European defence: Independence and reshoring

For much of the past few decades, European defence has been something investors have treated as an area of peripheral interest. The US security guarantee appeared solid, peace in Europe seemed relatively secure, which meant that defence spending competed with other priorities. That world increasingly feels like it belongs to another era.

What seems clear is that Europe’s security environment has fundamentally changed. Defence, supply chain resilience and strategic autonomy are no longer temporary responses to the war in Ukraine. They are becoming structural necessities.

The uncomfortable reality is that Europe appears far from prepared for that world. It remains heavily dependent on the US for critical capabilities, even as questions grow around how much of Europe’s security burden Washington might be willing to carry in future.

At the same time, the nature of warfare is changing extraordinarily quickly. Ukraine has become a testing ground for drones, artificial intelligence (AI), cyber and electronic warfare. The definition of security itself is consequently being tested and expanded.

That leaves investors with an important question: what comes next for Europe, and what does that mean for its defence sector?

Hybrid warfare is the more likely immediate risk for Europe

Much has been made of the risk of Russian tanks sweeping west across the Baltic states (Estonia, Latvia and Lithuania), and countries like Poland and Moldova, have long warned of the potential threat from Moscow, their history with and proximity to Russia giving them a perspective not always shared across Western Europe.

Given how stretched Russia’s military resources appear in Ukraine, its ability to sustain another major conventional front, should that be its intent, appears limited. But that is little cause for complacency. The threats Europe faces are broader and harder to define than conventional military aggression, with myriad vectors for hybrid warfare. Russia does not need to send tanks across a border to cause serious disruption to communications, energy networks, transport, financial systems, or foment political uncertainty.

Nor would peace in Ukraine necessarily mean Europe could return to its pre-2022 security assumptions. Russia’s economy is now geared for war, and this may not be simple to reverse. Any future instability within Russia could conceivably prove difficult for Europe to manage. There is no clarity over who might eventually follow Putin, for example, raising questions over whether any future transition might be orderly, or that new leadership necessarily more moderate.

While this latter point is speculative, it emphasises that Europe is dealing with a structural change in its security environment, rather than a transient problem related to the war in Ukraine.

Europe’s response has been a decisive shift to rearmament

Concerns about Europe’s future security may have been jolted by conflict in Ukraine, but the decisive catalyst that forced Europe’s hand on rearmament was the emergence of uncertainty over America’s commitment to European security guarantees. The US political climate has shifted substantially, and this has forced Europe to respond.

Rebuilding and developing defence capabilities on this scale is no small task. Europe’s NATO members remain heavily dependent on US intelligence, satellite capabilities, air defence, technology, and more. Europe needs to build credible capacity alongside NATO and the US, gradually filling the capability gaps that currently leave it vulnerable. However, this is no easy task given how far Europe lags in important areas today.

At the 2025 Hague Summit, NATO members committed to investing 5% of GDP annually in defence and security by 2035, with 3.5% for core defence assets and 1.5% for broader defence/security-related investment. But money alone is not a solution to this problem. Europe does not have a single government, defence market or procurement system. National self-interest naturally wants defence expenditure to support domestic industry and jobs, but the fragmented nature of this kind of procurement risks duplication, higher costs, smaller production runs and weaker interoperability.

Rearmament also requires societal and industrial change. From an investment perspective, we believe the consequences extend far beyond traditional defence companies, across every industry, from energy and manufacturing capacity to tech autonomy and financing.

Technology is fundamentally changing warfare

While Europe is reconsidering how to defend itself, it also has to confront how quickly warfare is changing. Ukraine has become a testing ground for drones, battlefield data and AI. The economics are a particularly striking aspect. The asymmetry of cheap drones being shot down by interceptors worth millions, and in limited supply, is unsustainable. Military advantage has become not simply about whether you can destroy a target, but how cheaply you can do it and how frequently.

