As President Donald J. Trump emerged victorious in the 2024 election and prepared to begin his second term, his team informed European officials that he expects their respective countries to spend at least 5% of their Gross Domestic Product (GDP) on building military capabilities.
As of 2024, it was estimated that virtually every country – even the U.S. – fell short of this target.
However, it bears noting that the U.S.' spending is significantly higher than that of almost every one of its European allies combined. Additionally, given the significant deployment of U.S. military assets over in Europe to buttress its defense from threats, it is intuitively logical that Europe could ideally stand to be more invested in its own defense (and an idea supported by many a U.S. think tank as well).
In the wake of President Trump's re-election, plans were underway within the European Union (E.U.) to increase spending by €500 billion per year, which the European Commissioner for Defence Industry and Space Andrius Kubilius argued was only enough to cover an air defence programme. Also, many of the bloc's nations balked at the prospect of raising the annual target from 2024's 2% to a mere 3% (which would cost the E.U. around €200 billion), due to economic difficulties and already-stretched balance sheets. Poland, an already-aggressive spender owing to its proximity to the ongoing Russo-Ukrainian conflict, suggested one of two methods to raise the required capital: the E.U. could sell more joint bonds backed by its own long-term budget or create a new special purpose vehicle modelled on the euro zone bailout fund, the European Stability Mechanism, to provide loans by selling bonds backed by paid-in and callable capital from participating countries.
The first option found few takers but the potential for non-E.U. countries such as the United Kingdom and Norway to participate in the second option created some buzz; however, markets expect that this "new borrower" would have pay a premium over the interest the E.U. pays for its bonds - thus adding to the cost burden.
In light of these difficulties, President Trump's demand for spending to go up by an ever larger margin had found few enthusiastic takers. On the 6th of March this year, the European Commission proposed the "ReArm Europe" plan, which aimed to raise €650 billion over four years (i.e. an average of €175 billion each year) by allowing member nations to increase their military budgets to up to 1.5% of GDP without being counted in their national deficits and raising €150 billion through EU-issued bonds, which would then be lent to member states at low-interest rates and long repayment terms.
The plan almost instantly ran into trouble, with Italy and Spain demanding broader definition of the plan to include anti-terrorism, satellite communication, artificial intelligence and quantum computing capabilities. Both nations also expressed discomfort with the name, with Spain stating outright that southern Europe faces threats that are altogether different from those faced by Eastern Europe. The plan's name was amended to "Readiness 2030".
Steering Away from U.S. Dependence?
E.U. officials proposed that European countries can partake in the €150 billion loan program - titled "SAFE" (Security Action for Europe) – if the products being procured have a definitive Europe connection. For ammunition, missiles and small drones, 65% of the costs must originate inside the E.U., European Economic Area (EEA), European Free Trade Association (EFTA) countries or Ukraine, with the manufacturer being located within these blocs and not controlled by another country. For more complex systems such as air and missile defense systems and larger drones, it must be possible to substitute components that could be subject to restrictions imposed by other countries.
While it is possible for an E.U.-based subsidiary of a British or U.S. company, the cost origination aspect implies that weapons manufactured in a British or American plant might not be eligible – a move that rankled U.S. officials, with Secretary of State Marco Rubio reportedly warning Europe that any exclusion of U.S. companies would be seen negatively by Washington.
This warning has a certain logic: outside of Ukraine (which became the world’s largest importer of major arms in the 2020–24 period), arms imports by the E.U. more than doubled between 2015–19 and 2020–24, with the U.S. supplying 64% of these arms.
With arms supplied to 107 countries in 2020-24, U.S. arms exports increased by 21% between 2015–19 and 2020–24, with its share of global arms exports growing from 35% to 43%. In effect, the U.S. is resolutely the world's largest arms exporter – with France a very distant second.
For the first time in two decades, the largest share of U.S. arms exports in 2020–24 went to Europe (35%) rather than the Middle East (33%), thus possibly underlining Secretary Rubio's concerns.
