Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Defense Stocks Are Outperforming
Transcript
- Lucas: So I was looking at the numbers this week, and there's one corner of the eurozone that is absolutely on fire, and it's not tech. European defense stocks are having a moment the likes of which we haven't seen since the Cold War. Luna: Defense? Really? I mean, we talk about banks, energy, manufacturing, but defense has always felt like the boring, politically awkward cousin in the European equity family. Lucas: Boring no more. Look at the broad European ETF, VGK, it's up three point four percent in five days. The eurozone-focused EZU is up over five percent. And the iShares MSCI Spain ETF, EWP, is up four point four. That's not a sleepy sector move, that's a rotation. Luna: And you're saying defense is driving that? I'd have thought it was the banks or maybe the exporters benefiting from a weaker euro. Lucas: It's not the euro. The euro is flat against the dollar at one fifteen. And it's not China, because Chinese factory activity unexpectedly contracted in July. The story is European governments finally putting real money behind defense after years of underfunding. Luna: So this is a policy-driven rally, not just a cyclical one. That's a big shift from the austerity mindset of the last decade. Lucas: Exactly. And the numbers back it up. European NATO members have committed to spending at least two percent of GDP on defense, and many are pushing toward three. That's a structural change, not a one-year blip. Luna: But we've heard promises before. What's different this time? I mean, the headline numbers are impressive, but is the money actually flowing? Lucas: The orders are real. European defense primes are reporting record backlogs. And it's not just the big players like Rheinmetall or BAE. Mid-caps across Spain, Italy, and France are seeing order books stretch out years. Luna: So is this a time to get in, or is it already priced in? The ETFs are up five percent in a week, that feels like a lot of enthusiasm. Lucas: That's the million-dollar question. But let's put it in context. The European defense sector was trading at a discount to US defense stocks for years, precisely because investors didn't believe the political will was there. Now the political will is showing up in contracts, and the earnings are starting to reflect it. Luna: So you're saying the rerating is still in early innings? Lucas: I think so. But it's not a straight line. There are risks, and we should talk about them. One is that some of these gains are already pricing in several years of growth. The other is the political risk, if a new government comes in and reverses course. Luna: Also, there's the question of capacity. Can these companies actually deliver on the orders? We've seen supply chain issues in other industries, and defense is notoriously complex. Lucas: That's a real constraint. But it's also why the multi-year backlogs are so valuable. These are not spot-market products. Once a contract is signed, it's revenue for years to come. Luna: I should mention that we don't have ads on this show, and that's a choice we've made from the start. If you've found these conversations useful, and you want to keep them ad-free, you can support us at buy me a coffee dot com slash fexingo. It's a small gesture that makes a big difference. Lucas: And we genuinely appreciate that. It's what keeps us independent and allows us to bring you these deep dives without worrying about sponsors. But back to defense, I want to talk about the Spanish angle specifically. Luna: Spain? Because EWP is up four and a half percent, but also because Spain has been the standout performer in the eurozone economy overall. Lucas: Right. Spain's GDP has been growing faster than the eurozone average, and that's partly because it's less exposed to the manufacturing slowdown that's hurting Germany. But now, Spain is also becoming a defense player, especially in naval and cybersecurity. Luna: So the narrative of Spain as just a tourism and construction economy is fading. They're moving up the value chain. Lucas: Exactly. And that's why I think the ETF numbers are so telling. The Spain ETF is up over five percent in five days, and it's not just because of one sector. It's a broad-based rally that's finally including defense. Luna: So, for a long-term investor, is this a theme to ride for the next decade? Lucas: I think so, but you have to be selective. The defense primes are the obvious play, but there are also suppliers and tech companies that are benefiting. Cybersecurity is a huge growth area, and European firms are gaining share. Luna: And what about the macro environment? We just saw US GDP slow to one point five percent annualized in the second quarter, and core inflation is still at three point three percent. How does that affect the eurozone story? Lucas: It's a mixed bag. On one hand, a slower US economy could mean the Fed is less aggressive, which would support risk assets. On the other hand, if the US slips into recession, that would hit European exports. But right now, the eurozone is growing, and defense is a domestic demand story that's insulated from global trade. Luna: That's a good point. Defense spending is essentially government consumption, so it's not dependent on the global cycle. Lucas: And that's why I think this is more than a trade. It's a structural shift in how Europe thinks about its security and its economy. Luna: Before we wrap up, let's talk about the risks again. You mentioned political risk. What about valuation risk? Are we seeing a bubble form? Lucas: There's definitely froth. Some of these mid-caps are up fifty percent year to date, and that's not sustainable. But if you look at the price to earnings ratios of the larger primes, they're still reasonable relative to their growth potential. The key is to avoid the ones that are purely momentum. Luna: So, a barbell approach: big established names plus a few high-growth suppliers, but avoid the pure momentum plays. Lucas: That's how I'd play it. And I'd also keep an eye on the euro. If it starts to strengthen beyond one point fifteen, that could headwind exporters, but it wouldn't hurt the defense champions as much because their revenue is mostly domestic or in euros. Luna: And with the dollar index at one hundred nineteen point seven, there's a lot of debate about whether that's a peak. If the Fed cuts, the dollar could weaken, and that might actually help European exporters. Lucas: Right, but the Fed is divided. Some members are worried about inflation, which is still above target. So we might see a period of no cuts, which would keep the dollar firm. That's actually good for European competitiveness. Luna: So the bottom line is: European defense is a real structural story, but you need to be selective. Is that fair? Lucas: I'd say so. And it's worth remembering that the eurozone economy surprised to the upside with two point one percent growth in the last quarter, so the backdrop is supportive. Luna: Good. So what should our listeners watch for in the next few months to confirm or refute this thesis? Lucas: Watch the order announcements from the primes. If we see more multi-billion euro contracts, that's confirmation. Also watch the NATO summit in the fall, where spending targets are likely to be raised again. And keep an eye on the German election, because defense spending is a hot topic there. Luna: That's a lot to track, but you've given us a clear framework. Thanks, Lucas. Lucas: Thanks, Luna. And to our listeners, if this episode made you think, you know where to find us. We'll be back tomorrow.