This suggests that Europe cannot simply rebuild the defence industry it had before. It needs to invest for a very different kind of conflict. That could support greater demand, not only for conventional aircraft, missiles and ammunition, but also cheaper counter-drone systems, sensors, electronic warfare and the computing power needed to process battlefield information quickly.

AI adds another dimension. Modern forces generate huge quantities of satellite imagery, intelligence, targeting information and communications. The advantage comes from turning that information into decisions and insights faster than your opponent.

This argues that the opportunity for investors is much broader than just traditional defence manufacturers. Semiconductors, secure cloud infrastructure, software, satellite communications and cyber security increasingly sit alongside aircraft and missiles as strategic assets. The same applies to energy supply chains, telecommunications and transport networks.

Security is starting to compete with efficiency

For decades, European companies have built supply chains around cost and production efficiency. Businesses sourced components where they could be produced most cheaply, while ‘just-in-time’ inventories helped to minimise the amount of capital tied up in production or storage. Geopolitics is changing that calculation.

If a component is critical, the question is now how resilient that supply needs to be, rather than just the price. Taiwan, for example, is hugely important for advanced semiconductor production, but any potential threat to that production could have widespread ramifications. Europe could feel the economic consequences regardless of whether it played any direct role in the conflict.

When it comes to defence, the same thinking applies to energy, critical minerals and the refined fuels needed to keep military aircraft in the air. Resilience inevitably involves some redundant capacity. More inventory, more diverse suppliers and, in some cases, bringing production closer to home (ie. near-shoring, onshoring).

The expected shift, in our view, creates greater demand for certain domestic industries, such as defence, infrastructure, logistics, technology, energy and materials. We see the potential beneficiaries as extending beyond Europe’s largest companies. Some of the more interesting opportunities could instead emerge among companies further up the supply chain, that are providing the components, infrastructure and specialist capacity that Europe increasingly wants closer to home.

There is a price for greater resilience

All of this investment has to be financed. Governments are already running sizeable deficits and face difficult choices over their spending plans (with little political appetite to cut social spending). Higher defence, infrastructure and supply chain expenditure adds to those funding needs, at the same time as the private sector continues to ramp up its demand for capital to fund AI development. We believe that this combination could keep real yields higher as public and private borrowers compete for cash.

Fortunately, attitudes towards financing the defence industry are changing. Historical restrictions from banks and institutional investors towards defence spending are being reassessed, which may help to improve access to capital at a time when Europe needs substantial scale in available investment.

There is an inflationary angle too. Rearmament, infrastructure and reshoring require raw materials, energy, manufacturing capacity and construction. Greater demand for those resources could keep inflation (and inflation expectations) higher than investors have become accustomed to since the Global Financial Crisis.

That makes this much more than an equity story. A more capital-intensive European economy could mean higher borrowing costs, greater pressure on government finances and a very different environment for bond and equity valuations.

The investment story is bigger than Europe

It seems clear that Europe’s experience is part of a much bigger geopolitical realignment. Russia may be the immediate concern, but risks elsewhere could prove just as significant. Sustained instability in the Middle East continues to put strain on global supply chains, energy markets and refined products delivery, with particular risks for vital fertiliser supplies. Similarly, any threat to semiconductor production and supply, or rare earth metals needed for their production, could have consequences across global technology and manufacturing.

What connects these risks is a growing recognition that security and economics can no longer be treated separately in a world of deglobalisation. Where goods are produced, where energy comes from, who controls important technologies and how resilient supply chains are in a crisis, increasingly matter alongside cost and efficiency.

That is quite a change from the world investors have become accustomed to since the end of the Cold War. Globalisation rewarded efficiency, specialisation and lean supply chains. A less certain geopolitical environment places a greater value on resilience, spare capacity and strategic control.

European rearmament is one very visible part of the wider investment story, but the wider shift in how governments and companies think about security could reshape where capital is spent, where things are made and which assets and businesses investors value for many years to come.

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