Janet Wilkinson 00:09
Hello and welcome to the Partner of Choice podcast, where we bring you expert insights from RBC Capital Markets on the key trends shaping global markets. I'm Janet Wilkinson, Managing Director and Head of Global Markets Flow Sales, EMEA. Today we're examining one of the biggest shifts in global security and defense policy. How President Trump's approach to NATO, military alliances and defense partnerships is reshaping defense strategies across the UK, Europe and the US.
With the U.S. President calling on NATO allies to increase defense spending to 5% of GDP and scaling back U.S. commitments in Ukraine, UK and European governments are being forced to rethink military procurement, industrial capabilities and strategic autonomy. So what does all of this mean for economies and for defense sectors, firms and investors? To break it all down today, I'm joined by two RBC Capital Markets experts, Peter Schaffrik, Chief European Macro Strategist, who will unpack the economic impact of UK and European defense spending shifts. And Ken Herbert, Senior Aerospace and Defense Analyst, who will discuss how defense companies are positioning themselves in this evolving landscape. Peter, Ken, great to have you both here.
Peter Schaffrik 01:32
Thank you very much.
Ken Herbert 01:34
Thanks, Janet, great to be with you today.
Janet Wilkinson 01:36
So Peter, turning to you first on policy. Trump's policies are putting unprecedented pressure on UK and European defense budgets, both by demanding that NATO Allies contribute 5% of GDP and by reducing US military commitments, including halting aid to Ukraine. What impact is this pressure having on UK and European defense spending?
Peter Schaffrik 02:01
Well, look Janet, it's having an impact very clearly, both on the political side and then later, by extension, on the market. So I think a natural starting point is with the German announcement. So Germany has been running this debt break that limits how much deficit they can have in any given year, and they have just reformed it in a way that excludes any defense spending north of 1% of GDP. And in fact, they've even broadened the definition of what defense spending is to also include cyber defense or the intelligence agencies, and we will almost certainly see a significant ramp up in defense spending that will also have a big impact on GDP. But it's not only Germany, also other European countries have tried to increase their defense spending. The big difference here is that they are struggling more than Germany does how to finance it, because Germany is in the very privileged position to have very low debt GDP levels, whereas countries like France or the UK have much higher debt GDP levels, and therefore cannot simply fund it by issuing more debt. And maybe the last point that I would mention is one of the other things that you're seeing, which have less to do with markets, but we clearly see the impact is there's a there's an active debate now in Europe about the nuclear deterrence that so far the US has provided, where, for instance, France has suggested they would extend their own nuclear deterrent to cover other European nations as well. So there's a lot of moving parts here that in part have financial market implication, and in part have more political implication.
Janet Wilkinson 03:43
Thanks, those were great insights. Moving on to some pitfalls,where do you see the pitfalls in this rapid defense spending shift? Will most of this budget be spent domestically, or will some of it flow to US defense firms, either out of necessity or as part of a deal with the US administration? Peter, what are your thoughts here?
Peter Schaffrik 04:02
Yes, that's, I think the million dollar question here, or million euro question, I should say. Let's break it down a bit. So I think, from a from a political point of view, the Europeans and the Germans in particular, would like to spend as much at home as possible. And the reason for that seems relatively clear. On the one hand, they have already stated, and I think this is probably one of these intended or unintended consequences of the Trump policies, that they would like to be a bit more independent from the US militarily. The second thing is the more you spend at home, the better it is for your own economy,and surely the European economies need all the support that they can get at the moment, because we've been struggling economically speaking. The question is whether that's actually doable, because what we've seen is over the last two years or so, that's certainly what came out of the Draghi report, is that about 78% of the European defense spending actually went abroad, and the vast majority of that went into the US. We also know that the Europeans, in some cases, do not have the production capacity for some of the military equipment that they're talking about, so they literally have to go abroad, because, at the moment, at least, they can't produce it at home. And then there's maybe another element that is, as of yet unclear. We're literally in the process of waiting for the announcement of tariffs to be introduced. And there is this notion that one part of the tariff deal is a potential negotiation wiggle room where the Europeans would offer something in return, and part of that something could be an increase in military spending that goes into the US and therefore helps to balance the trade deficit.
Janet Wilkinson 05:45
So Ken, Peter has outlined the strategic and economic pressures behind the spending shift. From an industry perspective, how do you see this impacting the defense supply chain, and in your view, which types of firms are best positioned to benefit?
