Donald Trump’s attempt to hammer out a truce between Russia and Ukraine remains in the balance, but defence shares are already slipping at the prospect of the three years of bitter fighting finally coming to an end. It is not hard to understand why. Defence has been one of the few stars in a generally dismal European economy, with shares soaring on expectations that governments across the continent would spend a lot of money in the years ahead on rebuilding their armed forces.
The big German defence contractors were the stand-out performers on the back of the huge increases in borrowing and spending, much of it directed to the military. Rheinmetall shares were up 170% over the last year, before the latest sell off. Yet with the European Union also planning a €150 billion common defence fund, all the continent’s major companies were expected to get a lot of lucrative contracts. So Italy’s Leonardo had doubled, while France’s Thales was up by more than 70%. Even environmental, social and governance (ESG) funds were starting to invest in the sector.
A ceasefire in Ukraine could change all of that very quickly. Trump is pushing hard for a deal and it will prove hard for Ukraine to hold out against that. The war has reached what looks like a stalemate, with huge losses on both sides. Sure, it would be better if Ukraine could achieve a victory and Vladimir Putin were removed from power in Russia. But there does not seem to be much chance of that happening. An end to fighting would save a lot of lives and might be the best option available. And so investors are right to reassess.
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If there is a peace deal, governments across Western Europe may very quickly go back to spending more money on welfare, or trying to bring their deficits under control and keep the bond markets happy. If there is no security emergency on their doorsteps, it will be hard to persuade voters to keep spending money on defence that could be spent on healthcare, social security or infrastructure instead. That is what they did after the Cold War ended, and it is very easy to think that the same thing will happen again. If it does, the defence giants may find their order books starting to dry up very quickly.
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Peace in Ukraine would not end the need to rearm
Even so, there are two reasons why this is not the most likely outcome. To start with, any peace deal will almost certainly include some security guarantees for Ukraine. It is not likely to be allowed to join Nato, but there may well be a peacekeeping force that is drawn from Europe, as well as help for restoring its own armed forces so it can defend itself from further attacks. All of that will mean that money has to be spent on kit for the soldiers who will be keeping an eye on the new border between Russia and its neighbour.
Next, and more importantly, if the Ukraine war is settled, at least for now, then the US will inevitably accelerate its withdrawal from Europe. This had already started under previous presidents, but Trump has made it very clear that the US does not intend carry on paying for the defence of the continent. Trump wants all the major countries to commit to spending 3% or more of their GDP on their armed forces, while the US turns its attention elsewhere. The war in Ukraine has kept America engaged in Europe for the past three years, but without that emergency, it will focus instead on the far larger contest with China for the dominant role in the Pacific. The result? Europe will have to carry on paying much more for its own defence. It won’t have any other choice. Russia will remain a hostile, threatening opponent, and with less support from America, Europe will have to remain in a high state of alert.
European governments, including of course the UK, might want to cut spending – there will be plenty of demand for more spending elsewhere. If the peace holds between Russia and Ukraine, it will be very tempting to make savings. But in reality, that won’t be possible. Military spending will have to keep rising – and that means the boom in defence shares will carry on for many more years to come.
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