Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why European Defense Stocks Are Outperforming the Broader Market
Transcript
- Lucas: So there is a trade happening in European equities right now that is very concentrated and very loud — and it's defense stocks. While the broad Eurozone ETFs like VGK and EZU are up two to three percent over the past five days, the defense and aerospace names have surged more than ten percent since late June. Luna: That is a huge gap. What lit the fuse? Lucas: A joint announcement on July first from France, Germany, and Italy — a commitment to create a two hundred billion euro joint defense procurement fund over five years. That is real money. And it's not just a political statement; they laid out specific governance, a timeline, and a commitment to fund it without breaking the Stability and Growth Pact. Luna: So they're essentially saying we'll spend on defense but we won't let it blow up our deficits. How do they square that circle? Lucas: The mechanism is a special-purpose vehicle — off-balance-sheet for national debt calculations, backed by jointly guaranteed bonds issued by a new European Defense Agency. The bonds would be treated as risk-free for bank capital requirements, similar to how German bunds are treated. That keeps national debt to gdp ratios from spiking, at least on paper. Luna: Clever. But does the market buy it? Because the bond market has been very twitchy about Eurozone fiscal expansion. Lucas: So far, yes. Yields on French and Italian ten-year bonds actually tightened a few basis points after the announcement. The market seems to be treating this as a credible, fiscally responsible plan — at least relative to the alternative of each country borrowing on its own. And the beneficiaries are obvious: Airbus, Thales, Rheinmetall, Leonardo, BAE Systems — all up sharply. Luna: And this is happening against a backdrop where the broader economy is still struggling with a strong dollar — the trade-weighted dollar index is at 120.9, and the euro is stuck around 1.14. That's been a headwind for Eurozone exporters, especially in autos and machinery. Lucas: Right. So you have a two-speed market: defense stocks roaring ahead on a specific policy catalyst, while the rest of the index is being dragged down by currency and trade headwinds. The German ETF EWG is up 4.1 percent in the past five days, but that's mostly defense and a few industrials — the export-heavy names are struggling. Luna: It reminds me of the dynamic we saw in the US in 2023 and 2024, where defense stocks outperformed the broader market on geopolitical fears and actual spending increases. But Europe has historically been slower to translate announcements into contracts. Is this different? Lucas: That is the critical question. The difference this time is the scale and the joint mechanism. National defense budgets have been creeping up since Russia's invasion of Ukraine, but they've been fragmented — each country buying its own systems, duplicating overhead. This fund is explicitly designed to pool procurement for big-ticket items: next-generation fighter jets, missile defense systems, cyber capabilities. That means contracts could be larger and more efficiently awarded. Luna: And it's not just about the contracts — it's about signaling to the market that European governments are serious about defense autonomy. The US political landscape has made European leaders nervous about relying on American security guarantees. Lucas: Exactly. The Hormuz deal earlier this year reshaped trade ties, but it also underscored that Europe needs to be able to defend its own interests. This fund is a direct response to that realization. And the market is pricing in a multiyear uplift in defense spending, not just a one-time bump. Luna: So for an investor looking at European equities today, is the play to overweight defense and underweight exporters? Or is there a risk that the defense rally is already overdone? Lucas: Valuations are getting stretched — some of these stocks are trading at thirty times forward earnings. But the earnings revisions are also accelerating. Analysts have been raising estimates for Airbus and Rheinmetall by double-digit percentages over the past two weeks. The rally may have more room if the contract pipeline materializes. But it's not a low-risk trade. Luna: And the broader macro environment still matters. If the dollar stays strong, export-dependent economies like Germany will continue to struggle, which could eventually weigh on the entire index. Lucas: Right. And that's the tension — the Eurozone is not a monolith. The defense boom is concentrated in a few countries and a few companies. Spain, for example, has less exposure to defense primes, and its ETF EWP is up only 1.7 percent in the past five days. Italy's EWI is up 3.4 percent, partly because Leonardo is a big component. So the dispersion is telling you something about the real economy. Luna: Speaking of the real economy — we talk a lot on this show about how these macro shifts affect people's jobs, savings, and investments. And I think a lot of listeners appreciate that we dig into the numbers without any of the usual ad breaks or sponsored content that clutter up other business shows. Lucas: Yeah, that's an intentional choice. The show is listener-funded — no ads, no sponsors. A small but meaningful group of listeners chips in monthly through buy me a coffee dot com slash fexingo, and that's what makes it possible to produce this many episodes with this level of detail. Luna: If you've found the conversations useful, it's a simple way to keep the podcast going, and it stays ad-free for everyone. Lucas: Alright — back to the defense story. One thing I want to watch is how the bond market reacts when the first bonds are actually issued, likely late this year. If the joint bonds are priced attractively, they could become a benchmark for a new asset class — European defense bonds — that might attract pension funds and insurers looking for yield with a sovereign-like risk profile. Luna: That would be a big deal for the European capital markets union, which has been talked about for years but never really materialized. Lucas: Exactly. And it would deepen the integration of Eurozone financial markets in a way that goes beyond just monetary policy. So this defense fund isn't just about tanks and jets — it's about the architecture of the European economy. Luna: And it's happening at a time when the ECB is navigating its own exit from tightening, with growth picking up but still fragile. Real GDP growth is annualized at 2.1 percent, which is better than last year, but the strong dollar and export headwinds are a persistent drag. Lucas: Yeah, it's a mixed picture. But the defense sector is a bright spot, and it's one that could have long-lasting implications for the Eurozone's fiscal and industrial landscape. We'll be tracking it closely. Luna: Good. I think our listeners will too.