Ken Herbert 06:01
Yeah, thanks, Janet. And as Peter indicated, I think it's hard to overestimate the shift we've seen in sentiment in Europe, both from an investor standpoint, but then also from the governments to defense spending. I think this is a very strong shift what you've seen, not only in Germany, but in other countries, and will have very significant implications for quite a long time to come. So I agree with a lot of Peter's comments. I think the challenge will be for European countries with a clear preference to source more from European suppliers. How much can they actually do here? And where will there be constraints? I would argue, in a couple of areas, but one of the most important would be on sort of industrialization or capacity. So we do expect a lot of the investment to go to support longer cycle defense investments. Think, certainly fixed wing aircraft, rotorcraft, missile defense areas like this that are not short cycle, not something that sort of you see a benefit one quarter to the next, or even one year to the next, but significant infrastructure investments to support a European industrial base, which has been, you could argue, underfunded for quite a period of time. So, you know, I would call out specific areas. Specific areas around combat aircraft is certainly a focus area. You think about surveillance and reconnaissance capability. You certainly think about cyber and space as a focus. You certainly think about, you know, next generation battlefield technology. All these areas are set to benefit significantly, because there's two things happening: one, all of Europe has been acutely aware of the lessons of Ukraine and implications of the Russia war in Ukraine, but then also longer term, where they need strength in the industrial base, where they want to invest, where they basically see the puck going in five to 10 years, and that's going to be where you're going to see significant investment, in our view.
Janet Wilkinson 07:48
So Ken, let's look at some strategic dependency here. One concern we're hearing more often is around this issue of dependency, specifically the idea of a US kill switch in critical defense systems like the F35. There's speculation that if European governments fall out with the US politically, they could lose access to key software updates, or even see their military systems disabled. How real do you think this risk is, and how is it influencing European procurement decisions?
Ken Herbert 08:20
Yeah, it's a great question. I think it's a very legitimate risk. I would make a few points. One, in the case of the kill switch, a lot of that debate revolves around the F 35 produced by Lockheed Martin, and concern amongst European countries that they would be over dependent on, certainly the United States around that aircraft in particular. If you think historically, there's a very strong reason why you've seen such a success of US hardware into the European market, in particular. One, there's obviously confidence that these companies will continue to be around. So you're going to continue to see support, services, upgrades on these products. And two, anytime you're doing joint training exercises, for instance, under a NATO umbrella, it's beneficial to have the interoperability that comes with matching hardware from a European country with what's used by the United States military. So in the case of the F 35 I think it's an aircraft that was designed and built that fits very well for the European theater. But having said that, you will see a clear preference for buy European where there's capability in Europe. I would argue that, you know, the F 35, we would be cautious that any European countries would cancel orders that are already booked. Future order activity is certainly a question but this is certainly a concern, and I think points to where you're going to see focused investment from the European countries. But I would also call out the fact that there are a number of areas where I think US firms continue to offer competitive advantages, and it'll take the European industrial base years to catch up, but this kill switch risk is very real, and you're going to continue to hear about this as certainly a topic of discussion as we think about future contracts and obviously where the European industrial base is investing.
Janet Wilkinson 09:59
Peter, in your view, how are bond markets reacting to this anticipated surge in UK and European defense spending?
Peter Schaffrik 10:07
Yeah. So great question, Janet, so the short answer is, yields went up. What we've seen is an immediate shift higher in all European bond yields across the curve, but particularly also at the longer end of the curve. So I think what the market is basically doing is saying, Well, look, on the one hand, we have more supply, and more supply means a lower price means a higher yield. Secondly, the debate is also about, okay, if the Europeans are now starting to invest much more heavily in in their own economy, and that's a GDP boost. If there's a GDP boost in an environment where the labor market is already tight, that probably means that the central bank will not be able to cut as much as previously was anticipated, and that has shifted shorter dated yields up as well and has repriced the ECB to some degree. And then the third point is probably also well, if, if that's all the case, we probably need a higher risk premium for longer dated maturities as well, and the curve has steepened. So I think there's a whole sort of follow through action that went through the bond market. But again, sort of the short answer is yields, went up. Now, I would like to contrast that a little bit, with other countries, and the UK is one of them, France might be another, Italy might be another, who simply do not have the same kind of fiscal leeway that Germany has. Now, as these countries really struggle to maintain their deficit, and as they're making cuts in other parts of their budget, they are more informed by what has happened to yields in previous occasions, like in the UK, the so called Liz Truss experience, in France, the wobbles in the OAT market around the government in the fresh elections last year in 2024 and they're quite desperate to avoid that happening again. So whereas on the one hand, Germany has just accepted that yields have shifted higher and there is a higher funding cost going forward, the others are desperately trying to avoid the same situation. So the bond market plays a very crucial role in all these decision making in Europe.
Janet Wilkinson 12:13
Ken, how is this playing out in defense sector equities and what investment trends are you seeing from the investor community?