Despite calls from within Europe to limit dependence on U.S. imports, European NATO members have over 500 combat aircraft and many other complex weapons systems still on order from U.S. suppliers. However, with "smaller" weapons and systems, it is likely that European manufacturers might be net beneficiaries.
Market Impact
While it is by now common knowledge that the broad market S&P 500 ( $S&P 500(.SPX)$ and $SPDR S&P 500 ETF Trust(SPY)$) has been under significant pressure and volatility in the lead-up to President Trump's “Liberation Day” tariff announcement, defense stocks have shown a widely varying trajectory as driven by investor convictions:
Despite both being European companies that are potentially beneficiaries of the E.U.'s largesse for arms buying, German arms manufacturer Rheinmetall ($Rheinmetall AG(RNMBY)$) substantially outperforms relative to France's engine manufacturer Safran ( $Safran SA(SAFRY)$). Despite being in the same industry as Safran (i.e. aviation systems) while potentially impacted by E.U. limitations, U.S. aviation technology majors Northrop Grumman and Lockheed Martin ($Lockheed Martin(LMT)$) have been somewhat resurgent.
Rheinmetall is expected to be a wide-ranging beneficiary from increases in E.U.'s expenditure on projectile weapon systems and munitions while historical “big-ticket” buy-ins of aviation systems by the likes of Northrop Grumman and Lockheed Martin by European armies are unlikely to be substituted out before said systems' end of life. Also, given the top-of-the-line performance characteristics by these systems, it's unlikely that European armies would be willing to settle for less or not be receptive to next-generation products. This creates some bottlenecks for the likes of Safran as they're found predominantly in French/European-produced aircraft.
Rheinmetall, Northrop Grumman and Lockheed Martin also outperform the broad market by a comfortable margin. Meanwhile, the Themes Transatlantic Defense ETF ($Themes Transatlantic Defense ETF(NATO)$) – which includes all four companies along many other manufacturers – pulls at nearly 10% outperformance relative to the S&P 500 as measured from the end of February till the 11th of April. After a period of decline, the "NATO" ETF is now drawing flat relative to the end of February and has a slight bullish momentum being imputed.
A "Balanced" Investing Style?
The "NATO" ETF is a more recent entrant in the defense ETFs space, where the likes of the iShares U.S. Aerospace & Defense ETF (ITA) and the Invesco Aerospace & Defense ETF (PPA) are likely to be better known to investors. Both of the latter solely feature U.S. tickers, with the top 10 holdings being strikingly similar albeit different in terms of weight distribution.
In a similar vein, the Select STOXX® Europe Aerospace & Defense ETF (EUAD) provides exclusive coverage to European aerospace/defence companies – albeit it is relatively concentrated with only 13 tickers.
The "NATO" ETF, on the other hand (and as the name suggests), is a little more balanced while remaining “international”:
While the top 10 holdings for the "NATO" ETF is closer in terms of weight distribution to that of Invesco's "PPA" ETF, it features the solid outperformer Rheinmetall in the top position. Also, the Top 10 holdings have a near-even balance between U.S. and E.U. tickers.
In overall holdings, however, U.S. tickers do make up almost 60% of the “NATO” ETF by weight. But with the remainder being driven by tickers mostly from the Continent, it has a profile that is distinct from both the U.S. ETFs.
An interesting feature is that the ETF assigns a slightly higher average constituent weight to European (i.e. EU, EEA and EFTA) tickers than it does to tickers from other regions, including the U.S.
In Conclusion
The favourable representation of European tickers in the "NATO" ETF might prove to be an interesting feature that might enable investors to capture the uptrend in European military spending. At the same time, it is unlikely that European nations would commit vast sums of capital to develop alternative "high-ticket" weapon systems that are entirely distinct or free from U.S. suppliers.
Overall, regardless of economic conditions, it is increasingly likely that nations in the Western Hemisphere remain locked into sustained and increased military spending, potentially creating ample opportunities for outperformance versus the market. The "NATO" ETF's distribution of weights across regions adds an interesting layer of consideration for investors looking to capitalize on spending patterns being implied by Western governments. It might make sense for investors to consider diversifying their portfolio by including this relatively recent instrument.
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