With geopolitical shifts of the magnitude of the US stance on Ukraine, Russia and other events taking place, countries are talking about large defence spending. This is giving rise to a radical shift in the investment landscape. Comments from JM Finn, WELREX, Indosuez Wealth Management, Edmond de Rothschild, and Goldman Sachs.

The shock in European capitals about the Trump administration's dramatic change of tack over the Ukraine-Russia war has galvanised European companies linked to defence – and wealth managers are working out how this affects their asset allocation strategy. 

The investment shift is hardly surprising: European financial markets soared this month in response to Germany's announcement – coinciding with recent federal elections – to bolster defence spending. The EU plans to unlock nearly €800 billion ($873 billion) to bolster security as the US has suspended military aid to Ukraine and turned up pressure on the Ukrainian government to reach a peace deal.

According to news breaking out early evening yesterday in Europe, State Secretary Marco Rubio said the US made an offer, which the Ukrainians have accepted, "to enter into a ceasefire and enter into negotiations to end this conflict in a way that is enduring and sustainable." As of the time of this story going live, talks continued. Western security officials said Russian President Vladimir Putin has no intention of compromising on demands on land, peacekeepers and Ukraine’s neutrality in any peace talks, complicating President Donald Trump’s efforts to secure a credible settlement (Source: Bloomberg, 11 March.)  

As if to highlight how defence has become an urgent investment topic in Europe – possibly at odds with ideas about ESG investing – yesterday WisdomTree launched a new exchange-traded fund,: The WisdomTree Europe Defence UCITS ETF (WDEF), listed on Börse Xetra, Borsa Italiana and the London Stock Exchange.

“Defence and security are underrepresented in many portfolios and have faced decades of underinvestment in Europe, resulting in a significant capability gap. A structural shift is underway in Europe as nations increase defence budgets to meet NATO targets and respond to geopolitical challenges,” Pierre Debru, head of research, Europe at WisdomTree, said in a note.

After years of being scolded by President Trump for not spending enough in percentage terms on defence, Europe is moving, so governments say. The EU's “Rearm Europe” package involves the activation of the national safeguard clause of the Stability and Growth Pact, enabling EU countries to increase their defence spending by an average of 1.5 per cent of GDP, or €650 billion that could be released over the next four years. It also entails a "new instrument" to provide €150 billion in loans to member states to finance joint defence investments in pan-European capabilities.

In Germany, Europe's largest economy, Berlin proposes to exempt defence from a budget restriction; it will launch an off-budget infrastructure fund of €500 billion over the next 10 years. That sum equates to about 1 per cent of GDP a year. The money can be used for civil and population protection, transport, energy, education, care and science infrastructure, in addition to hospital investments and research, and digitisation. The German federal states can also have a structural deficit of 0.35 per cent of GDP a year, from the current nil figure in percentage terms, equivalent to about €15 billion euros. Other European nations are taking similar action; UK Prime Minister Keir Starmer is also throwing his weight behind Ukraine and defence spending is set to rise.

Stocks of European businesses linked to this spending are rising. For example, shares in Rheinmetall, the German automotive and arms manufacturer, have risen, along with those of Britain’s BAE Systems and Paris-listed Thales. All of a sudden, defence is a hot area. Over the past year, Europe defence stocks rose 40.8 per cent, outpacing broader European equities at +11.4 per cent, according to Aneeka Gupta, director, macroeconomic research at WisdomTree. 

In the 12 months to 3 March, the STOXX® Europe Total Market Aerospace & Defense Index, to give an example, has risen 40 per cent.

Investment outlook
Indosuez Wealth Management CIO, Alexandre Drabowicz, thinks that Europe's economic and political response to Trump's trade tariffs and military policy shifts, particularly Germany’s fiscal stimulus and debt policy changes, will have a positive long-term impact on GDP growth, but the biggest impact is expected in 2026-2027 rather than 2025. He is cautiously optimistic on European equities, while avoiding chasing the rally, and underweight in European bonds due to rising debt.

Overall, in most of his portfolios, Drabowicz is constructive on equities, and close to neutrality on Europe. On the fixed income side, German bond yields have had their biggest surge since 1997, reflecting a high public debt trajectory and especially higher expected potential growth, in Europe’s largest economy. He is currently underweight in European duration and remains so even after such a strong move. 

Nabil Milali, multi-asset and overlay portfolio manager at Paris-based Edmond de Rothschild Asset Management, also highlighted how the effect of Germany’s historic announcement has been considerable on the markets, seen by the biggest daily rise in German bond yields since 1990. This momentum largely carried over to the rest of European yields, as investors took on board not only better growth prospects, but also government debt issuance is set to increase significantly.

According to initial estimates and pending completion of the plan, Milali believes that higher defence spending and public investment in infrastructure could result in an increase in German growth from +1 per cent by the end of 2026 to +5 per cent by 2028, compared with its previous trajectory.

Goldman Sachs research economists Niklas Garnadt and Filippo Taddei think the sharp rise in EU defence spending over the next two years will have a positive but limited impact on GDP growth.

Milali argues that concerns about rising debt issuance are exacerbated by discussions to encourage other European countries to increase their defence spending as well. “While Germany can afford such a stimulus plan without its debt trajectory becoming unsustainable (the debt-to-GDP ratio should only reach 68 per cent by 2028), doubts are more acute when it comes to France and the peripheral countries,” Milali said. “In any case, the face of Europe has definitively changed, and this paradigm shift will have lasting consequences on bond markets, with equilibrium levels being structurally revised upwards.”

Jon Cunliffe, JM Finn head of investment office, also highlighted the impact of US President Donald Trump's tariffs, creating economic uncertainty, as well as the unprecedented degree of commitment from Germany and its European partners to ramp up defence spending to secure future security in a world where the US is likely to be much more isolationist. 

"Against this background, and after a decade or more of US exceptionalism, investors with a high weight in US equities are having to reassess whether the still wide valuation gap between the US stock market and Europe/UK is still justified," Cunliffe told WealthBriefing. His view is that although US tech will continue to generate above-average earnings growth, the gap in earnings delivery versus the broader market and regions will inevitably narrow. As a result, he anticipates a broadening out of market returns by region and sector, with a US-centric equity allocation much less rewarding than in recent years.

Cunliffe also emphasised how ESG investing has, wrongly in his view, become heavily politicised in recent years. In the long term, he sees no reason why investing in higher-than-average ESG scoring equities within each sector should not deliver returns in line or better than the broad market. The schematic below flags the fact that ESG integration adds value to mitigating risk. "There is no reason why defence stocks can’t sit within this framework," Cunliffe said.

However, Kirill Pyshkin, chief investment officer at digital investment platform WELREX, prefers the idea of German chancellor-in-waiting Friedrich Merz of increasing infrastructure spending. “Unlike nuclear warheads, which hopefully would never be used, infrastructure investments have long-term benefits and are a foundation for sustained economic growth and development,” Pyshkin said. “For example, Germany could restart its nuclear power plants, securing lower energy electricity prices for industry, thus improving its competitiveness,” Pyshkin said.

Pyshkin prefers to see infrastructure rather than defence investments in Europe as that would ensure long-term competitiveness of the economy. “In contrast, defence will only provide a short-term boost to certain sectors but may increase the borrowing costs, negating the benefit,” Pyshkin said.

This news service is assessing the relationship between defence stocks and ESG-focused portfolios and where they sit together. In 2022, a few months after Russia's invasion of Ukraine, we wrote about how the boundaries of ESG are being shifted by the need to equip countries in their defence.

Those who wish to respond with comments can email: amanda.cheesley@clearviewpublishing.com