European defence stocks rally amid growing transatlantic divide: A paradigm shift?

·       Europe is firmly moving toward military autonomy in response to U.S. disengagement risks. The “ReArm Europe” plan and national-level hikes mark a long-term structural change in defence spending, which could push defence budgets to over 3% of GDP.

·       Even before stimulus measures were proposed, major defence firms like Rheinmetall already showed strong momentum with record order backlogs and new contracts—indicating robust, sustained demand.

·       Defence company CEOs express confidence in their ability to ramp up production capacity. Companies are leveraging automotive capacity for defence production.

·       We project a target price of EUR 443 for the WisdomTree Europe Defence UCITS Index, based on our fair P/E ratio of 26X. This translates to an upside potential of 42% by the end of 2027.

In response to growing concerns over Trump’s potential withdrawal of U.S. security support from NATO, Europe has expressed clear determination to pursue military independence. As a result, the European defence sector rallied more than 24% year-to-date, with leading stocks like Rheinmetall more than doubled (Chart 1).

Chart 1: European defence sector rallied. 

European militaries seeking to reduce dependency on U.S.  

Trump’s commitment to his ‘America First’ principle has become increasingly clear, demonstrated through a series of actions— including withdrawing from multiple global agreements, reducing support for Ukraine in the ongoing war, and urging NATO members to raise their minimum defence spending target from 2% to 5% of GDP. These moves have made it evident to Europe that America’s role in NATO may diminish in the long term, making the pursuit of military independence more urgent than ever.

EU and major European economies have proposed steep defence budget hikes, showing commitment in gaining military independence. On the EU level, President Ursula Von Der Leyan has announced a plan of “ReArm Europe”, with a fiscal stimulus totaling €800 billion over four years, which is essentially 1.1 percentage point of GDP annually, raising total defence spending from 1.9% to 3% of GDP. To be specific, €150 billion is allocated as loans for defence financing at the EU level, while the remaining €650 billion represents national-level defense spending that could be raised without triggering debt penalties.

The size of the stimulus

Since the outbreak of the war in 2022, Europe’s defence spending has already risen significantly—from 1.5% to 1.9% of GDP. Now, with the European Commission’s proposed €800 billion “ReArm Europe” stimulus over the next four years, this upward trajectory is set to accelerate even more sharply. If fully implemented, total defence expenditure could surpass 3% of GDP—marking not just a sustained increase, but a structural leap in military investment (Chart 2).

Chart 2: EU defence spending is projected to surpass 3% of GDP if the Rearmament plan follows through.

Where will the money be spent

In terms of whether the fund is allocated to equipment or personnel, the White Paper clearly outlines priority areas essential to strengthening European defence — all of which focus on capabilities such as air and missile defence, drones, ammunition, AI, cyber& electronic warfare etc. These are inherently equipment- and technology-driven domains, indicating a strategic emphasis on upgrading hardware and industrial capacity. At the national level, “Member States will retain responsibility for their own troops… and for the definition needs of their armed forces,” meaning that personnel-related spending remains a sovereign decision. However, given the urgency to close critical capability gaps and the scale of rearmament required, a considerable portion of the national-level defence spending is also expected to go toward equipment.

Exemption from the debt penalty

There may be concerns that the debt penalty might restrict EU member states from increasing defence spending. However, the EU has specifically proposed to activate the “escape clause” in the relevant regulations, which allows its member states to boost defence budget without breaching deficit limits. This would allow countries who are already highly leveraged and traditionally constrained by the fiscal limit, such as France and Italy, to have significant incentive to spend. Even nations typically cautious with debt have greater determination to use debt to finance the rearmament. For instance, Germany has exempted defence spending from its rigid fiscal cap.

A strong growth trajectory prior to stimulus

Even before any additional stimulus, European defence companies were already on a strong growth trajectory with substantial order backlogs and new contracts. The surge in orders stem from accelerated procurement following the Ukraine war, while the simultaneous rise in backlogs suggests demand is outpacing current production capacity. For instance, Rheinmetall saw a 38% jump in the orders received in 2024, following a 110% jump from the previous year, highlighting consistently strong demand and solid earnings support. BAE Systems and Thales continue to report double-digit backlog expansion in both 2023 and 2024 (Chart 3). The recent stimulus measures are expected to further amplify this growth. 

Chart 3: Main defence companies have demonstrated robust growth even before the stimulus.

Local defence companies will ramp up production capacity in the longer term

Some may be concerned that European defence companies are unable to quickly ramp up production capacity, especially since orders during the Ukraine war were partly reliant on U.S. imports. However, statements from several European defence CEOs suggest optimism—they’ve emphasised that, as long as governments commits to big orders, they are ready to scale up. Additionally, many factories are currently underutilised, meaning they have the potential to expand output to meet rising demand.

Take the Eurofighter Typhoon as an example, The Eurofighter Typhoon is a joint project between multiple European defence companies. At its peak around 10 years ago, they produced around 60 jets per year. Today, production has slowed to just 12 annually. But the manufacturing infrastructure is still in place, meaning output could ramp up relatively quickly if demand accelerates.

Besides, European military providers can boost their production capacity, by strategically taking over and utilising the automotive production line. First, car manufacturers are downsizing their production in Europe especially Germany, shrinking their traditional cars production line, in response to the structural shift in sectoral trend from fuel-powered cars to EV. This forms a drastic contrast to the surging demand that defence companies are currently facing. Plus, the precision engineering, automation, logistics overlap, and skilled labour can pivot roles quickly. Therefore, there’s incentive for both parties to facilitate this transaction, creating an opportunity for defence companies to absorb underutilised capacity and rapidly scale up production to meet surging demand.

For instance, Rheinmetall is considering taking over one of Volkswagen’s soon-to-be idle plants, as the growing arms maker scours Germany for extra production capacity.

Investor sentiment changes to support defence

Political and public support for defence production is the highest it’s been in decades, even overcoming past ESG concerns. In fact, major European asset managers who once shunned defence stocks for “sustainability” reasons are now “reconsidering their policies to help fund the continent’s race to re-arm.”​

Despite high valuations, there is still upside potential considering the structural shift

Right now, European defence stocks are the most expensive they’ve ever been, even after the recent pullback. Volatility is high, since investors become more sensitive to headlines and will take profit on any signs of headwinds. However, if we consider Europe’s military independence to be a long-term commitment, the market deserves valuation expansion. Hence, it still holds a decent upside potential despite this year’s significant rally. We project a target price of EUR 443 for the WisdomTree Europe Defence UCITS Index, based on our fair P/E ratio of 26X. This translates to an upside potential of 42% by the end of 2027 (Table 1).

Investors who wish to gain exposure to European defence sector may consider the WISDOMTREE EUROPE DEFENCE UCITS ETF - EUR ACC (LSE: WDEF). Incepted on 4^th of March this year, this ETF focuses on European defence companies. Weights are assigned based on market cap, however, adjusted by their exposure to defence activities, which provides investors with a specialised exposure to defence. Total expense ratio is 0.4%.

As can be seen from the top holdings, Thales SA, Rheinmetall AG and Leonardo Spa each takes up around 12.5% of weight, different from usual index holding such as STOXX Europe Total Market Aerospace & Defence, where Airbus SE is usually the top holding by purely market-cap weighted method (Table 2). Individual stock is capped at 12.5% and the index will be rebalanced twice a year (March and September).

Table 2: ETF’s top 10 portfolio holdings