After years of soaring military budgets, emergency spending in Ukraine and soaring defense stocks, Europe’s rearmament drive must prove it can turn hundreds of billions of euros into weapons, factories and usable military power.
The question for investors no longer appears to be defense demand or political ambition, but whether valuations outweigh the industry’s ability to execute.
That test has taken on added significance ahead of next week’s NATO summit in Ankara, Turkey, where leaders will review progress since last year’s summit and develop a roadmap to meet new spending targets to “translate allies’ commitments into concrete results.”
But the path from higher budgets to weapons delivery has proven uneven. Procurement delays, fragmented national programs, labor shortages and strained supply chains have raised questions about how quickly Europe can rebuild an industrial base hollowed out by decades of defense spending cuts.
Pressure is building from both sides of the Atlantic. NATO allies agreed to a dramatic increase in defense spending at a summit last year, reflecting growing concerns that Europe can no longer survive under U.S. protection.
The pressure intensified earlier this month when U.S. Army Secretary Pete Hegseth announced a review of U.S. forces in Europe, warning that allies that don’t meet spending commitments could face consequences. The review is expected to take up to six months, adding new urgency to a debate already transformed by Russia’s war in Ukraine and a shift in the United States’ approach to NATO.
“There’s no question that this was a critical moment in the evolving geopolitical position of the United States,” Hugues Lavandier, a senior partner at McKinsey, told CNBC. This accelerated Europe’s realization that “the time for peace dividends is over” and that governments need to reinvest in their defense capabilities, he said.
Defense trade evolves
This shift is already changing investor expectations. european defense companies line metal to BAE Systems, leonardo, Thalesand serve It has benefited from a surge in orders since Russia’s invasion of Ukraine in 2022 as governments ramp up military spending.
McKinsey estimates that NATO’s core defense spending in Europe has doubled since 2019 and could reach around 800 billion euros ($912 billion) by the end of this decade. That would put NATO on track for a new core metric: each member country spending 3.5% of its gross domestic product (GDP) on defense. Venture capital is also flowing into European defense technologies such as drones and autonomous systems.
Lavandia said the market is in a “moment of price discovery.” While backlog was initially the clearest indicator of growth, investors now have a better read on which companies can convert backlog into production, revenue and profit, he said.
Last week, Germany announced it would buy eight smaller Meco A-200 frigates from Germany, scrapping its multibillion-euro F126 frigate program due to delays and expected cost increases. thyssenkrupp marine systems (TKMS) instead. The stock price of Rheinmetall, which was expected to be the prime contractor for the abandoned program, plummeted.
“This news is a reminder that (governments) can and do change their minds,” JPMorgan analysts said.
Performance of defense stocks over the past five years.
However, Germany’s defense budget is still increasing rapidly. Lavandier said the cancellation is an example of the government reevaluating priorities such as procurement costs, delivery timelines and military strategy.
But for investors, Rheinmetall’s selloff is “a stark reminder that the sector has experienced delays and setbacks over the past few years, despite various governments’ commitments to increase defense spending,” Dan Coatsworth, head of markets at AJ Bell, said in an emailed comment.
What is holding back Europe’s rearmament drive?
It has proven difficult for Europe to build the capabilities necessary to secure strategic autonomy.
A February McKinsey report found that despite soaring investments in defense, European NATO countries’ equipment inventories remain below 2021 levels, reflecting military contributions to Ukraine, the retirement of legacy systems, and longer delivery times for new equipment.
It also found that platform fragmentation in Europe is more than four times higher than in the US, impacting interoperability, logistics and industrial scale.
Lavandia said the biggest bottlenecks are labor and supply chain. He added that Europe’s defense industry “has not been used for mass production for a long time.” In addition to large contractors, the sector relies on multiple suppliers, many of which are small, family-run businesses, all of whom need to scale up at once.
“If one or two parts are missing, a new jet cannot be delivered,” he said.
How supply chains are slowing down defense production
S&P Global Ratings found similar constraints. The report said European defense suppliers are predominantly small and medium-sized, with limited ability to raise capital for expansion, and large contractors are exposed to bottlenecks across complex supply chains.
The credit rating agency also warned that increases in defense spending will be uneven across Europe. Poland and the Baltic states are making the fastest progress, with Germany having more room to accelerate fiscally, while France, the UK, Belgium and parts of southern Europe face greater debt constraints and competing political priorities.
S&P said increased defense spending could support the creditworthiness of defense companies, but could increase pressure on government budgets and force politically difficult trade-offs.
The report also noted that Europe remains structurally dependent on U.S. suppliers for fighter jets, air defense systems, precision weapons, electronics, software, and strategic enablers such as intelligence, surveillance, airlift, and command and control.
This means that increasing Europe’s budget will not automatically create a more independent European defense base.
Lavandier said about half of Europe’s defense spending currently flows to Europe, with the rest going to other supplier countries such as the United States, Israel and South Korea. He expects more governments to support domestically designed and manufactured equipment, not necessarily as an anti-American move, but because “if you want the productivity flywheel to work, you need to reinvest most of that money back home.”
Stefan Wintels, CEO of German state bank KfW, told CNBC’s Annette Weisbach on Friday that growth in the defense industry is “not a short-term phenomenon” but that Europe needs to increase scale, become more price competitive and create a more supportive policy framework to make this transition work.
Wintels also said that the joint ownership plan for tank maker KNDS is a potential model for deepening European cooperation. France and Germany have agreed to become equal 40% shareholders in the Leopard 2 maker ahead of its planned listing in Paris and Frankfurt.
His hope is that KNDS will eventually airbus This is proof that Europe can develop domestic champions into a globally competitive defensive group.
However, this comparison also highlights the difficulty of such a goal. Airbus takes decades to build, and Europe’s security challenges cannot wait decades.
