The Defence Boom Has a Fiscal Problem

The drone attack on a Kyiv apartment building on September 9th was neither the first nor the last of its kind in a war that has now entered its fifth year. It is, however, one more reminder of the structural force reshaping European government budgets — and the companies that profit from them.

What happened to one building on one evening matters less to investors than the question it implies: how long will European governments keep paying for security, and can anyone actually build fast enough to spend the money they are promising?

The answers point to Rheinmetall, Germany's largest defence firm, and to a gap between political commitments and fiscal arithmetic that has yet to fully show itself in the stock market.

The spending machine

Europe's military spending rose by 14% in 2025 to $864 billion, the fastest increase in Central and Western Europe since the end of the Cold War, according to the Stockholm International Peace Research Institute. Germany alone increased defence spending by 24% to $114 billion. At a NATO summit in The Hague in June 2025, all 32 allies agreed to raise defence- and security-related expenditure to 5% of GDP by 2035 — up from the old 2% floor. NATO reported in July that core spending by European allies and Canada rose another 11% in the first half of 2026.

On the American side, Congress appropriated $1 trillion for defence in 2026, the largest budget in U.S. history. President Trump has requested $1.5 trillion for fiscal 2027, which would represent a 42% increase from current levels. Whether Congress delivers remains an open question — in 2025, most of the $173 billion in mandatory defence funds from the prior year's legislation appeared largely unspent, with total military spending only 3% higher than the same period a year earlier.

Rheinmetall sits at the centre of the European spending wave. The firm reported full-year 2025 sales of €9.94 billion, up 29% year on year, with pre-tax earnings of €1.68 billion. Its order backlog hit a record €63.8 billion, a 36% jump. For 2026 the company expects sales between €14 billion and €14.5 billion — growth of 40% to 45% — and projects its backlog could more than double to €135 billion. The operating margin is guided at approximately 19%, up from 18.5% in 2025.

In 2021, Rheinmetall's revenue was roughly €2.6 billion in 2021. Over four years it has grown by more than 280%.. Among European defence firms, only Saab has shown comparable revenue acceleration. By 2025, Rheinmetall had risen to become Germany's seventh-largest company by market value, with a market capitalisation of approximately €47 billion.

The gap between orders and money

The arithmetic behind the orders looks formidable. Management flagged a potential €67 billion in German orders over four quarters. The "Arminius" Boxer armoured-vehicle package alone includes a €12.5 billion fixed tranche plus a €25 billion option running to 2035, with €37 billion scheduled to be booked in 2026. Naval work adds another €12–13 billion in potential.

The trouble is that an order book is not a bank balance. It is a set of contractual expectations, many of which depend on budget approvals that have not yet been granted, in governments that face serious fiscal headroom problems.

Germany's public debt stands at 63.9% of GDP — manageable by European standards. But the countries with the largest gaps to the 5% target are often the most indebted. Italy, at 135.3% debt-to-GDP, would need to increase its military burden by 211%. Belgium faces a 292% increase. France, at 113.1% debt, would need a 144% increase.. Spain secured an exemption, arguing that its existing 2.1% GDP spending already yields equivalent capabilities.

Even Germany, the poster child of European rearmament, is only at 2.3% of GDP — well short of the new 5% target. Reaching it would require a 164% increase in military burden. That is not impossible. It is a massive ask from a country that spent a decade cutting defence budgets after 2004, when military spending relative to GDP fell by 10%.

The result is a structural tension: defence firms have backlogs that reflect political ambition, while the Treasury departments that ultimately write the cheques are grappling with debt, interest costs, and public opinion that correlates inversely with the gap to the 5% target. Countries further from the target — Slovenia, Italy, Belgium — show lower public support for further spending increases. In Germany, 32% of the population rejects further military expansion, according to surveys cited by researchers at the Institute for International Economics.

What the market is pricing in

Rheinmetall's trailing P/E ratio sits at 39, implying the market is valuing each euro of past earnings at nearly 40 euros. The forward P/E of 19.4 is more reasonable — but it assumes the company actually delivers its aggressive 2026 guidance and keeps growing from there.

Investors have shown they are quick to punish missed expectations. When Rheinmetall issued its preliminary 2026 guidance in February, shares fell 6.5%. The March full-year report, which included 29% revenue growth and record backlogs, was met with another 5.2% drop — because Jefferies analysts described the guidance as "realistic but soft" and the stock had already risen approximately 1,700% since the start of 2022. The market had priced in near-perfect execution.

The correction broadened in March 2026 when the MSCI Europe Aerospace and Defence Index fell by nearly 10% in a single month, its largest decline in five years. Profit-taking joined with growing uncertainty. The Iran conflict of early 2026 exposed the cost asymmetry of modern warfare: Gulf states fired hundreds of U.S.-made Patriot interceptors, each priced at approximately $4 million, against comparatively cheap drones. Defence groups have responded by investing more in drones, surveillance, and counter-drone systems — a shift that could redistribute revenue within the sector rather than simply expand it.

Rheinmetall is not immune to these dynamics. Its Q1 2026 free cash flow was negative €285 million, down sharply from €243 million a year earlier, as customer advance payments dried up and working capital was consumed by inventory builds for the projected sales surge. The backlog figure was also complicated by a €5.5 billion contribution from a newly consolidated naval systems segment, acquired in February.

Morningstar assigns Rheinmetall a wide economic moat and a fair value estimate of €2,380 per share — implying further upside from current levels of roughly €1,000. But that estimate was published in July and assumes continued order conversion and margin expansion. It does not model a scenario in which European governments, pressed by debt and public opinion, slow or phase their spending commitments.

The American comparison

Lockheed Martin, by contrast, trades at a trailing P/E of approximately 20 — less than half Rheinmetall's multiple — despite similar themes of rising defence spending and record backlogs. Lockheed's stock rose 31% year to date through early September, with a market capitalisation of roughly $140 billion. The company raised its 2026 forecast in July, alongside RTX Corporation, as the Pentagon looked to restock weapons drawn down for Ukraine and the Iran operations.

The valuation difference reflects two realities. First, the U.S. defence budget is larger and more stable than any European government's. Second, Rheinmetall's growth is far more compressed into a shorter period — a 280% revenue increase over four years — which demands that execution be flawless and that government spending actually materialises. A slower-growing company at a lower multiple leaves more room for disappointment.

The investment question is not whether European defence spending is rising. It is whether the market has already priced in everything that the political commitments promise, and what happens when budget reality catches up.

Rheinmetall's stock rose because governments pledged to spend more. The pledges are genuine — the 5% NATO target is binding in a political sense, and the war in Ukraine makes retrenchment electorally costly. But pledges are not appropriations, and backlogs are not revenue. At 39 times trailing earnings, Rheinmetall is priced for continuous fulfilment of promises that have not yet been written into law.

A patient investor would want to see the orders convert, the cash flow turn positive, and the guidance hold before paying today's price. The structural trend is real. The question is whether the market has been too enthusiastic about its speed.