European defence stocks retreat as funding worries hit spending trade

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European defence stocks retreat

Highlights

Stoxx Europe Targeted Defence index drops over 15 per cent from its January peak, erasing billions for firms like BAE Systems, Thales, and Rheinmetall amid funding and spending concerns.
Morgan Stanley downgrades European defence sector to neutral, citing a lack of catalysts, weaker earnings momentum, and disappointing Q1 2026 revenues at Rheinmetall, Airbus, and Thales.
Investors pivot toward high-tech defence stocks, with Parrot up 36 per cent and MilDef up nearly two-thirds in 2024, while traditional arms lag amid political uncertainty and possible Russia-Ukraine ceasefire progress.

Funding strain reshapes defence outlook

As reported by Financial Times, the Stoxx Europe Targeted Defence index has fallen more than 15 per cent since its January peak, with much of the decline coming since the start of the U.S.-Israeli war against Iran. The sell-off wipes billions of euros from companies including BAE Systems, Rolls-Royce, Thales, Leonardo and Rheinmetall.

The reversal interrupts a multiyear rally in which the defence index rises more than 40 per cent annually since 2022, and almost doubles in 2025. That surge is driven by Germany's large infrastructure and military investment plans and by a Nato agreement to lift defence spending to 5 per cent of GDP.

Investors are now focusing on the cost of financing those commitments as government borrowing costs rise this year, partly because of the Iran war and the near-closure of the Strait of Hormuz. Higher energy prices are also increasing pressure on European governments to support households and businesses, adding to fiscal strain in energy-importing economies.

Barclays strategist Emmanuel Cau says the market is questioning whether a debt-funded defence spending boom is sustainable as deficits widen and interest rates rise. Those concerns are spilling into politics and procurement, with UK defence secretary John Healey resigning on Thursday after saying the government is unwilling to commit sufficient resources, while Germany this month tells France it will withdraw from plans for the joint fighter jet at the core of the 100 billion euro Future Combat Air System programme.

Czech Prime Minister Andrej Babis also tells the Financial Times last week that the country will probably miss the Nato benchmark of spending 2 per cent of GDP on defence. State Street data indicates institutional investors are unwinding overweight positions in the sector as doubts grow over whether pledges will convert into actual spending.

Shift toward high-tech warfare themes

Morgan Stanley's European equity strategists this week downgrade the defence sector to neutral after holding a bullish stance since January 2024, citing a lack of material catalysts and weaker earnings revision momentum than peers. Nuveen strategist Laura Cooper says investors are reassessing how quickly defence commitments can translate into revenue and earnings, after recent results show profits are taking longer to emerge than many expected.

First-quarter 2026 revenues from Rheinmetall, Airbus and Thales disappoint investors in Europe, reinforcing concerns that expectations have run ahead of delivery. TrinityBridge's Giles Parkinson says defence earnings growth looks weak compared with the rapid profit expansion generated by AI-linked stocks.

Investors also say the Middle East conflict underlines the growing importance of drones and missiles over tanks and heavy armour. That is helping more technology-focused names outperform, with French drone maker Parrot up about 36 per cent this year and Swedish military IT company MilDef rising by nearly two-thirds.

Barclays says buyers now prefer defence stocks with a stronger technology tilt, while Citi argues the market may be entering the last phase of the broader European defence trade. Morgan Stanley adds that signs of progress toward a Russia-Ukraine ceasefire could further limit near-term upside for the sector.

We previously reported on John Healey’s resignation and how it intensified scrutiny of Labour leader Keir Starmer ahead of the next UK general election. Our coverage highlighted that the high-profile departure exposed internal divisions over policy direction and raised questions about Labour’s unity and readiness for government.

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