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"Overlooked" defence shares rally on higher spending prospects

Pressure builds on Nato countries to meet spending commitments as expert forecasts a new "militarised border" through the middle of Europe and ESG thinking shifts
"Overlooked" defence shares rally on higher spending prospects
  • US currently accounts for 70 per cent of Nato's $1.17tn expenditure
  • Spending by European nations to meet target needs to increase by $73bn

Defence shares soared this week as investors began to realise that however the war in Ukraine ends, the need for European nations to spend more on strengthening their borders has become self-evident. Following the invasion, there have even been calls for ESG funds to stop screening out weapons makers, although some in the sector have pushed back forcefully on this. 

“I think we’re going to end up with a militarised border down the middle of Europe again. We haven’t seen that for a long, long time,” said Kim Catechis, an investment strategist at Franklin Templeton Institute.

“The peace dividend that Europe has enjoyed looks like it’s being reversed, at least temporarily.”

Since Russia’s invasion of Ukraine last Thursday, shares in UK defence companies have soared. BAE Systems (BA) and Chemring (CHG) have jumped by 23 per cent and Avon Protection (AVON) by 22 per cent. Other defence-related companies such as Cohort (CHRT), Qinetiq (QQ) and Babcock (BAB) have all made double-digit gains.

One key catalyst for the re-rating was German chancellor Olaf Schulz’s announcement on Sunday (see boxout) that the country would raise defence spending above the 2 per cent threshold that members of the North Atlantic Treaty Organisation (Nato) commit to spend, but which few actually meet.

The last time Germany reached the 2 per cent threshold “was in 1989-90, which is when the Berlin Wall was falling”, Catechis said. It spent an estimated 1.5 per cent of GDP on defence last year, according to investment bank Jefferies. Other European giants were even bigger laggards – Italy spent 1.4 per cent while Spain, which  only managed 1 per cent.

The US still does most of Nato’s heavy lifting, coughing up around 70 per cent of the organisation’s expenditure of $1.17tn (£880bn).

Former US president Donald Trump “was constantly going on at Nato members to pay their dues and he was pretty much ignored”, said David Morrison, senior markets analyst at brokerage Trade Nation.

“[Now] I think the situation really has changed. They can’t, in all consciousness with what’s going on in Europe now, not be seen to be putting in the very basic commitment.”

If European Nato members increase spending to meet the 2 per cent threshold, analysts at Berenberg believe spending would increase by $73bn. This equates to a 7 per cent rise, or 23 per cent excluding US contributions.

European defence companies have posted the strongest gains, with Germany’s Rheinmetall (DE:RHM) up 58 per cent since last Wednesday’s close. Italy's Leonardo (IT:LDO) has also gained 30 per cent and France’s Thales (FR:HO) 27 per cent. Growth in the valuations of US defence contractors Northrop Grumann (US:NOC), Lockheed Martin (US:LMT) and Raytheon has been less spectacular but are still in double-digit territory.

An overlooked industry

Russian invasion aside, shares in defence companies have been “overlooked and undervalued” for a while, said Henry Carver, an analyst at Peel Hunt.

The FTSE 350 Aerospace and Defence sub-index is up 11 per cent since the start of this year, but down 6 per cent over the past five years, according to FactSet. Followig recent gains, it now trades at 16-times forward earnings, above the broader benchmark's 12-times.

Shares in the sector were sidelined as investors poured more money into ESG funds, which typically run negative screens to omit investments in military companies, tobacco firms and other investments that are deemed unethical.

Fund managers have found it easy to ignore shares on ESG grounds given their underperformance in recent years but this may be harder to do given their renewed growth impetus, Carver said.

Moreover, with many governments around the world sending arms to Ukraine to give the country a better chance of defending itself, Carver said there is an argument to be made that some defence stocks “should sit on the right side of ESG”.

“There’s a humanitarian rationale to equipping the right kind of military,” he said, adding that companies in the sector offer protection to people, soldiers and assets.

Swedish bank SEB this week lifted some of its restrictions on investing in defence companies, although it maintained a block on any company involved in the making of “controversial weapons”, such as anti-personnel mines, biological and chemical weapons or cluster bombs.

Whether those who invest in ESG funds would be happy to see their money buying shares in companies that make tanks or bombs is another matter, though.

While there are scenarios where it can be argued that weapons are being put to a positive use, "I think there's still a very strong argument for exclusion" from ESG funds, said James Alexander, chief executive of the UK Sustainable Investment and Finance Association.

"If you're a weapons manufacturer, a big part of your work is sales and you're incentivised to get as many weapons out into the world as possible. I don’t think that’s aligned with the sort of world we want to create."