Defense and Security Sector Volatility: Navigating Geopolitical Uncertainty and Regulatory Risk in 2025

The defense and security sector has entered a period of unprecedented volatility, driven by a confluence of geopolitical tensions, regulatory shifts, and supply chain fragility. As global conflicts escalate and regulatory frameworks evolve, investors must grapple with both the tailwinds of surging demand and the headwinds of operational and compliance risks.

Geopolitical Tensions Fuel a Defense Spending Supercycle

The past three years have seen defense budgets surge in response to conflicts in Europe and the Indo-Pacific. A Morningstar report Morningstar report places European nations at the forefront of this spending supercycle, with Germany projecting a 2025 defense budget of $110 billion-a 6.8% annual growth rate from 2024 to 2035, outpacing the U.S. and other global powers. This trend is mirrored in the Gulf states and the Indo-Pacific, where military modernization and competition with China are driving demand for advanced systems like drones, cyber defenses, and AI-enabled platforms, as described in a MarketMinute article MarketMinute article.

The Russia-Ukraine war has been a catalyst for this shift. A ScienceDirect study ScienceDirect study found that 81.4% of global defense companies experienced stock fluctuations during the conflict, underscoring the sector's sensitivity to geopolitical shocks. Meanwhile, the Israel-Hamas war and escalating tensions in the Middle East have further intensified demand for military hardware and logistics. Defense contractors such as Lockheed Martin, General Dynamics, and European firms like Rheinmetall and Saab are reporting record-high order backlogs, with stock performance reflecting this optimism, per CFRA research CFRA research.

Regulatory Risks: A Double-Edged Sword

While demand is robust, regulatory risks are complicating the landscape. In the U.S., the Trump administration's recent executive orders have overhauled defense acquisition processes, freezing Biden-era policies on DEI programs and greenhouse gas disclosures in government contracts, as noted in a Latham & Watkins weekly review Latham review. The revocation of Executive Order 11246, which mandated affirmative action in federal contracting, has introduced uncertainty for firms reliant on federal contracts. Additionally, a hiring freeze on non-national security roles could ripple through the defense industrial base, affecting staffing for critical projects, according to Morgan Lewis guidance Morgan Lewis guidance.

Cybersecurity compliance has emerged as a focal point. The Department of Justice recovered $93 million in False Claims Act settlements from defense contractors in fiscal year 2024, with a major aerospace firm facing a $428 million penalty for cybersecurity lapses, as highlighted in the Deloitte outlook Deloitte outlook. These enforcement actions signal a zero-tolerance approach to compliance failures, particularly as the sector adopts AI and digital tools to optimize operations, a trend discussed in a RealClearDefense piece RealClearDefense piece.

Internationally, NATO and the EU are recalibrating supply chain strategies. NATO identified twelve essential raw materials in 2024, according to Rare Earth Exchanges Rare Earth Exchanges. The EU's Critical Raw Materials Act and stockpiling strategy aim to reduce reliance on Chinese suppliers, but implementation lags behind ambition, creating bottlenecks for manufacturers, per a Compliance & Risks update Compliance & Risks update.

Supply Chain Disruptions: A Looming Challenge

Supply chain vulnerabilities are compounding regulatory risks. The defense industry's reliance on semiconductors, rare earths, and advanced materials has exposed it to global shortages. For example, the Department of Defense's updated Chinese Military Companies List prohibits contractors from using products linked to listed entities, adding layers of scrutiny to procurement, as outlined in a Guidehouse report Guidehouse report.

In the Middle East, regulatory shifts are reshaping supply chain dynamics. Saudi Arabia and the UAE have aligned their technical standards with EU norms, while Turkey and Egypt have introduced new automotive and data protection rules, according to an EY analysis EY analysis. These changes, though aimed at boosting compliance and safety, require firms to adapt quickly to avoid operational delays.

Strategic Opportunities and Risks for Investors

For investors, the defense sector presents a paradox: high-growth potential amid significant risks. The surge in defense spending is creating opportunities for firms specializing in AI, cyber systems, and next-generation platforms. However, supply chain bottlenecks and regulatory uncertainty could delay projects and inflate costs.

A visual analysis of defense spending trends reveals stark contrasts: while Europe and the Indo-Pacific are experiencing double-digit growth, the U.S. faces challenges in balancing its $150 billion defense budget with domestic economic pressures . Investors must also weigh the long-term implications of regulatory shifts, such as the Biden administration's freeze on cybersecurity rules, which has left many contractors in a compliance gray zone .

Conclusion

The defense and security sector is at a crossroads. Geopolitical tensions are fueling a spending supercycle, but regulatory and supply chain risks threaten to undermine its potential. For investors, success will depend on identifying firms that can navigate these challenges through innovation, resilience, and strategic partnerships. As NATO and the EU continue to prioritize supply chain security, the ability to adapt to a rapidly shifting landscape will separate winners from losers in this high-stakes arena.