Geopolitical Risk and the Reshaping of U.S.-Middle East Defense Contracts: A New Era for Defense Sector Valuations

The U.S. defense sector is undergoing a seismic shift as geopolitical risks in the Middle East intersect with heightened political scrutiny of defense contracts. In 2025, the White House announced the largest defense sales agreement in history—a $142 billion package with Saudi Arabia—while simultaneously deepening military partnerships with the UAESullivan Legislation Strengthens U.S./Israel Alliance, Reinstates Peace-Through-Strength Policies in the Middle East^[2]. These developments, however, are occurring against a backdrop of legislative and policy changes that are redefining the financial landscape for defense contractors.

Geopolitical Tensions and the Surge in Defense Spending

Global military spending surged by 6.8% in 2023Defense Budgets in an Uncertain Security Environment^[3], with the U.S. defense industry at the forefront of this growth. The Middle East, a region marked by escalating tensions between Iran, Israel, and regional actors, has become a focal point for U.S. military modernization efforts. For instance, Saudi Arabia's $142 billion defense deal includes advanced air and missile defense systems, while the UAE's Major Defense Partnership with the Pentagon institutionalizes joint R&D initiatives and cybersecurity collaborationPentagon Announces Major Defense Partnership with UAE^[4]. These contracts are not merely transactions; they reflect a strategic recalibration in response to regional instability and the need for technological superiority.

However, the financial implications for defense contractors are complex. While increased spending drives short-term revenue, political scrutiny under the new administration is introducing compliance costs and operational risks. The Department of Defense's expanded FOCI (Foreign Ownership, Control, or Influence) requirements, now applicable to non-classified contracts over $5 million, force firms to conduct rigorous ownership assessments to mitigate foreign influenceRegulatory Shifts in Aerospace and Defense: What Businesses Need to Know as 2025 Takes Flight^[1]. Similarly, the Cybersecurity Maturity Model Certification (CMMC) program, which mandates compliance with evolving cybersecurity standards, adds layers of complexity to contract eligibilityCMMC Compliance and Its Implications for Defense Contractors^[5].

Legislative Scrutiny and Its Financial Impact

The United States-Israel Defense Partnership Act of 2025, introduced by Senator Dan Sullivan, exemplifies the new administration's focus on strategic alliances and sanctions enforcementSullivan Legislation Strengthens U.S./Israel Alliance, Reinstates Peace-Through-Strength Policies in the Middle East^[2]. This legislation not only expands funding for U.S.-Israel joint programs like counter-UAS and anti-tunneling technologies but also reinforces a “peace through strength” approach to countering Iran. For defense firms like Raytheon Technologies (RTX) and Lockheed Martin (LMT), this means increased opportunities in niche, high-margin sectors. However, the same bill's Enhanced Iran Sanctions Act restricts business with entities linked to Iran, potentially limiting revenue streams for firms with diversified regional operations.

The financial toll of compliance is evident. According to a report by Morgan Lewis, defense contractors now face a 30–50% increase in compliance costs due to expanded FOCI and CMMC requirementsDefense Budgets in an Uncertain Security Environment^[3]. These costs are particularly burdensome for mid-sized firms lacking the infrastructure of industry giants like Northrop Grumman (NOC) or General Dynamics (GD). As a result, stock volatility has risen: the iShares U.S. Aerospace & Defense ETF (ITA) gained 17% in May–June 2025 but experienced sharp intraday swings following congressional debates over contract oversightDefense Stocks Were Already Outperforming. How Iran Changes the Outlook^[6].

Investor Behavior and Market Trends

Defense sector ETFs have become a barometer for geopolitical risk. The ITA ETF, which includes major contractors like LMT and RTX, surged 27% year-to-date in 2025, outperforming the S&P 500 by over 15 percentage pointsDefense Stocks Were Already Outperforming. How Iran Changes the Outlook^[6]. This momentum is driven by both institutional and retail investors seeking exposure to a sector insulated from economic downturns. For example, the Invesco Aerospace & Defense ETF (PPA) saw a 46.6% gain in the past year, fueled by demand for AI-driven defense systems and drone technologyCMMC Compliance and Its Implications for Defense Contractors^[5].

Yet, analysts caution against over-optimism. A Morningstar report notes that while short-term conflicts boost defense budgets, prolonged instability could strain government spending and delay contractsDefense Stock Rally an ‘Exaggerated Reaction’ to Short-Term Events^[7]. This duality is evident in the UAE's stalled F-35 procurement, which remains unresolved due to U.S. concerns over technology leakage and Chinese 5G infrastructureSullivan Legislation Strengthens U.S./Israel Alliance, Reinstates Peace-Through-Strength Policies in the Middle East^[2]. Such delays highlight the fragility of long-term revenue projections for defense firms.

Opportunities in a Shifting Landscape

Despite these challenges, the defense sector remains a compelling investment. European defense budgets, projected to grow at 4.5% annually through 2030Defense Budgets in an Uncertain Security Environment^[3], provide a secondary tailwind for U.S. contractors. Companies specializing in cyber defense, AI, and autonomous systems—such as L3Harris and Boeing—are particularly well-positioned to capitalize on this trend. Additionally, the Middle East's push for military modernization ensures sustained demand for advanced systems, even amid political scrutiny.

Conclusion

The interplay of geopolitical risk and political scrutiny is reshaping the U.S. defense sector. While legislative reforms and compliance costs introduce friction, they also create opportunities for firms with robust compliance frameworks and technological edge. For investors, the key lies in balancing exposure to high-growth ETFs with a nuanced understanding of regulatory headwinds. As the Middle East remains a flashpoint for global instability, defense stocks and ETFs will likely continue to outperform—provided companies can navigate the evolving policy landscape.