European defence stocks are becoming hot property again as governments across the continent signal an urgent need to increase military spending. The pan-European Stoxx 600 closed the session on 17 February 0.54% higher, lifted by a 4%-plus jump in the Stoxx 600 Aerospace and Defence index.

With geopolitical tensions intensifying and European governments committing to increased military spending, analysts at investment bank Morgan Stanley re-spun their bullish thesis on the sector, identifying key players such as Germany’s Rheinmetall (RHMG:ETR), Italy’s Leonardo (LDO:BIT) and the UK’s BAE Systems (BA.) as preferred stocks.

‘Comments by secretary-general Mark Rutte that NATO members will have to boost their defence spending by ‘‘considerably more than 3%’’ of GDP put a rocket underneath defence stocks,’ said Russ Mould, investment director at AJ Bell.

All three of Morgan Stanley’s picks turned sharply higher at the start of the week, chalking up gains of between 14% and 8%, with Sweden’s Saab (SAAB-B:STO) and Thales (HO:EPA) of France also surging.  

‘BAE Systems jumped to the top of the FTSE 100 risers list as investors hoped its earnings prospects would be greatly improved. Mid-cap defence player Chemring (CHG) also enjoyed a boost,’ pointed out AJ Bell’s Mould.

Shares in defence companies had already rallied hard since Russia invaded Ukraine as investors took the view rising geopolitical worries would spur governments around the world to fortify their own defences.

Rutte’s comments effectively confirm this line of thinking and have acted as another share price catalyst, even though markets had already priced in a stronger earnings environment for the sector.

The fact Donald Trump is keen for European countries to spend as much as 5% of GDP on defence adds to the narrative supporting the sector as leading NATO members haven’t spent that proportion of GDP on defence since the peak Cold War years.

In 2024, the UK’s share of GDP spent on defence was 2.33%, while France and Germany’s GDP shares were 2.06% and 2.12% respectively, behind European leader Poland (4.12%). Meanwhile, the US spent 3.37% of GDP on defence last year.

At the Munich Security Conference, the European Commission said it was considering an escape clause excluding defence-related expenditure from EU budget deficit calculations, a move which could allow governments greater financial flexibility to boost military investment.

Analysts at Stifel believe a new NATO spending target of 2.5% to 3% could result in an annual increase of between $85 billion and $176 billion in European defence expenditure alone. 

DISCLAIMER: Financial services company AJ Bell referenced in this article owns Shares magazine. The author of this article (Steven Frazer) and the editor (Ian Conway) own shares in AJ Bell.

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