Paul Walsh: Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's Head of Europe Product.
Ross Law: And I'm Ross Law, Head of the European Aerospace and Defence Team.
Paul Walsh: Today, we're discussing the outlook for European defense amid renewed pressure for more military spending from the Trump administration.
It's Monday, the 27th of January, at 9.30am in London.
Now Ross, the new Trump administration is now in place, and shifting NATO's defence burden to Europe is a top priority for President Trump. In fact, President Trump has made several comments throughout his campaign and after taking office. He has suggested that Europe should increase defence spending to 5 per cent of GDP. And just for reference, right now, many European countries are at or above NATO's target of spending 2 per cent of GDP on defense.
What's your reaction? Are President Trump's demands of 5 percent realistic?
Ross Law: In short, we don't think so. In a perfect world, yes, 5 per cent is exactly where Europe should be, to make up for the huge underspend that we've seen over the past three decades since the end of the Cold War, which we've calculated at around the $2 trillion mark. There's also a desire in Europe to reduce its reliance on the US, particularly under a Trump presidency. But we see the 5 per cent spending level as unrealistic on multiple fronts.
Firstly, from an economic perspective, given the lack of fiscal headroom in Europe; and for reference, 5 per cent would require an additional $600 billion of spend annually. Secondly, from a political perspective, given multiple pockets of uncertainty, and the fact that a rise in defence spending may mean a cut to spending elsewhere. And lastly, from an industry perspective, given the multi-decade underspend I mentioned, we don't think the industry could absorb anywhere close to such a strong increase in demand, at least near-term.
So, while we do see upside pressure to European defence spending, our base case is that 3 per cent could be a more reasonable target. Not only would this be a compromise between the current 2 per cent target and Trump's 5 per cent demands; it would also allow Europe to match the spending levels of the US, which is expected at around 3.1 per cent in 2024. Even still, this would represent a 50 per cent increase or around $200 billion per year in additional European spent. This would, of course, further improve industry fundamentals and why we remain very positive on the sector.
Paul Walsh: And as of now, Europe is heavily dependent on the U.S. for its defense. According to various data sources, more than 50 per cent of European arms imports came from the U.S. in 2019 through 2023, and that's up from 35 per cent in 2014. Given this, what steps would Europe need to take to reduce its dependence on the U.S.?
Ross Law: The first step is to invest in the defence industrial base. Europe buys equipment from the U.S. for several reasons. Firstly, because the U.S. develops some of the most advanced technologies in the world because it has consistently invested in its defence industry. Secondly, because the U.S. equipment is often cheaper due to the benefits of scale. And thirdly, because it supports the very unique relationship between Europe and the U.S., which has essentially provided a security umbrella for the past three decades.
So, Europe needs to invest, both to develop capabilities and technologies to rival U.S. peers, and also to expand capacity so that we can meet our own equipment needs. This, of course, all requires investment and also time. So, Europe will remain reliant on the U.S. for many years to come. But if Europe is serious about wanting to be more sovereign, we need a more capable defense industry.
Paul Walsh: So, you talked there, Ross, about investment and time. So now the big question, how would Europe fund this upward pressure on defence budgets?
Ross Law: Well, this is the million-dollar question, or the 200-billion-dollar question, you might say. Unfortunately, this is part of the equation that is, so far, most unclear – and the basis for an ongoing series of reports we've entitled the “European Defense Dilemma” – essentially the very clear need to spend more on defence, but no clear way to fund it. So far, we've seen some creative ways to fund near-term spending plans, from off balance sheet special funds like in Germany, to using the interest received on frozen Russian assets.
But these, in our view, all seem fairly temporary in nature. What we really need is structural change, and that requires political commitment. Clearly, there is a lot of political change happening right now in Europe. Germany is holding an election in a few weeks time. France doesn't yet have a budget. There's also fiscal issues here in the UK. But we're hoping that 2025 is the year in which we may get clearer political commitments to longer-term structural improvements in defence spending. The German election is a clear near-term catalyst for us, where the raising of the debt break may in part be used to fund higher defence spending. But we're also looking to the upcoming NATO summit in June as an opportunity to officially increase the NATO spending target, we think potentially to 3 per cent, to support a more structural increase in European defence spending.
Paul Walsh: In light of all of this, what's your outlook for the European defence industry?
Ross Law: We remain bullish. In fact, we turned even more bullish as part of our 2025 outlook published earlier this month. The pressure to raise spending even to 3 per cent of GDP should progressively benefit industry fundamentals.
So, we see upside to both forecasts. Given these are currently premised on a 2 per cent of GDP assumption, as well as devaluation multiples, which we view today as very attractive, with the sector trading in line with this long-term average – despite the improving fundamentals I've just described.
Paul Walsh: And finally, Ross, what developments if any might change your outlook?
Ross Law: The key for us this year is seeing clear political commitments from governments on more structural increases in spending. So, we're going to be watching the German election and the outcome of the French budgetary process very carefully. It's unlikely to be plain sailing. There was a media article published just this morning suggesting the UK government may be unwilling to raise spending beyond the current 2.3 per cent level. But we are hoping that as a whole 2025 sees Europe make a stronger commitment to defending itself.
Paul Walsh: Ross, fascinating as always. Thanks for taking the time to talk.
Ross Law: Great speaking with you Paul.
Paul Walsh: And thanks for listening. If you enjoy thoughts on the market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.
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