Morgan Stanley Research looks at how the European defense
industry might respond to military spending pressure from the
Trump administration.
----- Transcript -----
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 Defense 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 defense 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 defense 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 defense 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 defense 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 defense 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 defense 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 defense 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 defense, 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 defense 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 defense 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 defense spending.
Paul Walsh: In light of all of this, what's
your outlook for the European defense 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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