In defence of growing returns: Increasing military spending in a more dangerous world

Governments around the globe have been increasing their defence spending amid mounting geopolitical risk. In 2024, world military expenditure rose 9% to $2.7tn, equivalent to 2.5% of global GDP – the steepest yearly increase in decades. While this has triggered strong demand for defence stocks, pushing up valuations, we still see good opportunities for long-term returns within the sector.

What are the biggest long-term trends in this sector?

The US remains the largest defence spender, accounting for nearly 40% of global outlays, prioritising strategic deterrence (preventing attack by convincing potential adversaries that the costs will outweigh the gains), next-generation air superiority, hypersonic weapons, and cyber capabilities. 

Europe, after decades of underinvestment in defence, is undergoing a paradigm shift. Collective European defence spending increased 17% in 2024 amid the ongoing Russia–Ukraine war and the threat of America pulling back on military support for Europe under President Trump’s new administration. A structural shift within NATO, with less reliance on America, also underpins the long-term growth outlook for the defence sector in Europe: allies have committed to spending 5% of GDP on defence by 2035 – with 3.5% for core defence and 1.5% for broader security (cybersecurity, resilience and critical infrastructure). This implies a multi-year rearmament cycle, with annual growth in European defence budgets projected to be in the high single to low double-digits.
 

Europe still below NATO targets: 

Most European countries remain well short of NATO’s new goal to spend 5.0% of GDP on security and defence, including 3.5% on core defence.

Hover each country to see how much it spends on defence, as a share of GDP.

How are these trends affecting valuations?

The substantial increases in defence budgets, to meet the need for EU member states to act independently in the areas of security and defence, has triggered strong demand for shares in Europe’s defence sector. This has pushed valuations (such as prices relative to expected earnings and cash flows) higher. In the near term, the shares remain sensitive to headlines around peace negotiations in the Russia–Ukraine war, but the structural drivers of higher defence spending remain intact. In addition to this need for strategic autonomy, money will also need to be spent on rebuilding from low levels of military equipment and investing in the new weapons of modern warfare. 

What’s the best way to invest in the sector?

We believe the valuations of companies that tend to have longer-term contracts (such as for complex, capital intensive projects such as fighter jets, aircraft carriers or missile systems) are relatively attractive. In particular, these ‘long-cycle’ contractors’ shares seem to be discounting less upside from increased European defence spending than their short-cycle peers, which are focused on smaller projects such as weapons and ammunition.

We also think it makes sense to focus on how well companies execute their plans, on the resilience of their supply chains and on the rates of return they get from incremental investment. These factors will be critical in converting government commitments for orders into profitable growth.

Are any long-term trends emerging that could be even more important?

Advances in computing are feeding into the trend toward cyber warfare, and AI-enabled intelligence, surveillance, reconnaissance and targeting, as well as unmanned and autonomous systems (including drones). Other technological advances include hypersonic weapons and new weapon systems, known as directed-energy solutions, that use concentrated electromagnetic energy (such as lasers) rather than projectiles (such as missiles) to disable or destroy targets.

These shifts have opened the door for new, agile defence-technology companies developing disruptive solutions at speed. Established contractors also have the opportunity to embrace innovation, including through strategic partnerships, joint ventures and corporate ventures. The opportunity to compete – and increasingly collaborate – in shaping Europe’s future defence ecosystem is significant, for both startups and established players with broad capabilities.

Elsewhere, US Secretary of War Pete Hegseth recently outlined a major overhaul of the Pentagon’s procurement approach, with a focus on speed and cost-effectiveness. Major US defence contractors, which previously operated in a highly consolidated market, have now been warned they must adapt or will fade away.

What are we watching in the short-term?

Budget intentions take time to convert into orders and deliveries. At the same time, European governments face fiscal trade-offs, given other priorities and overall spending constraints. Still, recent policy initiatives – such as EU Readiness 2030 – are designed to ease constraints and accelerate joint procurement and growth in industrial capacity. We think this means spending on defence will stay resilient, despite budgetary pressures. We are monitoring companies’ order books, their additions to capacity and potential supply-chain bottlenecks to determine how quickly the headlines on increases in defence spending translate into sales and profits.

How have geopolitical events reshaped investor attitudes towards defence?

The Russia–Ukraine war marked a turning point, when some investors who had historically excluded defence companies on ethical grounds came to view them as essential to safeguarding democracy and stability. This shift has broadened institutional and retail investment in the sector. Beyond Europe, renewed tension in the Indo–Pacific and Middle East has reinforced the importance of defence. These investors can benefit from the sector’s dependable multi-year projections for growth in sales and profits, resilient cash flows, and expertise in critical technologies that could produce strong future returns.

What are the ethical and reputational risks still associated with defence investing?

While some ethical concerns have abated, environmental, social, and governance risks remain significant. These include environmental impacts, the lethal nature of the products, human-rights concerns, bribery and corruption, and opaque supply chains. Disclosures can be limited by customer sensitivity, necessitating close due diligence and rigorous engagement with companies on governance issues. Most investors, including Rathbones, still maintain exclusions on controversial weapons – such as anti-personnel landmines and cluster munitions – even when allowing conventional defence exposure. This underscores the ongoing reputational sensitivity of investing in defence.

Personal reflection

I was struck by the pace of innovation within the defence sector that was on display at last year’s Defence Security Equipment International trade show in London, a flagship event for the UK defence sector. Out on the exhibition floor, I saw both established contractors and emerging tech firms showcasing next-generation capabilities – from AI-enabled uncrewed vehicles, planes and submarines to robotic systems for replacing human intervention in dangerous situations. The breadth of technologies on display also underscored how rapidly the sector is evolving and highlighted the growing role of automation, autonomy, and advanced AI in shaping future defence strategies.