SUMMARY
Europe looks set to ramp up military expenditure. We believe this could potentially help drive further equity upside in the defense sector
KEY TAKEAWAYS:
US defensive guarantees to allies are now in doubt
Europe is set to spend much more on its defense
The defense sector and the wider regional economy may benefit
We see potential in the sector’s higher-quality segment
Europe is often at its most responsive under severe pressure. We saw this in 2012, when the financial crisis seemed to threaten the very future of the single currency. A public commitment to do “whatever it takes” from the European Central Bank, followed by unprecedented monetary easing, helped to save the day.
We believe that another such “whatever it takes" moment is upon us. Today, the challenge concerns Europe’s security, rather than its financial system. The European Union and its allies now seem to recognize that the US may no longer fulfil its longstanding role of guarantor of peace on the continent amid the threat of an expansionary Russia.
The recent commitments by European states to spend more on defense are unprecedented. Over the next four years, the amounts could represent up to 1.1% of GDP for the 27 EU nations annually, and as high as 2.5% of GDP for Germany. To help enable this spending, the European Union has relaxed the fiscal rules it applies to its members.
The potential benefits of European rearmament
We believe that increased defense spending could benefit Europe beyond just the main goal of maintaining peace.
The fiscal multiplier effect is where greater government expenditures feed through into further consumption and investment, potentially providing a much-needed uplift to limp European growth. Our rough estimate is for regional GDP growth to be 0.2–0.3 percentage points (pp) higher in year 1 (2025), 0.4–0.5pp higher in year 2 (2026), and average around 0.75pp higher in years 3 and 4 (2027–28).
A further boost could come from easing trade tensions with the US. If the EU increases near-term spending on US defense equipment, it could help to placate the Trump administration, especially if combined with higher imports of US liquified natural gas. The US could conceivably withdraw some of its new tariffs and refrain from imposing more.
The European defense sector’s scope for upside
The European defense sector – as measured by the MSCI Europe Aerospace & Defense Index – is up 161% since December 2021. By contrast, the wider MSCI Europe Index is up by 21%. A major driver of this outperformance has been strong earnings-per-share (EPS) growth for the sector in Europe.
We believe greater spending on European security will likely sustain the defense sector’s EPS momentum over the medium term. This could help it to extend its outperformance of US peers. It is worth noting that European defense firms are generating on average 44% of the revenue from within the region. Any increase in EU member states’ security outlays may therefore bolster EPS growth.
Admittedly, the latest rally in European defense equities looks somewhat stretched. Against the wider stock market, valuations are close to the top of their range of the last two decades. Compared to US defense, however, the sector in Europe is valued in line with its 20-year average, with a relative P/E of 0.75x. We believe this leaves room for more upside.
What could undermine our view?
The challenge facing Europe could scarcely be more serious. Indeed, for some of the Baltic states, nothing short of their existence as independent nations may ultimately be at stake. Were EU member states to be dominated by outside powers, it would be most damaging to the bloc’s credibility. For such reasons, we believe that Europe will rise to the occasion.
Nevertheless, we take nothing for granted. The sums involved are large, and simply spending money on defense will not guarantee the desired outcomes. The necessary outlays could be delayed or even rendered impossible, perhaps by Germany’s lawmakers opposing the necessary changes to the country’s constitutionally enshrined fiscal restraints. A serious economic downturn, financial crisis or other shocks to the system could also hinder progress.
Europe’s voters may, in time, present a further obstacle. Increased spending on defense could crimp the region’s generous welfare provision. Especially for citizens of countries far away from Russia, reduced entitlements may prove a more pressing concern.
Several European populist movements – which are either already in power or may gain power in coming years – have expressed opposition to their nation’s support for Ukraine.
The case for quality defense
Despite the upside potential that we see, we do not expect a one-way street. Instead, European defense equities may experience volatility amid uncertainty over a ceasefire in Ukraine and possible delays in defense spending increases by individual EU member states. Considering the strong year-to-date rally, we believe a pullback in the European defense sector may offer a tactical entry point. Over the medium term, as EU countries continue to ratchet up defense spending, we see potential for further sectoral outperformance. Within the sector, our bias would be towards high-quality companies with strong balance sheets and high free cash flows.
