European defence supercycle means scrapping deficit fears
LONDON, June 10 (Reuters) - European defence stocks have been on a tear since the devastating conflict in Ukraine started in 2022, a trend that has only accelerated since announcements of European rearmament plans. But the beneficial economic impact of the European defence supercycle may be heavily dependent on how it's financed.
The Stoxx Europe TMI Aerospace & Defense index has posted annualised returns above 40% since February 2022. Earlier this year, some investors thought the defence rally might slow as a ceasefire in Ukraine started to seem more likely. But ceasefire hopes have been dashed for now, and the NATO summit on June 24-25 may see European countries boost their commitments to defence spending even more.
NATO General Secretary Mark Rutte recently said he expects the bloc to agree at the summit to increase defence spending to an eye-catching 5% of GDP, with 3.5% of that directed to 'hard' defence like weapons, personnel, and infrastructure. The rest would be dedicated to measures like home defence and civilian preparation.
But even this 3.5% target is ambitious. Currently, only Poland meets this target, while the U.S. and Estonia come close at 3.4% of GDP.
The amount of spending being proposed here is enormous. For example, if the UK, France, Spain, and Italy were to raise defence budgets to 3.5% of GDP by the mid-2030s, they would each have to increase their annual defence spending by about $40 billion. In total, NATO members would have to boost their annual defence budgets by around $375 billion.
For context, the global aerospace and defence market currently has annual revenues of roughly $1.3 trillion, and Europe's defence industry accounts for about a quarter at $330 billion, opens new tab.
Increased defence spending could help Europe overcome its persistent growth challenge. Going back to 1960, every euro spent on defence has increased European GDP growth by around one euro as well. This fiscal multiplier is at the upper end of the 0.6 to 1.0 range that academic studies about the U.S. typically find, opens new tab.
Moreover, as European defence spending increases, the fiscal multiplier rises as well because the region's defence industry capacity remains severely constrained, so contractors are forced to quickly hire new employees at higher salaries or build new facilities, amplifying the impact of the fiscal stimulus.
For example, German defence contractors like Rheinmetall and Hensoldt had to borrow workers and entire factories from other businesses like Continental and Bosch to keep up with the increased demand from the Ukraine war.
Importantly, if NATO agrees to further expand defence spending into the 2030s, even if the Ukraine conflict ends, they can provide European defence companies with the confidence they need to build new factories, hire employees, and train much-needed specialists to overcome these capacity constraints.
The main challenge will almost certainly not be the region's willingness to re-arm, but rather how to pay for it.
In the case of the United Kingdom, the British government last week published its strategic defence review, which sets out a plan to get the country war ready and increase defence spending to 3% of GDP in the next parliament between 2029 and 2034.
Unfortunately, barring any major surprises at the 2025 spending review to be published on June 11, the UK government will continue to stick to its fiscal rules and limit investment spending to an annual real growth rate of 1.3% until 2030.
The Institute for Fiscal Studies, opens new tab has calculated that by adhering to these rules, increasing defence spending will have to come at the expense of non-defence investments.
This means that any boost to growth from increasing defence spending in the UK could be offset by the negative impacts of deteriorating civilian infrastructure and public services, such as healthcare and education.
Another option, which may be more economically beneficial long-term, is financing increased defence spending with additional debt issuance, as the EU plans to do with its Readiness 2030, opens new tab initiative.
This will mean reforming self-imposed fiscal rules. But if running larger deficits now can boost growth, this should keep debt-to-GDP ratios under control, create jobs, and help to secure Europe's future.
True, increased deficits risk drawing the ire of bond vigilantes. But the market reaction to the announcement of Readiness 2030 and Germany's huge infrastructure package suggests that bond investors are fine with additional deficits as long as the money is expected to be spent on productive investments. While government bond yields rose briefly after these spending plans were announced, they have already reversed these moves.
The biggest risk is that the spending does not prove as productive as expected, which could eventually lead Europe into another debt crisis, but given the enormous economic and security challenges that the continent faces, this may be a risk worth taking.
(The views expressed here are those of Joachim Klement, an investment strategist at Panmure Liberum, the UK's largest independent investment bank).
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