A major financial firm recently issued a research note on European defense stocks which asked: “Where are we in the super-cycle, and is it already priced in?” The report’s conclusion was that European defense stocks present more downside risk than upside risk.
There were a number of analytic issues in the report, although they are not unique to Europe or defense. They are a reminder of the old adage on Wall Street that the four most dangerous words are, “It’s different this time.” But it is equally disadvantageous not to recognize fundamental changes or to consider historic periods and data that are foundationally different, particularly if they are the basis on which to draw conclusions.
The report relied on stock price and broader market data from 2005-24. The first question is whether this period is even relevant to the 2024-30 time frame.
From the early 1990s to 2014, European defense was primarily focused on instability in the Middle East and supporting a NATO mission in Afghanistan. The end of the Cold War was accompanied by a dramatic drawdown in force size and composition as the Warsaw Pact evaporated.
One symbol of the changed relationship with Russia was France’s 2010 sale of two new Mistral-class amphibious ships to Russia. The deal was canceled in 2015. Russia’s military operations in the Donbas region of Ukraine in 2014 and the capabilities its armed forces demonstrated formed an inflection point, but it was the 2022 large-scale invasion of Ukraine that was the major catalyst for a changed European security posture. The extent of the change in Europe was underscored by Sweden and Finland joining NATO.
It would be far more appropriate to consider a period when European defense spending was increasing as a result of a foundational shift in threats. U.S. defense spending from 1980-2024 is a poor substitute.
Different periods in the Cold War may be analogous, although the 1930s could work, too. I don’t have data (yet) for European spending in the 1950s. But defense expenditures on equipment and research and development in what was then West Germany increased at a 6% compound annual growth rate from 1965 to a peak in 1984, after which it was relatively flat until the Berlin Wall came down in 1989.
This was a period when the Soviet Union modernized its military forces, posing a significant conventional threat to Europe, and the U.S. also increased its spending. West Germany moved from a military largely equipped with U.S. equipment to one using weapons developed by domestic industry or in cooperation with other European states. The U.S. was firmly committed to NATO and had large forces stationed in Europe. The U.S. Navy’s primary conventional focus was on defeating the Soviet Navy and ensuring safe passage of troops and supplies to Europe in the event of war.
European defense is in a different position today. There are open questions about the U.S. ability to sustain support for Ukraine and what would happen to U.S. NATO commitments if Donald Trump is elected U.S. president in 2024.
There is a major war on Europe’s border now. If Ukraine were forced to cede territory to Russia and President Vladimir Putin—or someone like him—remains in power, Russia’s desire for a larger security buffer and historic revisionism would be unlikely to change. There are plenty of historic memories in the Baltic states, Finland, Germany, Poland, Romania and Sweden suggesting what that would mean for their security in 2025 and beyond.
Of course, there are risks to increased European defense spending. Putin could fall and be replaced by a government with pro-Western views, Russia could devolve into a failed state, or fiscal capacity in Europe could be more constrained. There are demographic issues that states must grapple with, too.
Another analytic issue is that there is not a good set of European defense stocks whose performance over periods of prior military buildups is known. The report used a basket of stocks to show performance, but the nature and composition of that basket has changed. Rheinmetall had a higher contribution from automotive components in its portfolio, though it exited piston and other engine components in recent years. Cobham and Ultra were acquired by Advent International in 2020 and 2021, respectively.
In the 1980s or earlier, European industry was different than today, although some strands of consistency remain. KraussMaffei was the primary German armor vehicle manufacturer in the 1970s and ’80s; it is privately owned, as are Diehl, and Rohde & Schwarz. Others have been multisector and were merged in the 1990s (e.g., GEC, Ferranti and Lagardere’s Matra) or were state-owned (Aerospatiale and Finmeccanica). Rolls-Royce went bankrupt and was nationalized in 1971 and was then privatized in 1987.
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