Morgan Stanley analysts describe the recent retreat in European defence equities as largely sentiment-driven and argue the investment thesis for the sector is "stronger than ever." They say the fall in share prices reflects multiple compression more than any deterioration in company earnings.
According to the bank, every stock in the EU defence sector is trading below its one-year high, with the average shortfall around 20%. The sector's forward price-to-earnings (P/E) ratio has decreased from about 23x to roughly 20x - a level the analysts place at the bottom of what they consider the 20-25x range that most accurately captures fundamentals.
"This does not match up with our view that fundamentals for the sector continue to improve," the analysts led by Ross Law wrote, pointing to recent geopolitical events - specifically Iran, Greenland and Venezuela - as factors that strengthen the case for increased European defence budgets and amplified strategic autonomy.
On that basis, the analysts said they would treat the recent underperformance as an attractive entry point. "As such, we believe the investment thesis underpinning our positive view on the sector remains firmly intact and would use the recent lacklustre performance as an attractive buying opportunity," they added.
What drove the pullback?
Morgan Stanley outlines four primary, and in its view temporary, drivers behind the sector's weakness:
- Equity degrossing tied to Middle East conflict: Hedge funds with significant defence positions engaged in degrossing related to the Middle East conflict. The bank notes these funds typically face no ESG restrictions and so held concentrated positions that were reduced.
- Relative growth appeal elsewhere: An improved growth outlook for U.S. and Asian defence markets in recent months has diluted Europe's relative attractiveness to some investors.
- Rotation toward names with U.S. exposure: Renewed debate over conventional versus modern weaponry in the wake of the Middle East conflict has prompted flows toward companies with greater U.S. exposure. The analysts contend this debate is "misplaced for Europe," where the principal threat profile is land-based and requires investment across both conventional and modern capabilities after more than three decades of underinvestment.
- Order delays and fiscal pressures: Delays to orders in Germany and ongoing fiscal constraints across Europe have produced what Morgan Stanley calls "thesis fatigue" among investors. The bank views these as largely timing-related issues that do not reflect underlying demand.
Geopolitics and the long-term case
Morgan Stanley argues the geopolitical environment supports, rather than undermines, the long-term rationale for European rearmament. The bank points out U.S. military focus and resources are increasingly occupied with the Middle East, which could reduce the level of support available to Ukraine. In addition, transatlantic relations have frayed, with senior U.S. officials questioning NATO's value and signalling that Europe must assume greater responsibility for its own defence.
On the economics of prolonged conflict, the bank estimates that easing of sanctions on Russian oil could yield an additional $150 million per day for Moscow, a factor that could extend Russia's capacity to sustain operations in Ukraine.
Bottom line
Morgan Stanley's view is that recent share-price weakness in European defence names reflects temporary market dynamics rather than a shift in underlying fundamentals. With forward multiples nearer the lower end of the bank's assessed range and geopolitical trends reinforcing the case for higher European defence spending and strategic autonomy, the analysts recommend viewing the current period of underperformance as an opportunity to add exposure.
Note: The article reports the bank's analysis and does not provide an assessment of any single company's outlook beyond those collective sector observations.