European Defense Stocks Poised for Growth as NATO Spends 5% of GDP by 2035

The geopolitical landscape in Europe has shifted dramatically since Russia's invasion of Ukraine in 2022. As NATO allies grapple with the fallout, the alliance has committed to a historic increase in defense spending—raising the target from 2% to 5% of GDP by 2035. This surge, announced at the 2025 NATO Summit in The Hague, is directly tied to the escalating threat from Russia, particularly along the Poland-Ukraine border. The move has created a goldmine of opportunities for investors in European aerospace and defense sectors, where companies are racing to meet surging demand for advanced military technology.

The 5% GDP Target: A Catalyst for European Re-Armament

NATO's 2025 commitment reflects a broader strategic shift. The 5% GDP target is split into 3.5% for core defense spending (e.g., weapons, aircraft, and troop readiness) and 1.5% for defense-related infrastructure, cyber resilience, and innovation. This aligns with the EU's ReArm Europe initiative, which includes a €150 billion loans-for-arms fund to accelerate procurement. Eastern European nations like Poland—already spending 4.7% of GDP on defense in 2025—are leading the charge, with Germany, Italy, and Sweden following suit.

The urgency is palpable. With Russian incursions into Polish airspace and drone attacks near the Ukraine border, NATO has prioritized air and missile defense systems, cyber capabilities, and AI-driven logistics. European defense firms are now the beneficiaries of this arms race, with contracts and production pipelines expanding rapidly.

Key Sectors Driving Growth: AI, Cyber, and Drones

1. Air and Missile Defense:
   The need to counter Russian ballistic and cruise missiles has made this sector a top priority. Companies like Rheinmetall (RHM.DE) and Leonardo (LDO.MI) are securing contracts for next-gen radar systems and anti-aircraft batteries. Rheinmetall's SkyMaster system, for instance, is being deployed across NATO's eastern flank.

1. Cybersecurity:
   As hybrid warfare evolves, cyber defense has become a critical investment area. Startups like Mapon (Latvia) and Evrotrust (Bulgaria) are developing AI-powered threat detection systems, while established firms like Saab (SSABb.ST) are integrating secure communication networks for military and civilian infrastructure.

2. Drones and Autonomous Systems:
   The Ukraine war has demonstrated the tactical superiority of drones. European firms are now capitalizing on this trend. Patria (Finland) leads the AI-WASP project, developing AI-controlled drones for both manned and unmanned systems. Meanwhile, Ukrainian startups like 3DTech and Fourth Law are producing AI-guided drones for export, with NATO allies snapping up their innovations.

High-Conviction Investment Opportunities

Beyond the well-known names, several under-the-radar companies are positioned for outsized gains:

• Patria (FIN): Finland's defense contractor is at the forefront of AI integration in military systems. Its AI-WASP project, a pan-European collaboration, is expected to secure €2 billion in contracts by 2027.
• LPP Holding (Czech Republic): This manufacturer of AI-guided drones has already supplied systems to Ukrainian forces. With NATO seeking to replicate Ukraine's drone success, LPP's revenue could grow 300% in 2025.
• Fourth Law (Ukraine): A startup specializing in autonomous drone swarms, Fourth Law has attracted interest from NATO's Innovation Hub. Its technology, designed for GPS-denied environments, could disrupt traditional warfare paradigms.
• Rebel Group (Romania): Focused on fiber-optic solutions for military communications, Rebel Group is addressing a critical gap in secure data transmission. With NATO's emphasis on cyber resilience, its contracts are set to triple in 2026.

ETFs and Broader Market Trends

Investors seeking diversified exposure should consider defense ETFs like Themes Transatlantic Defense ETF (NATO), which has surged 35% in 2025, and iShares European Defense ETF (EUAD), up nearly 70%. These funds track companies across the defense value chain, from traditional arms manufacturers to AI and drone innovators.

Strategic Risks and the Path Forward

While the long-term outlook is bullish, risks remain. Over-reliance on government contracts and geopolitical volatility could disrupt short-term earnings. However, the EU's Defense Omnibus Simplification—aimed at reducing regulatory barriers—should stabilize the sector. Additionally, the U.S. Replicator Program's focus on uncrewed systems suggests global demand for European drone technology will persist.

Conclusion: A Golden Age for European Defense

The convergence of NATO's 5% GDP spending target, Eastern Europe's military mobilization, and technological innovation is creating a unique investment window. Companies like Rheinmetall and Leonardo are already reaping the rewards, but the real alpha lies in smaller firms pioneering AI, cyber, and drone solutions. For investors with a medium-term horizon, European defense stocks and ETFs offer a compelling hedge against geopolitical uncertainty—and a chance to profit from the continent's renaissance in military capability.

Final Note: As the Russia-Ukraine conflict enters its fourth year, the defense sector remains in a golden age. For those who act now, the rewards could be as transformative as the technologies reshaping modern warfare.