European Defense Equities in the Geopolitical Reckoning: A Strategic Investment Play

The geopolitical tectonics reshaping Europe since Russia's 2022 invasion of Ukraine have catalyzed a historic realignment of defense priorities across NATO-aligned markets. As European nations confront a new era of strategic competition, defense spending is surging to levels not seen since the Cold War. This shift is not merely a reaction to immediate threats but a recalibration of long-term security paradigms, with profound implications for defense and security equities.

The Fiscal Commitment: From 2% to 5% of GDP by 2035

NATO's 2025 summit marked a pivotal moment, with member states agreeing to a long-term target of 5% of GDP for defense spending by 2035-split into 3.5% for core defense (troops, weapons) and 1.5% for infrastructure and resilience, according to an ECB analysis. This follows the 2024 milestone where over two-thirds of NATO members met or exceeded the 2% of GDP guideline, a threshold that had been a persistent point of contention for years, noted in a Fitch report. Poland, already at 4.12% of GDP in 2024, exemplifies this shift, with public support for defense spending exceeding 70%, according to NATO Review. Conversely, nations like Germany and Spain lag behind, spending 1.9% and 1.4% of GDP, respectively, in 2024, the Fitch report also noted, despite new political mandates to close the gap.

The European Central Bank (ECB) estimates that cumulative defense spending across the euro area will rise by 0.6% of GDP by 2027, while Thales reports that initiatives like the EU's Readiness 2030 plan are streamlining joint procurement and fiscal flexibility. However, challenges persist: seven NATO members, including Italy and Spain, had yet to meet the 2% target in 2024, the Fitch report observed, and sustaining these increases will test fiscal discipline, particularly in high-debt economies.

Defense Contractors: Riding the Wave of Geopolitical Demand

The surge in defense budgets has turbocharged demand for European defense contractors, many of whom are now operating at capacity. BAE Systems, for instance, reported a 24% year-on-year increase in sales for H1 2025, with a £75.4 billion ($98 billion) order backlog, according to an AeroTime article. Its recent $1.2 billion contract with the U.S. Space Force for missile-tracking satellites and progress on the Global Combat Air Programme (GCAP) further underscore its strategic positioning, the same report noted. Similarly, Rheinmetall's H1 2025 results revealed a 24% sales increase to €4.7 billion, driven by a €3.1 billion contract to modernize Germany's infantry systems, according to the ECB analysis.

Thales, a French multinational, has also capitalized on the defense boom. In H1 2025, it secured contracts totaling €10.4 billion, including a GBP 1.16 billion order for 5,000 LMM missiles from the UK and a €1.2 billion contract to supply 26 Rafale Marine aircraft to India, the Thales report states. The company's adjusted EBIT rose 13.9% year-on-year, reflecting robust demand across its defense electronics, space, and cybersecurity divisions, Thales reported.

U.S. firms are not sidelined in this European rearmament. Lockheed Martin and Raytheon Technologies have secured multibillion-dollar contracts for missile systems and precision strike capabilities, often in collaboration with European partners to navigate local content rules, the Fitch report highlighted. For example, Northrop Grumman's $899.6 million IBCS contract for Poland illustrates the growing interdependence between transatlantic defense ecosystems, Fitch observed.

Economic Implications: Growth, Inflation, and Fiscal Risks

The ECB's analysis suggests that increased defense spending will provide a modest growth boost to the euro area, particularly in 2026–2027, with inflationary effects remaining muted, the Thales report noted. However, the long-term sustainability of these increases hinges on fiscal management. Countries with limited fiscal space-such as Italy and Portugal-face difficult trade-offs between defense investments and social spending, potentially straining political consensus, the AeroTime article warned.

Moreover, the defense sector's labor-intensive nature could indirectly impact domestic demand. For instance, Rheinmetall's €3.1 billion contract is expected to create thousands of jobs in Germany, but similar projects in Southern Europe may struggle with skilled labor shortages, the ECB observed.

Investment Outlook: Opportunities and Strategic Risks

For investors, the defense sector in NATO-aligned markets presents a compelling case. The Fitch report notes that European defense stocks have repeatedly hit record highs in 2025, driven by a combination of contract visibility, geopolitical urgency, and policy tailwinds. However, risks remain:
- Execution Risk: Delays in contract awards, as seen in Germany's post-election procurement bottlenecks, the ECB analysis documented.
- Geopolitical Volatility: A shift in U.S. policy under President-elect Donald Trump could alter funding dynamics, Fitch cautioned.
- Fiscal Constraints: High-debt nations may struggle to meet spending targets without compromising other priorities, the AeroTime article observed.

Despite these challenges, the sector's resilience is evident. Fitch highlights that U.S. defense contractors' 2025 budget will stabilize backlogs and revenue visibility, while European firms like Leonardo and Safran are expanding skilled workforces to meet long-term demand, the Thales report noted.

Conclusion: A New Era of Strategic Self-Reliance

The European defense renaissance is not merely a fiscal adjustment but a geopolitical necessity. As one expert aptly noted, "The era of geopolitical outsourcing is over," as observed in the AeroTime article. For investors, this translates to a sector characterized by strong tailwinds, but one that demands careful scrutiny of company-specific fundamentals and macroeconomic risks. The key to success lies in identifying firms with diversified capabilities-such as BAE's next-gen combat aircraft ventures or Thales' lunar lander contracts-and those positioned to benefit from transatlantic collaboration.

In this new security paradigm, defense equities are no longer a niche play. They are a cornerstone of strategic investment in an uncertain world.