Loading summary
Transcript14 lines
- [00:01]
A
Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's Head of Europe Product.
- [00:06]
B
And I'm Ross Law, head of the European Aerospace and Defence Team.
- [00:10]
A
Today we're discussing the outlook for European defence amid renewed pressure for more military spending from the Trump administration. It's Monday 27th 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% of GDP. And just for reference, right now many European countries are at or above NATO's target of spending 2% of GDP on defence. What's your reaction? Are President Trump's demands of 5% realistic?
- [00:58]
B
In short, we don't think so. In a perfect world, yes, 5% 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% spending level as unrealistic on multiple fronts. Firstly, from an economic perspective, given the lack of fiscal headroom in Europe, and for reference, 5% 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 dimensions, 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% could be a more reasonable target. Not only would this be a compromise between the current 2% target and Trump's 5% demands, it would also allow Europe to match the spending levels of the US, which is expected at around the 3.1% in 2024. Even still, this would represent a 50% 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.
- [02:41]
A
And as of now, Europe is heavily dependent on the US for its defense. According to various data, more than 50% of European arms imports came from the US in 2019 through 2023, and that's up from 35% in 2014. Given this what steps would Europe need to take to reduce its dependence on the us?
- [03:04]
B
The first step is to invest in the defence industrial base. Europe buys equipment from the US for several reasons. Firstly, because the US develops some of the most advanced technologies in the world, because it has consistently invested in its defence industry. Secondly, because the US equipment is often cheaper due to the benefits of scale. And thirdly, because it supports the very unique relationship between Europe and the us, 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 US 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 US for many years to come. But if Europe is serious about wanting to be more sovereign, we need a more capable defence industry.
- [03:59]
A
So you talked there, Ross, about investment and time. So now the big question. How would Europe fund this upward pressure on defence budgets?
- [04:07]
B
Well, this is the million dollar question, or the $200 billion question, you might say. Unfortunately, this is part of the equation that is so far most unclear and the basis for our ongoing series of reports we've entitled the European Defence 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%, to support a more structural increase in European defence spending.
- [05:31]
A
In light of all of this, what's your outlook for the European defence industry?
- [05:35]
B
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% of GDP should progressively benefit industry fundamentals. So we see upside to both forecasts given these are currently premised on a 2% of GDP assumption as well as to valuation multiples, which we view today as very attractive with the sector trading in line with its long term average despite the improving fundamentals I've just described.
- [06:08]
A
And finally, Ross, what developments, if any, might change your outlook?
- [06:12]
B
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% level. But we are hoping that as a whole, 2025 sees Europe make a stronger commitment to defending itself.
- [06:43]
A
Ross, Fascinating as always. Thanks for taking the time to talk. Great speaking with you, Paul, 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.
- [06:57]
C
The preceding content is informational only and based on information available available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for.