European defence: a growth story without the IT factor

The decades following the ending of the Cold War saw successive European governments significantly underinvest in their respective military capabilities. Not anymore. Defence spending in Europe is on the rise.

The about-turn can be traced back to the outbreak of the Russia/Ukraine conflict in 2022. Persistent calls from US President Donald Trump for Europe to shoulder the responsibility for its own security, and NATO more than doubling its defence spending target for members from 2% to 5% of GDP by 2035 (3.5% to be spent on core defence) have contributed too.

At the headline level, the new NATO target equates to a CAGR of 7% for the period 2024-2035. Arguably, that figure significantly underplays the growth rate for defence firms. With Europe prioritising defence readiness, a large proportion of the increase is set to be spent on equipment, the majority of which will be procured from Europe rather than the US. The CAGR for defence spending on equipment in Europe could be closer to 11%, IT-esque territory.

The market has taken note. Back in 2020, aerospace and defence was very much viewed as a value play and a 2-3% weighting in the UK large-cap benchmark reflected a low level of investor interest. An industry based around lumpy, albeit large, government contracts, generating unpredictable cash flows and poor earnings visibility, was always going to struggle to pique the interest of growth managers. Furthermore, back then, the US was by far the largest market with superior technology and greater scale, making it the place to invest to gain defence exposure, not Europe.

Crucially, this could be the start of a prolonged period of outperformance and not just a short-term fillip like we have seen in recent months. Most European and UK defence names are currently sitting on record order backlogs - at Saab and BAE, the ratio of order backlog to sales is already estimated at around three times. And governments are only just starting to increase their defence spending. Further significant order flow can be expected. A multi-year runway of growth is in place: increased orders, leading to production ramp ups and potential earnings upgrades.

Given the way valuations have moved, it is important to remain selective. As always there will be those companies that stand to benefit more than others. A company’s customer exposure will be key. For example, the Baltics, Scandinavia and Germany have a far better defence spending trajectory than southern European countries like Italy and Spain. Then there are the major capability gaps the EU has identified, such as in air and missile defence, as well as drone and anti-drone systems. It follows that exposure to these gaps will likely be supportive.

Capacity constraints are another consideration. Short-cycle products can be ramped up relatively quickly. Sweden’s national defence champion Saab, for example, has stepped up production of its shoulder-to-launch missiles, which are being used extensively in Ukraine, doubling in 2022 and set to increase by about four times by 2025. Fighter jets and submarines, by contrast, are more complex and long cycle, making it harder to increase production rates. In response, companies are being innovative – Rheinmetall is talking to car manufacturers to take over some of their factories.

The problem is, it’s not possible to pick and choose who defence companies sell their wares to. A significant portion of UK defence names generate revenues by selling to the US and other countries that may not align with a client’s current view of who the good guys are. As always, clients need to set their own agenda. The final decision to invest (or not) boils down to the individual’s viewpoint.

Those who are comfortable investing in the sector would be gaining exposure to what could be a multi-year growth story, and perhaps most appealingly, a story that is not centred around the rise of Artificial Intelligence (AI), data centres and ever more powerful chips.

Approver Quilter Cheviot: 06/10/2025

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