European defense stocks: The magnitude of Europe’s rearmament remains underappreciated

Geopolitics is front and center to start 2026. From the U.S. capture of Venezuelan President Maduro to President Trump’s provocative stance toward Greenland and civil unrest in Iran, recent developments have put the spotlight back on rising global defense outlays.

Emblematic of this environment, on January 7, Trump declared he would ask Congress to boost the Pentagon’s budget to $1.5 trillion for 2027, up more than 50% from 2026 levels, citing “troubled and dangerous times.” And while Venezuela has limited direct implications for Europe’s defense industry, the tensions with NATO allies over Greenland hit far closer to home. Together, these flashpoints reinforce an increasingly unstable geopolitical backdrop and the case for higher military spending as a structural necessity.

European defense stocks have been strong out of the gate this year, with the STOXX Europe Targeted Defence Index up 14% and the Goldman Sachs Europe Defense basket up 18% year to date, respectively (as of 30 January 2026). These stocks surged in the first half of 2025 before momentum faded later in the year. As impressive as recent performance has been, we believe markets continue to underappreciate the magnitude and duration of Europe’s rearmament cycle.

European defense sector: Why 2025’s gains tell only part of the story

While European defense stocks outperformed in 2025, the bulk of the gains came in the first three months of the year. Recall, at that time President Trump’s tariff rhetoric gave rise to a so-called “Sell America” trade that saw U.S. financial assets come under pressure globally. Meanwhile, the United States’ desire to pull back from its traditional role as global security guarantor put renewed pressure on NATO allies across Europe to increase defense budgets.

However, the initial surge gave way to more uneven performance through the rest of the year as the Trump administration’s “Liberation Day” tariff reversal sparked a broad relief rally across other sectors. European defense benchmarks not only lagged U.S. peers in the second half of 2025 – they declined outright. Speculation about an imminent Russia-Ukraine peace agreement further weighed on sector sentiment in the fourth quarter. Those peace talks stalled entering 2026 as the two nations remained far apart on major territorial disputes.

While a period of consolidation after the rapid rise at the start of last year may be understandable, we believe the relative weakness exhibited during the fourth quarter was unwarranted. In our view, markets have been overly fixated on near‑term geopolitical gyrations rather than the longer‑term structural forces reshaping the European defense industry. The sharp rebound in European defense stocks to start 2026 suggests investors may be starting to recognize this disconnect.

Assessing the scale and duration of the European rearmament cycle

After decades of underinvestment since the end of the Cold War, Europe now faces the challenge of rebuilding military readiness – a process that will span well over a decade. At last year’s NATO Summit in The Hague, European allies made a pivotal commitment to raise core defense spending to 3.5% of GDP by 2035 (from the prior 2% target), with an additional 1.5% earmarked for broader security-related investments, bringing total defense-related spending to 5% of GDP.

Although defense spending across the region has risen substantially since Russia’s invasion of Ukraine in 2022, outlays still lag well behind U.S. levels, and reaching the 3.5% target by 2035 remains a long way off. While some countries will boost spending faster than others, narrowing the gap is likely to remain a priority for the foreseeable future. Adding to the urgency is mounting pressure from Washington: The United States’ recently published National Security Strategy called for Europe to “take primary responsibility for its own defense,”¹ a position likely to endure beyond Trump’s presidency.

Even if the Ukraine conflict ends, most European countries now view Russia as a long-term threat to national security, and peace-keeping efforts will require sustained investment. Indeed, at a summit in Paris in early January, European leaders signed a declaration pledging security guarantees for Ukraine, including long-term military support and readiness to deploy a multinational force once a ceasefire is in place.²

The implications for well-positioned European defense companies are clear. Restoring military readiness across the region will require steady investment for at least the next decade, translating to long-term contracts and earnings visibility.

European governments are also likely to favor domestic suppliers over U.S. imports. In the European Defence Industrial Strategy launched in 2024, the EU called on Member States to make progress toward procuring at least 50% of defense investments within the EU by 2030, and 60% by 2035.³ As orders continue to build, leading firms not only stand to benefit from growing domestic budgets but also the opportunity to take market share.

Germany as a foundation for Europe’s defense industry rebuild

Germany stands out as the cornerstone of Europe’s defense rebuild, entering the cycle with fiscal flexibility and a clear mandate for accelerated modernization. As Europe’s largest economy – and third globally – Germany carries a debt burden of roughly 62% of GDP compared with 82% for the EU and 88% for the broader Euro area.⁴

In 2025, Germany’s “debt-brake” reforms effectively removed constraints on defense spending. This came amid a broader, coordinated effort to stimulate the domestic economy, supported by a €500 billion federal investment fund aimed at boosting industrial growth. Within this strategy, the defense industry is viewed not only as essential to national security but also as a strategic growth engine.

The impact is already visible. Germany’s 2026 federal budget earmarks approximately €108 billion for defense, a 25% year-on-year increase that will push spending to an estimated 2.6% of GDP. Importantly, the country aims to reach the 3.5% target by 2029, six years ahead of NATO’s guideline. In December 2025, lawmakers approved new procurement projects worth nearly €50 billion – a meaningful signal that spending plans are translating into concrete demand.

Near-term challenges argue for a selective approach

While the fundamental backdrop for the industry remains highly supportive, valuations are higher than a year ago, raising the bar for execution. And as we saw at the end of 2025 – and, more recently, after Trump’s apparent U-turn on Greenland in Davos – any de-escalation of geopolitical tensions can drive short-term volatility. Such swings in sentiment, however, would not derail the long-term thesis, in our view.

The varying fiscal positions across the region also warrant careful consideration. More heavily indebted countries may face political resistance to rapid spending increases. This environment favors firms with local manufacturing footprints as governments seek to offset fiscal impacts with domestic industrial activity. We believe those firms with differentiated capabilities at scale, including local champions and global leaders, are best positioned to benefit.

Ultimately, the long march toward restoring military preparedness across Europe remains in its early stages. For investors, identifying the most compelling opportunities requires going beyond the headline-driven noise. In our view, an active approach grounded in deep fundamental research may help pinpoint these opportunities as Europe’s rearmament progresses.

IMPORTANT INFORMATION

Aerospace and defense industries can be significantly affected by changes in the economy, fuel prices, labor relations, and government regulation and spending.

Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.