Thoughts on the Market: Europe’s Defense Dilemma

Host: Paul Walsh, Morgan Stanley's Head of Europe Product
Guest: Ross Law, Head of the European Aerospace and Defence Team
Release Date: January 27, 2025

Introduction

In the January 27, 2025 episode of Thoughts on the Market, hosted by Paul Walsh and featuring Ross Law, the discussion centers on the evolving landscape of European defense spending. With the Trump administration exerting renewed pressure on NATO allies, Europe faces critical decisions regarding its military expenditure and strategic autonomy.

Trump's Demand for Increased European Defense Spending

Paul Walsh opens the conversation by highlighting the Trump administration's push for Europe to boost its defense spending to 5% of GDP. Currently, many European nations are at or exceeding NATO's target of 2%.

Quote:
"President Trump has made several comments... suggesting that Europe should increase defense spending to 5% of GDP."
— Paul Walsh [00:09]

Ross Law responds by expressing skepticism about the feasibility of reaching the 5% target.

Feasibility of the 5% Defense Spending Target

Ross Law elaborates on the challenges Europe faces in meeting Trump's 5% defense spending demand:

• Economic Constraints: Europe lacks the fiscal flexibility to allocate an additional $600 billion annually required for a 5% GDP defense budget.
• Political Uncertainties: Increasing defense budgets may necessitate cuts in other spending areas amidst political volatility.
• Industry Limitations: The European defense industry has endured decades of underspending and may struggle to scale rapidly.

Quote:
"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."
— Ross Law [02:07]

Law suggests a 3% target as a balanced and achievable goal, aligning Europe’s defense spending closer to the United States’ anticipated 3.1% in 2024.

Dependence on the US for Defense and Steps for European Sovereignty

The discussion shifts to Europe’s heavy reliance on the United States for defense, with over 50% of European arms imports originating from the US between 2019 and 2023, up from 35% in 2014.

Quote:
"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."
— Ross Law [03:58]

To reduce dependency, Europe must:

1. Invest in the Defense Industrial Base: Develop advanced technologies and expand production capacities to meet internal demands.
2. Increase Capability and Capacity: Rival US defense capabilities through sustained investment and innovation.

Law emphasizes that achieving greater sovereignty requires significant investment and time, indicating that dependency on the US will persist in the near future.

Funding Challenges for Increased Defense Budgets

Funding the increased defense spending presents a complex dilemma for European nations. Ross Law identifies this as the "European Defence Dilemma," emphasizing the need for structural changes and political commitment.

Quote:
"The very clear need to spend more on defence but no clear way to fund it."
— Ross Law [04:07]

Current funding strategies include:

• Off-Balance Sheet Special Funds: Utilized by countries like Germany.
• Interest from Frozen Russian Assets: Serving as a temporary financial boost.

Law argues that these measures are short-term solutions, and sustainable funding requires long-term political strategies. Upcoming political events, such as the German election and the French budgetary process, are poised to influence future defense funding commitments.

Outlook for the European Defense Industry

Despite the challenges, Ross Law maintains a bullish outlook for the European defense sector. The anticipated increase to a 3% of GDP defense budget is expected to bolster industry fundamentals significantly.

Quote:
"We remain bullish. In fact, we turned even more bullish as part of our 2025 outlook published earlier this month."
— Ross Law [05:34]

Key factors contributing to this optimism include:

• Improved Industry Fundamentals: Increased defense spending will enhance the sector’s growth prospects.
• Attractive Valuation Multiples: The sector is trading in line with long-term averages, presenting favorable investment opportunities.

Potential Developments Influencing the Outlook

Ross Law outlines potential developments that could impact the European defense landscape:

1. Political Commitments: Clear and sustained commitments from European governments are crucial for structural increases in defense budgets.
2. German Election: The outcome could influence funding strategies, particularly regarding debt financing for defense.
3. NATO Summit in June: An opportunity to adjust and potentially raise NATO’s defense spending targets to support Europe’s increased commitments.

Quote:
"We're going to be watching the German election and the outcome of the French budgetary process very carefully."
— Ross Law [06:12]

Law also notes skepticism regarding the UK’s willingness to exceed its current 2.3% defense spending level, highlighting the uncertainty surrounding unified European defense commitments.

Conclusion

The episode concludes with Paul Walsh thanking Ross Law for his insights. The discussion underscores the complexity of increasing European defense spending amidst economic, political, and industrial challenges. While a 3% GDP target appears attainable and beneficial for the defense sector, achieving broader strategic autonomy from the US and securing sustainable funding remain significant hurdles.

Notable Quotes Summary:

• "President Trump has made several comments... suggesting that Europe should increase defense spending to 5% of GDP." – Paul Walsh [00:09]
• "Our base case is that 3% could be a more reasonable target..." – Ross Law [02:07]
• "Europe will remain reliant on the US for many years to come..." – Ross Law [03:58]
• "The very clear need to spend more on defence but no clear way to fund it." – Ross Law [04:07]
• "We remain bullish. In fact, we turned even more bullish as part of our 2025 outlook..." – Ross Law [05:34]
• "We're going to be watching the German election and the outcome of the French budgetary process very carefully." – Ross Law [06:12]

This comprehensive summary encapsulates the key themes and insights from the "Europe’s Defense Dilemma" episode, providing a clear overview for listeners and those interested in the strategic developments within European defense spending.