Late in the quarter, NATO announced its plan to increase its defense spending from around 2% of its GDP today to 3.5% by 2035. If realized, that would nearly double total spending—from around US$400 billion to US$800 billion, implying a 7% annualized growth rate. As Germany and other NATO countries loosen fiscal constraints and boost defense budgets, Industrials stocks, particularly in aerospace and defense, have rallied.
But structural challenges remain. For most of the past couple of decades, European defense companies generally exhibited poor growth, in part due to stagnant defense budgets, though the recent upturn could improve that outlook. Many of the publicly listed European defense companies also have partial state ownership of their shares, creating a dynamic in which their largest shareholders are also their largest buyers. This often leads to pressure to offer state owners favorable terms for contracts, which has weighed on the profitability of these European defense contractors relative to their US counterparts.
Still, there are a few compelling quality-growth opportunities in the sector. One example is Safran, a French aerospace firm. Safran’s primary source of growth has been the rise of commercial air traffic and the success of its jet engines. Once in operation, these engines generate decades of higher margins after sale service revenue. But the company generates roughly 20% of its revenue from military exposure tied to jet fighter engines, aircraft components, and positioning and navigation systems. If European defense spending does in fact increase at the proposed rate, that should offer Safran further growth opportunities.
