For years many member countries have lagged behind their Nato targets, spending less than 2 per cent of GDP on defence spending.
But defence spending could see an upward shift in the event of a Donald Trump victory in the US election later this year, due to a potential 'Trump effect'.
Trump recently threatened not to support underspending nations in the event of an attack and is considering raising the target for defence spending by NATO members from 2 per cent to 3 per cent of GDP.
He is expected to make the 3 per cent call when the 32 member nations gather for Nato’s 75th anniversary in Washington this month. With the former president threatening to stop supporting underspending nations, there is more pressure than ever for Nato nations to up their budgets.
Recent conflicts, most notably the Ukraine war, have prompted nations to invest more heavily in defence, and defence spending in Europe is now up to 40 per cent higher than estimates from 2021.
Beyond Trump, there are two key reasons why we believe this is not just a short-term phenomenon.
Restocking and rising global conflict
First, Nato allies are currently facing difficulties in keeping up with the required supply reserves due to the high usage rate in Ukraine, leading to quick depletion of stocks. Restoring these inventories to levels seen before the conflict could potentially take as long as a decade, especially for countries like Germany.
Second, there is an overall pick-up in global conflicts. Continued aggression on the part of Russia has led figures like French President Emmanuel Macron to warn of an existential danger to the EU.
Furthermore, with the current conflict in the Middle East, the ongoing threats from North Korea to South Korea, and China toward Taiwan, the momentum is clearly moving towards a need to bolster defence spending.
As decades of post-Cold War underinvestment in European defence are reversing, European defence firms like BAE Systems, Thales, Leonardo, and Rheinmetall are all seeing material revenue increases and margin expansion.
Share prices for the major defence firms have rallied too, as investors seek out the potential upside of many of these stocks.
Most notably, we see upside potential in German munitions manufacturer Rheinmetall, which is currently rated four stars by Morningstar and offers close to 40 per cent upside from the prevailing share price.
Playing the defence theme with funds
Investors choosing funds rather than single stocks to play this theme can diversify away from company-specific risks unconnected with the development of a theme, while remaining exposed to the desired risk and return of the given theme.
Every thematic fund defines and tracks its theme differently, leading to significant variations in investor outcomes. If we consider cost alone, we prefer DFND, a defence and aerospace sector fund managed by Europe's largest ETF provider.
However, Boeing and Airbus are among the fund's top holdings, together accounting for nearly one-fifth of the fund's exposure. Although both companies have defence businesses, the majority of their revenues come from commercial airplanes, thus not providing 'pure play' exposure to the defence theme.
