Geopolitical Risk and the Defense Sector: A New Era of Investment Opportunities

The global defense and security sector is undergoing a seismic shift, driven by escalating geopolitical tensions and the urgent need for strategic autonomy. As nations recalibrate their priorities in response to conflicts like Russia's invasion of Ukraine and China's assertive posturing in the Indo-Pacific, defense spending is surging into a new supercycle. According to a Morningstar report, global defense expenditures are projected to grow at a 4.9% annual rate, with the market size expanding from USD 2,563.1 billion in 2024 to USD 2,688.7 billion in 2025. Europe, in particular, is emerging as a pivotal growth engine, with defense budgets rising at an annual rate of 6.8% through 2035, the Morningstar report notes. Germany's commitment to a $110 billion defense budget in 2025-placing it among the world's top four spenders-exemplifies this trend, as Morningstar also highlights.

The Drivers of Growth: Technology and Strategic Alliances

The surge in defense spending is not merely about quantity but also quality. Modern warfare demands advanced technologies, and investors are witnessing a paradigm shift toward innovation. Cybersecurity, artificial intelligence (AI), and unmanned systems are now central to military modernization. For instance, European defense firms like Rheinmetall and BAE Systems are partnering with U.S. and Israeli tech innovators to bridge gaps in AI and drone capabilities, according to a Hogan Lovells outlook. Similarly, U.S. defense giants such as Lockheed Martin and Northrop Grumman are capitalizing on global demand for fifth-generation fighter jets and next-generation satellite systems, as noted in the Morningstar report.

Geopolitical risks are also reshaping regional dynamics. In the Indo-Pacific, the U.S. has accelerated alliances with Japan and Australia under frameworks like AUKUS, while Japan has bypassed long-standing arms export restrictions to supply naval destroyers to the Philippines, a development described in the Hogan Lovells outlook. Meanwhile, the U.S. Navy's $990-million IDIQ contract for infrastructure projects across the Indo-Pacific-including command-and-control facilities in the Philippines-highlights the region's strategic importance, according to a Frontiers study. These developments underscore a broader trend: defense spending is increasingly tied to geopolitical contingency planning, with nations prioritizing readiness for high-end conflicts.

Europe's Defense Renaissance and the Role of the EU

Europe's defense sector is undergoing a structural transformation. The 2025 NATO Summit in The Hague marked a watershed moment, with allies committing to increase defense spending to 5% of GDP by 2035, according to a Goldman Sachs analysis. This pledge has catalyzed a wave of cross-border cooperation, including the EU's ReArm Europe/Readiness 2030 plan, which streamlines procurement rules and mobilizes €800 billion in defense investment-an initiative highlighted in the Goldman Sachs analysis. European defense M&A activity has surged by 35% in the first half of 2025, with firms like Airbus and BAE Systems securing contracts to modernize air defense systems and armored vehicles, as noted in the Hogan Lovells outlook.

However, challenges persist. Fragmented national regulations and economic disparities among EU members complicate efforts to create a unified defense market. The Morningstar report argues that achieving strategic autonomy will require not only increased spending but also industrial retooling and regulatory harmonization. For example, the European Sky Shield Initiative-a 24-nation effort to coordinate air defense acquisitions-demonstrates the potential of pooled procurement, though scaling such initiatives remains a work in progress, the Goldman Sachs analysis adds.

Investment Implications: Navigating Volatility and Innovation

For investors, the defense sector presents both opportunities and risks. Geopolitical events like the Russia-Ukraine war have historically caused volatility in defense stock returns, with European and U.S. firms reacting sharply to shifts in conflict dynamics, a pattern documented in the Frontiers study. Yet innovation is proving to be a more enduring driver of value. The Frontiers study found that AI and unmanned systems have a stronger long-term impact on defense stock performance than geopolitical risk itself. This suggests that companies with robust R&D pipelines-such as those investing in autonomous drones or cyber warfare platforms-are better positioned to weather short-term turbulence.

Active and diversified strategies are essential. BlackRock highlights that defense stocks often correlate positively with gold and the VIX Index during geopolitical crises, making them a hedge against uncertainty. Moreover, firms with long-term government contracts, such as those maintaining aging U.S. military assets like the F-35 fighter jet, offer more stability than traditional corporate investments, BlackRock notes.

Conclusion: A Sector Shaped by Uncertainty and Resilience

The defense and security sector is at a crossroads. While geopolitical risks drive immediate spending, the sector's future hinges on technological innovation and strategic collaboration. For investors, the key lies in balancing exposure to high-growth areas-such as AI and Indo-Pacific infrastructure-with a focus on companies that can navigate regulatory and geopolitical headwinds. As the world grapples with a fragmented and unpredictable security landscape, the defense sector's ability to adapt will determine its role in shaping the next decade of global markets.