker who owns a home and equities may benefit through wages and asset appreciation. A renter in a civilian service job may receive little direct support while facing higher prices and interest rates.

In the near term, the spending could be positive for defence shares, industrial orders, employment and nominal GDP.

It may also support the dollar if stronger growth expectations keep U.S. interest rates above those in other economies.

But the same policy could be negative for long-term bonds and fiscal credibility.

Larger deficits mean more Treasury issuance. Persistent government demand may keep inflation elevated. Investors may demand higher yields to hold long-dated debt, while the Federal Reserve may have less freedom to cut rates.

Markets could therefore face a divided environment: stronger corporate revenues and nominal growth alongside higher bond yields, expensive capital and worsening public finances.

Investors will need to look beneath every headline.

A strong jobs report matter less than which sectors are actually hiring. Most recent Non-Farm Payroll Data showcases the majority of jobs growth are linked to medicare and medicaid spending (government adjacent jobs - jobs that would not exist without government spending).

Once this bill passes, I encourage readers to be on the lookout for government adjacent jobs in military adjacent jobs. If the primary drivers of NFP growth are government linked, it is not an indicator of a strong economy, rather a dependant one.

Faster GDP growth will matter less than whether it reflects private productivity or deficit-financed government demand.

The central danger is not that military spending will fail to create activity.

If there is one main takeaway from this letter it is that there is a danger the headline figures will be mistaken for structural health.

Government contracts can hide weak private hiring. Defence production can conceal softness in civilian manufacturing. Federal spending can support consumption while household finances deteriorate. Military investment can lift GDP while debt, interest costs continue to rise and the standard of living continues to plummet. These are not only economic harms, but will also translate to future political issues - considering how polarised US politics is today...it is sadly yet to get much worse.