Bob Homan: The troops are marching ahead of the music
This column was originally written in Dutch. This is an English translation.
By Bob Homan, Head of ING Investment Office
European NATO countries want to increase their self-reliance and are tightening their belts. Sharp investors see where profits are going to decline.
This week in The Hague, NATO members reached an agreement to drastically increase their defence spending from 2% to 5% of gross domestic product (GDP) by 2035. This means that hundreds of billions of euros (!) will be spent on personnel, tanks and barracks in the coming years. At first glance, this appears to be a powerful economic stimulus for European businesses, but its impact could well be smaller than many analysts currently believe.
European defence sector highly fragmented
In the run-up to the decision, investors were already enthusiastic. European stock markets – led by defence stocks – have risen sharply this year. However, the reality is more complex. The main winners from the increase in spending may not be where one would expect. This is because, although Europe has a solid industrial base, the defence sector has become highly fragmented as a result of years of underinvestment. Instead of a single integrated market, most defence companies operate at national level, with relatively small production volumes focused on the domestic market. Only a limited number of Member States have large, internationally competitive players. As a result, Europe remains highly dependent on major American manufacturers for its armaments.
A lot of money is at risk of leaking to the US
And that dependence has increased in recent years. According to figures from the Stockholm International Peace Research Institute (SIPRI), arms imports by European NATO countries more than doubled between 2015–2019 and 2020–2024. The share of US deliveries rose from 52% to 64% in the same period. For critical items such as missile systems, fighter jet engines and cybersecurity capabilities, Europe will continue to rely heavily on the United States for the foreseeable future. As long as further consolidation of the European defence industry and joint procurement strategies fail to materialise, there is a risk that a lot of European money will leak to the US.
US defence stocks relatively cheap
As mentioned above, defence stocks have risen sharply since the beginning of this year due to rising arms sales. The European defence sector now has a price-earnings ratio of 43, almost twice as high as that of its US counterparts. For investors, this means that the European defence sector is firmly priced. Despite favourable business prospects, the upside potential therefore appears to be limited.
How investors can still capitalise on the trend
The real opportunities may lie elsewhere, particularly in the technology sector. NATO has decided to broaden the definition of “defence spending” to include infrastructure and defensive and offensive cyber capabilities, among other things. The technology sector is particularly well positioned to benefit from technological rearmament. Ironically, interesting opportunities in this area are again mainly to be found in the United States. Technology accounts for 40% of the S&P 500 index, compared with only 13% of the MSCI Europe ex-UK index. With such an investment, you also avoid the ethical objections that can be associated with investments in traditional arms manufacturers.
