Navigating European Equities in a Fractured World: Defense Risks and Tech Opportunities Amid U.S.-China Tensions

The geopolitical and macroeconomic landscape of 2025 is defined by two parallel forces: escalating U.S.-China trade tensions and the fallout from the Russia-Ukraine war. For European equities, this has created a stark divergence between sectors. While the defense industry has surged on geopolitical fears, it now faces headwinds from supply chain fragility and labor shortages. Meanwhile, the tech sector—though historically vulnerable to trade wars—could emerge as a beneficiary of any de-escalation in U.S.-China relations. Investors must navigate this split, favoring companies insulated from defense spending cuts and exposed to trade resolution tailwinds.

Defense: A Surge with Structural Weaknesses

The European defense sector has been a star performer in 2025, fueled by a projected €800 billion decade-long spending boom and the Select STOXX Europe Aerospace & Defence ETF (EUAD) rising 52% year-to-date. However, its gains are increasingly fragile.

Key Risks:
1. Supply Chain Fragility: Over 40% of critical materials for defense manufacturing, including rare earth metals, are sourced from China. The EU's sanctions against Russian imports have exacerbated this dependency, creating a chokepoint for firms like Airbus and Rheinmetall.
2. Labor Shortages: A projected 3.9 million skilled labor gap by 2027 threatens production timelines. While companies like Thales and BAE Systems are investing in AI-driven retraining, the pace of progress lags behind demand.
3. Policy Uncertainty: The EU's Directive 2024/1226 criminalizes sanctions violations, forcing firms to adopt costly compliance systems. Those reliant on Chinese supply chains without alternatives face penalties or operational halts.

Why It's Underperforming Now:
Despite strong fundamentals, defense stocks are lagging expectations as investors price in risks. For instance, Rheinmetall's Q2 earnings missed forecasts due to delays in Ukrainian artillery deliveries, while Airbus warned of “structural headwinds” from material bottlenecks.

Tech: A Pivot to Trade De-Escalation

The tech sector, long a casualty of U.S.-China trade wars, now holds the keys to European equity upside—if diplomatic breakthroughs materialize.

Catalysts for Growth:
1. EU Regulatory Tailwinds: The “28th regime” harmonizing corporate tax and labor laws across the EU has created a unified market for tech firms. Estonia's distributed profits tax model, delaying corporate tax until profits are distributed, reduces capital costs for scaleups.
2. DeepTech Funding Boom: The Scaleup Europe Fund, part of the €115 billion EU Innovation Council, is prioritizing AI, quantum computing, and green tech. Late-stage firms like Germany's Sila Nanotechnologies (battery tech) and France's Neuraven (AI healthcare) have secured €1.2 billion in funding this year.
3. Trade Resolution Plays: Companies with diversified supply chains or exposure to China's “critical technology” sectors—such as ASML (semiconductors) or SAP (enterprise software)—could benefit from reduced tariffs.

Investment Strategy: Sector-Specific Plays

1. Defense: Proceed with Caution, Target Diversifiers
2. Hold: Companies with strong R&D pipelines and non-military revenue streams. Thales (FR0000131798), for example, derives 30% of revenue from cybersecurity and rail systems, mitigating defense spending risks.

3. Avoid: Firms overly reliant on Russian or Chinese supply chains, such as European aerospace suppliers lacking rare earth alternatives.

4. Tech: Focus on Trade-Sensitive Winners

5. Buy: ASML (ASML.AS) and SAP (SAP.GR), which benefit from EU-China “technology corridors” and the $1 trillion annual data center spending boom.

6. Scaleups: Back the Scaleup Europe Fund's portfolio, including quantum firms like Pasq and green tech companies like VoltStorage.

7. ETF Plays:

8. Underweight: The Select STOXX Europe Aerospace & Defence ETF (EUAD), given its exposure to supply chain risks.
9. Overweight: The SPDR S&P Europe Tech UCITS ETF (Acc), tracking firms like SAP and ASML.

Conclusion

European equities remain bifurcated: defense's geopolitical gains are constrained by structural risks, while tech's potential is unlocked by trade de-escalation. Investors should pivot toward tech firms with diversified supply chains and exposure to EU-China reconciliation, while treating defense as a tactical, not strategic, play. In this fractured landscape, the next chapter of European growth will be written by those who bet on innovation over instability.