European defense stocks are facing a re-armament test

After years of rising military budgets, Ukraine’s emergency spending and soaring defense stocks, Europe’s rearmament push must now prove it can turn hundreds of billions of euros into weapons, industry and usable military capability.

The question for investors is no longer seen as a need for defense or political ambitions, but whether valuation has moved ahead of the industry’s ability to implement.

That assessment becomes more critical ahead of next week’s NATO Summit in Ankara, Turkey, where leaders must review progress since last year’s summit and set a roadmap for delivering new spending goals to “turn collective commitments into tangible results.”

But the path from high budget to delivered weapons shows an imbalance. Delays in procurement, fragmented national systems, labor shortages, and complex supply chains raise doubts about how Europe can rebuild an industrial base stripped from decades of defense spending.

Pressure is rising from both sides of the Atlantic. NATO allies agreed to a dramatic increase in defense spending at last year’s summit, reflecting growing concerns that Europe will no longer be able to survive under US protection.

The pressure intensified when US Defense Secretary Pete Hegseth earlier this month announced a review of US forces in Europe and warned that allies who fail to meet spending commitments could face consequences. The review, which is expected to last six months, has added new urgency to a debate already changed by Russia’s war in Ukraine and the changing US approach to NATO.

“There’s no doubt that America’s changing landscape has been a real moment of truth,” Hugues Lavandier, senior partner at McKinsey, told CNBC. It accelerated Europe’s recognition that “the era of peace isolation was behind us” and that governments needed to reinvest in defense capabilities, he said.

The change has already changed investor expectations. European defense companies from Rheinmetall to BAE Systems, Leonardo, Thalesagain Saab they have benefited from a growing order book since Russia invaded Ukraine in 2022, as governments increased military spending.

McKinsey calculates that European NATO core defense spending has doubled since 2019 and could reach around 800 billion euros ($912 billion) by the end of the decade. That would put it on track towards NATO’s new core benchmark of each member spending 3.5% of their GDP on defence. Venture capital also flows into European defense technologies, such as drones and autonomous systems.

Lavandier said the market is “in a period of price discovery.” The backlog was the clearest path to growth, he said, but investors are now learning better how companies can turn those order books into production, revenue and margins.

Last week, Germany canceled the multi-billion euro F126 program after delays and expected cost overruns, saying it would buy eight Meko A-200 small frigates ThyssenKrupp Marine Systems (TKMS) instead. Shares in Rheinmetall, which was expected to be the lead contractor on the abandoned project, fell sharply.

“These stories remind us of that [governments] they can and will change their minds,” JP Morgan analysts said.

But Germany’s defense budget is still rising rapidly. Lavandier said the cancellation is an example of governments reassessing key issues, such as procurement costs, delivery times and military strategy.

But for investors, the sale of Rheinmetall is “a stark reminder … that the sector is facing delays and setbacks, despite various governments’ pledges over the past few years to boost defense spending,” Dan Coatsworth, head of markets at AJ Bell, commented in an email.

Building the capacity Europe needs to ensure strategic independence has been difficult.

Even though defense investments have increased significantly, equipment stocks in European NATO countries remain below 2021 levels, reflecting military contributions to Ukraine, the withdrawal of legacy programs, and long delivery times for new equipment, according to a February report by McKinsey.

It also found that European platform fragmentation is four times higher than the US, with implications for interoperability, organization and industry scale.

The biggest issues are labor and supply chains, Lavandier said. He added that the European defense industry “has not been used to mass production for a very long time.” Beyond large contractors, the sector relies on a network of suppliers, many of which are small family-owned companies, which must all come together.

“If you’re missing one or two parts, your new jets can’t be delivered,” he said.

S&P Global Ratings received a similar margin. It said European defense suppliers are often small businesses with limited ability to raise equity to scale, exposing large contractors to bottlenecks across complex supply chains.

The credit rating agency also warned that high defense spending will not be balanced across Europe. Poland and the Baltic states are moving too fast, Germany has more fiscal room to accelerate, while France, the UK, Belgium and parts of southern Europe face major debt problems and competing political priorities.

Higher defense spending may support the credit quality of defense companies, S&P said, but it could add pressure to private budgets and force tough political trade-offs.

It also noted that Europe remains dependent on US aircraft suppliers for fighter jets, air defense systems, precision weapons, electronic equipment, software and strategic equipment such as intelligence, surveillance, aviation and command and control.

That means that large European budgets will not automatically create an independent European defense base.

Lavandier said that about half of the money spent on defense in Europe goes to Europe, while the rest goes to suppliers in other places, including the US, Israel and South Korea. He expects more governments to favor domestically designed and manufactured machinery, not necessarily as a move against the US, but because “if you want the manufacturing flywheel to work, you need to reinvest most of that money in your own countries.”

Stefan Wintels, chief executive of German state bank KfW, told CNBC’s Annette Weisbach on Friday that the growth of the defense industry is “not temporary,” but said Europe needs balance, price competition and a more supportive policy framework to make the transition work.

Wintels also said that planned joint ownership of tank maker KNDS is a possible way for deeper European cooperation. France and Germany have agreed to 40% equity stakes in the Leopard 2 manufacturer, ahead of the planned listings in Paris and Frankfurt.

The hope, he suggested, is that KNDS could eventually become a smaller-scale version Airbus as proof that Europe can develop national champions into internationally competitive defending teams.

But the comparison also underscores the difficulty in such a goal: Airbus took decades to build, and Europe’s security challenge cannot wait decades.