While EU defence stocks are in fashion, US defence stocks represent more value now. We would wait for corrections in Europe, and favour US defence stocks.
We see more risks than benefits to investing in EU defence stocks after the strong rally in February…:
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- NATO spending commitments are the catalyst for defence stocks. Some nations remain below NATO’s current 2% of GDP guideline. Von der Leyen said that EU member states’ collective spending should increase to above 3% of GDP.
- Recent statements from the US government are causing concern in Europe given their high reliance on US equipment. As Trump has threatened to withdraw the US from NATO, EU states could look into local manufacturing and suppliers.
- Another catalyst may be potential tariffs, which could also shift spending plans to Europe. In a trade war, European countries may prioritise local manufacturers.
- Main risks:
- Sharp EPS increases are expected but mainly from FY27 onwards. Investors are currently buying on expectations of companies delivering major programmes. Risks are that they get watered down or delayed.
- Valuations are higher than ever in EU defence stocks and could become more sensitive to negative impacts from not hitting spending targets.
- Additionally, not every EU state enjoys the fiscal space that Germany has – Spain and Italy could struggle to meet spending targets due to their deficits.
- Fragmentation in the EU makes it difficult to build economies of scale. Different technical requirements, political agendas and cultural attitudes have made cross-border collaboration challenging.
…while US stocks represent better value now:
- Valuations in US defence stocks have come down and are lower than EU defence stocks, making US defence stocks more interesting. They seem to have priced some of the uncertainty about budget cuts, as well as the migration to EU defence stocks.
- US defence stocks benefit from European spending, with over 50% of Europe’s spending going to US contractors. It is difficult to see how Europe could completely cut ties with the US in terms of arms/equipment imports, as the EU is heavily reliant on the US. We could expect Trump to push for more spending from Asia-Pacific allies (Korea, Japan, Australia) as he did in his first term.
- This will likely be in conjunction with US defence exports, which he also pursued in his first term with a forum in the Arabian Gulf that advocated for USD110bn in purchases.
- The Trump administration could raise the defence budget. The efforts of DOGE appear primarily targeted at headcount reduction, which may cause operational issues but should not tie directly to Department of Defence (DoD) procurement.
- While there could be defence budget cuts in the US following a potential Russia-Ukraine deal, geopolitical tensions are still high and countries could continue to look for US defence equipment. For example, the US may be willing to provide Lockheed Martin F-35 fighter jets to India.