Europe's Defense Deficit: Why Underinvestment Spells Risk—and Opportunity in Defense Stocks

The Ukraine war has exposed a stark reality: Europe's defense preparedness remains uneven, with many NATO members lagging behind the alliance's 2% GDP spending target. As tensions with Russia persist and NATO's new 5% GDP defense spending goal by 2035 looms, the underfunded defense sectors of Southern and Western Europe pose significant strategic risks. Yet for investors, this gap represents a compelling opportunity to capitalize on the rearmament wave sweeping the continent. Let's dissect the risks, the opportunities, and the stocks poised to benefit.

A Continent Divided: NATO's Spending Gaps

Since 2014, NATO members have been urged to spend at least 2% of GDP on defense. By 2024, 23 of 32 members hit the target, but disparities persist. Poland (4.12% of GDP), Estonia (3.43%), and Latvia (3.15%) lead, while Southern members like Spain (1.24%), Italy (1.85%), and Slovenia (1.5%) trail far behind.

The Ukraine war has amplified these gaps. Eastern members, facing direct Russian threats, have accelerated spending. Meanwhile, Southern and Western allies—stretched by high public debt (Italy's is 135% of GDP) and fiscal constraints—struggle to meet even the 2% goal. The new 5% target by 2035, split into 3.5% for core military spending and 1.5% for resilience and cybersecurity, compounds the challenge.

Strategic Risks of Underinvestment

Chronic underfunding leaves Europe vulnerable. Consider Spain, which spends just 1.24% of GDP on defense, relying on U.S. forces for deterrence. If the U.S. scales back its European troop presence (currently 84,000), Madrid's military would be ill-equipped to counter Russian hybrid threats. Similarly, Italy's aging fleet and underfunded air force leave it dependent on allies for regional stability.

The risks extend beyond combat readiness. Underfunded defense industries in Southern Europe could hinder Europe's goal of reducing reliance on U.S. arms suppliers. Currently, European defense companies lack the scale to compete with American firms like Lockheed Martin or Raytheon. This dependency risks strategic autonomy—and opens opportunities for investors to back undervalued regional players.

The Investment Case: Defense Stocks to Watch

The rearmament wave will boost demand for equipment, cybersecurity, and infrastructure. Investors should focus on companies in regions where spending is set to surge, particularly in Eastern Europe and Nordic nations, where governments are outpacing NATO targets.

1. Saab (SAAB.ST) – Sweden's Cybersecurity and Jet Leader

Saab, Sweden's premier defense firm, designs advanced fighters (JAS Gripen), cybersecurity systems, and air defense. With Sweden's defense spending at 1.4% of GDP (rising to 2% by 2035) and its NATO membership, Saab stands to benefit from Nordic and Baltic rearmament. Its valuation (P/E 12x) is undemanding relative to peers, offering upside as orders flow.

2. Elbit Systems (ESLT.TA) – Israel's Cross-European Play

Elbit, an Israeli firm with a strong European presence, specializes in drones, simulation, and cyber defense. Its systems are used by Poland and Germany, two NATO members accelerating spending. With a P/E of 15x and exposure to both European and U.S. markets, Elbit's diversified portfolio offers resilience against regional slowdowns.

3. Nexter (part of Thales) – France's Ground Warfare Leader

Thales's subsidiary Nexter produces battle tanks (Leclerc) and armored vehicles. France's defense spending, at 1.9% of GDP in 2024, is set to grow to 2.5% by 2030. Nexter's expertise in armored systems positions it to capture orders from Germany (€100B defense modernization plan) and Poland (€200B rearmament).

4. Polish Military Industries (PZL) – Poland's Rising Star

Poland's defense budget, already at 4.12% of GDP, is set to grow further as Warsaw seeks to reduce reliance on Russian-made equipment. PZL, which builds helicopters and drones, is a key beneficiary. Its stock (PZL.WA) trades at a P/E of 8x, reflecting underappreciated growth potential.

Risks and Considerations

• Economic Constraints: High public debt in Southern Europe could delay spending. Italy's fiscal struggles, for instance, may limit its defense budget.
• Accounting Loopholes: Some nations count pensions or infrastructure as defense spending, inflating figures without boosting combat readiness. Investors must scrutinize cash flow and order books, not just GDP targets.
• Geopolitical Volatility: A sudden Ukraine ceasefire or diplomatic breakthrough could reduce urgency. Monitor U.S.-Russia relations and NATO's 2029 progress review.

Conclusion: Buy Defense Stocks Before the Surge

Europe's defense deficit is a ticking clock. With NATO's 5% target and Russia's continued assertiveness, underfunded Southern and Western allies must ramp up spending—or face strategic irrelevance. For investors, this means buying now into companies like Saab, Elbit, and Poland's defense firms, which are undervalued relative to their growth trajectories.

The risks are real, but the payoff is too large to ignore. Europe's military modernization will be a multi-decade process. Those who act now can secure outsized returns as the continent arms itself for an uncertain future.