Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Defense Stocks Are Breaking From EU Budgets
Transcript
- Lucas: There's a fascinating divergence happening in Eurozone defense stocks right now, and it's not about who's winning the most government contracts. Luna: Because that used to be the whole story, right? Whoever got the biggest budget allocation from Berlin or Paris would lead the sector. Lucas: Exactly. And for a while, that correlation held. But over the past six months, some of the biggest defense names have started marching to a different beat. Take Rheinmetall, the German tank and ammunition maker — it's up roughly 18 percent year-to-date, even as Germany's defense budget talks have stalled. Luna: So the stock is decoupling from the political calendar. That's a shift. Lucas: It is. And it's not just Rheinmetall. Thales, the French defense electronics firm, has outperformed the broader Eurozone market by about 12 percentage points this year, while Leonardo in Italy is up nearly 15 percent. These moves are happening against a backdrop where Eurozone GDP grew at an annualized rate of 2.1 percent in the first quarter of 2026, up from just 0.5 percent a year earlier. So the macro environment is supportive, but that alone doesn't explain the sector's divergence. Luna: What does? I mean, the headlines lately have been dominated by renewed Hormuz hostilities — that's obviously a tailwind for defense spending globally. Lucas: It is, but here's the thing: the ECB is now having to rethink its rate path because of that geopolitical volatility. Wholesale prices just declined unexpectedly in June — down 0.3 percent — but the Hormuz situation could reverse that quickly if energy costs spike. So defense stocks are being repriced not just on current orders, but on a structural shift in how Europe thinks about security. Luna: Meaning investors are betting that defense is becoming a permanent, higher share of GDP, not a cyclical bump. Lucas: Right. And that changes which companies benefit. If the thesis is that Europe needs to spend more on defense regardless of annual budget negotiations, then the winners are companies with proprietary technology and export flexibility — not just those tied to one country's procurement cycle. Luna: So Rheinmetall, Thales, Leonardo — they all have significant export businesses. Rheinmetall's ammunition lines are running at full capacity, and they're selling to multiple NATO countries, not just Germany. Lucas: Exactly. And Thales has a strong position in sensors and cybersecurity, which are less politically sensitive than tanks. Leonardo has been expanding its helicopter and electronics portfolio. These are businesses that can grow even if Italy or France hits a budget snag. Luna: But there's a flip side. Some of the pure-play national champions, like the smaller companies that rely almost entirely on domestic procurement, have underperformed. Lucas: They have. And that's the divergence. The market is essentially saying: we believe in European defense spending as a long-term trend, but we're not going to pay a premium for companies that can't adapt if a specific government tightens its belt. Luna: And the numbers back that up. The trade-weighted US dollar index is at 120.5, which is high, and the euro is flat around 1.14 per dollar. That makes European exports more competitive in dollar-denominated markets, which helps these export-heavy defense firms. Lucas: Good point. A weaker euro relative to the dollar boosts the value of overseas sales when translated back. So that's another layer: currency tailwind plus geopolitical tailwind plus a structural repricing. Luna: But is there a risk that this repricing overshoots? Defense stocks aren't exactly cheap anymore. Rheinmetall trades at a price to earnings ratio around 28, which is high for an industrial company. Lucas: It's high, but you have to consider the growth trajectory. Their earnings per share have been compounding at over 20 percent annually for the last three years. If that continues, the P/E compresses quickly. The question is whether the growth is sustainable. Luna: And that depends on the geopolitical backdrop — which is inherently unpredictable. If Hormuz de-escalates, or if EU governments start prioritizing fiscal consolidation over defense, the thesis weakens. Lucas: Absolutely. But here's what's interesting: even in a scenario where tensions ease, the structural case for higher European defense spending remains strong. NATO's spending targets aren't going away, and the US has made clear it expects Europe to carry more of the burden. So we're looking at a multiyear trend, not a one-year spike. Luna: And that's exactly what the bond market is pricing in. Eurozone bond yields have been falling despite sticky services inflation — the market is betting that the ECB will have to keep rates lower for longer to support growth, and that defense spending will be a key part of the fiscal mix. Lucas: So you have a convergence of factors: low real yields make defense stocks' future cash flows more valuable in a discounted cash flow model; geopolitical risk provides a floor for demand; and the currency environment supports exporters. Luna: It's a pretty compelling setup. But it also means that the easy money might already have been made. The sector has run up significantly since 2022. Lucas: True. But the divergence we're talking about — between the multinational exporters and the national champions — suggests there's still alpha to be captured if you can identify which companies have genuine competitive moats versus those that are just riding the political wave. Luna: So for an investor looking at Eurozone defense today, it's not enough to just buy a broad defense ETF. You need to be selective. Lucas: Exactly. And that's a different mindset from two years ago, when the whole sector moved together on every headline out of Brussels or Washington. Luna: Speaking of different mindsets, you know, if this conversation has been useful — if it's helped you think about the Eurozone economy differently — we do have a small way listeners can support the show and keep it ad-free. Lucas: Yeah, it's a tiny thing. If today's episode was worth a coffee to you, that link is buy me a coffee dot com slash fexingo. Seriously, no pressure — we're just happy you're listening. Luna: And it genuinely helps us keep going. So thank you to everyone who has already done that. Lucas: Alright, back to defense. So where does this leave us for the rest of 2026? I think the key thing to watch is not just the headlines from Hormuz or NATO summits, but the actual earnings reports from these companies. The next quarter's results will show whether order books are translating into revenue growth and margin expansion. Luna: And whether the export story is real. If Rheinmetall and Thales can show that their non-European revenue is growing faster than their domestic business, that would confirm the decoupling thesis. Lucas: Exactly. And if that happens, the sector could re-rate further. But if we see a quarter where domestic orders are what's driving growth, then the divergence narrative might be premature. Luna: So it's a wait and see, but the data so far is pointing in an interesting direction. Lucas: It is. And honestly, that's what makes this such a compelling moment for Eurozone investors. The old rules of thumb — buy the national champion, ride the budget cycle — are being challenged. And the companies that adapt will define the next phase of European defense. Luna: And we'll be watching. That's all for this episode of The European Economy Podcast. Thanks for listening.