Ken Herbert 12:21
Yeah, thanks, Janet. I mean, we've seen since the Trump election, and certainly since his inauguration, I would call out a few things. One more recently, a very significant increase in the value of European defense equities. I think it's been one of the most topical areas as we meet with investors that's come up and I think you've seen a number of these, the stocks perform very well this year. In fact, we've seen a chart recently that basically calls out that you've seen, give or take, 100 billion euro increase in the equity value of European defense equities, which basically offsets the decline in market value we've seen with US Defense primes since the election of President Trump. So I think the response from equity investors has been very pronounced, and shouldn't surprise anybody in our view. I do think, as you look at US Defense primes, I think the exposure to Europe for most of these companies, directly, is maybe high single digits to mid-teens. So it's not significant both on the positive or the negative side. I do believe, however, as we talked earlier, this structural shift has significant room to run as you think about sort of sentiment and the shift in Europe in terms of defense spending and investment. So you know, it'd be interesting to see here in the United States what happens with the fiscal 26 budget request, and what happens with the pivot here in the United States to companies with more disruptive and advanced technologies. But we've certainly seen that become a much more prominent theme in Europe, and we certainly expect that trend to continue, and as I indicated, you've seen it reflected in a lot of the European equities that have exposure to the defense investments.
Janet Wilkinson 13:58
Peter. Let's look at the EU's role here. The EU has been vocal about providing cohesion on defense policy, but decision making is still dominated by individual governments. What role is the EU actually playing in defense spending and how much influence does it really have?
Peter Schaffrik 14:17
Yeah, it's a great question. Janet, so again, if I, if I start with the short answer is, it’sa limited role, as you point out. I mean defense is the ultimate national sovereignty of the single countries. And with all the integration that has happened in other areas, the integration in European defense is relatively limited. And what the EU has done this time around is they have set up a new funding vehicle to the tune of 150 billion that can be tapped by various countries, where the EU goes to the market issuers and then gives a loan to other European countries for defense spend. Now, in the greater scheme of things it is actually quite small. Because first of all, probably not all of that is going to be tapped. Some countries, such as Germany, the Netherlands, have cheaper funding costs than the EU themselves, so there's no need for them to tap the EU. And secondly, it's supposed to run over multiple years, so the actual year on year impact is probably quite limited. So in my mind, from that angle, the heavy lifting will have to be done by the various nation states. Now, what the EU is also trying to do is it tries to create more cohesion, as you said, by encouraging, for instance, European nations to do procurement together jointly. But again, whether or not that ultimately bears fruit remains to be seen. So the clearest pathway that they have is through the financial markets, through the financial umbrella. But as I said, even there, the role is relatively limited.
Janet Wilkinson 15:47
Now Ken, as we close out on the podcast, given your close proximity to U.S defense strategy and its impact on the global defense industry, are there any other key trends or strategic shifts that you think investors and industry leaders should be paying close attention to in the coming months.
Ken Herbert 16:07
Yeah, thanks, Janet. It's a great question. Let me just provide a few highlights. The first I would say, as you look at defense spending here in the United States, Secretary of Defense Hegseth released a memo a few weeks ago now that called for basically an 8% cut in existing defense spending to make room for investments in new areas. They weren't calling for an absolute cut to defense spending, but clearly trying to signal that they want to accelerate a shift toward new priorities. So as we look at our coverage universe and spending here in the United States, companies with more exposure to areas of legacy defense spending, clearly at more risk of some slowdown there. But as part of this spending shift, the department identified 17 areas that are high priorities, and these include areas around space autonomy, cyber, nuclear and the nuclear modernization efforts here in the United States, missile defense, amongst a number of other areas. So it's pretty clear that the pivot away from some legacy programs, ground based systems as one example, to free up money to really invest in the higher priority areas for the new administration, should hit the ground fairly quickly. Here, we look for details of this specifically associated with the fiscal 26 defense budget request here the United States, which we expect to get at the end of April or in early May. And I would say, with all of this, we've just seen a lot more disruption in the legacy defense industry and how that ultimately translates to procurement reform and structural shift in sort of the risk appetite or risk burden of the industry still to be determined, but I think it's pretty clear that you've seen better performance of smaller cap defense stocks that tend to lean into more of these new technologies, and an expectation that the private companies, or companies that are known as more disruptors in the industry, will continue to really be net benefactors as you think about U.S. defense equities and opportunities here moving forward.
Janet Wilkinson 17:58
This has been a fascinating discussion on UK, European and US defense strategy and the economic implications of Trump's policies. Thank you both to Peter and Ken for sharing their insights.
Ken Herbert 18:12
Thanks, Janet.
Peter Schaffrik 18:13
Thank you again for having us, Janet.
Janet Wilkinson 18:15
And thank you all for tuning into Partner of Choice, an RBC Capital Markets podcast recorded on the 20th of March 2025. And if you enjoyed this episode, please share it with your peers.