Trump ramping up pressure on EU and UK defense policy
The narrative coming out of Washington is impacting both policy and markets across the Atlantic. Schaffrik underlines the German position which contrasts with Trump’s call for a NATO-wide 5% GDP increase in defense spending: “Germany has been running this dead break that limits how much deficit they can have in any given year; they have just reformed it in a way that excludes any defense spending north of 1% of GDP.”
Other European countries face different military financing issues. “While Germany enjoys low debt GDP levels, France and the UK are not in such a privileged position and therefore cannot simply fund by issuing more debt,” explains Schaffrik.
The million euro question is whose economy will benefit from the rapid shift in defense spending – will budgets will be spent domestically or flow to US defense firms? “The Europeans and the Germans in particular would like to spend as much at home as possible. Whether an intended or unintended consequence of Trump’s policies, they would like more independence from the US military,” says Schaffrik.
While 78% of EU defense spending currently goes abroad, primarily to the US, Europe doesn’t have the production capacity for various military equipment. While we await the tariff announcement, the European bargaining chip may be to increase military spending going into the US.
“The Europeans and the Germans in particular would like to spend as much at home [on defense] as possible.”
Peter Schaffrik, Chief European Macro Strategist
Is Europe seeking less dependency amid a US kill switch?
Historically, confidence in business continuity and continued support service upgrades have made US hardware a success in the European market. Not to mention the interoperability that comes with matching hardware from a European country with what’s being used by the US military. However, there is speculation that a political fallout with Washington could see European governments lose access to key software updates or military systems.
“The US kill switch is a very legitimate risk. Lockheed’s F-35 fits very well for the European theater. But there’s a clear preference for ‘buy European’ where there’s capability in Europe. While we would be cautious that any European countries would cancel booked orders, future order activity remains uncertain. However, US firms continue to offer competitive advantages, and it’ll take the European industrial base years to catch up,” explains Herbert.
Industrialization and capacity are two key areas of constraint, and opportunity, for European countries with a clear preference to source more from domestic suppliers. “We expect a lot of the investment to support longer-cycle defense investments, such as fixed wing aircraft and missile defense. While benefits won’t be seen in the immediate term, it’s likely we’ll see significant infrastructure investments to support a European industrial base, which arguably has been underfunded for quite a period of time,” says Herbert.
Areas such as combat aircraft, surveillance and reconnaissance capability and next-generation battlefield technology are also under the microscope. “Europe has been acutely aware of the lessons of Ukraine, but then also in the longer term, of where they need to strengthen their industrial base,” continues Herbert.
But who will have to pull their weight? Despite political and economic cohesion across the EU, military decision making by Brussels is still limited. “Defense is ultimately the national sovereignty of member countries,” explains Schaffrick. While there is a new funding vehicle to the tune of 150 billion EUR for member states to tap into, it’s spread across multiple years. “Moreover, countries like Germany and the Netherlands have cheaper funding alternatives,” says Schaffrik.
“Ultimately the heavy lifting will have to be done by the various countries. That being said, the EU is driving for more cohesion by encouraging nation states to do procurement together, jointly. The clearest pathway for that is through the financial markets, but the EU’s role remains limited,” concludes Schaffrik.
“We’ll see significant infrastructure investments to support a European industrial base, which arguably has been underfunded for quite a period of time.”
Ken Herbert, Senior Aerospace and Defense Analyst
Investment flows: Bonds and equities react to surge
The markets have seen an immediate upward shift in European bond yields across the curve, but particularly at the longer end of the curve, suggests Schaffrik. “More supply means a lower price means a higher yield. This could also precede a GDP boost which, in an already tight labor market, may mean the central bank’s rate cut could be lower than anticipated, potentially pushing up shorter dated yields too,” he explains.
The steepening curve also increases risk perception, with investors potentially demanding a higher risk premium for longer rated maturities.
“While Germany has accepted that yields have shifted higher, with a higher funding cost going forward, other European nations are desperately trying to avoid the same situation,” concludes Schaffrik.
From a European defense sector equities perspective, there’s been a significant increase in value. “We’ve seen, give or take, a 100 billion EUR increase in the equity value of European defense equities, which offsets the decline in market value we’ve seen with US defense primes since the election of President Trump,” explains Herbert.
While US defense companies have limited direct exposure to Europe, there is a strong, ongoing structural shift in European defense spending and investor sentiment. “We’re watching the US fiscal 2026 budget with renewed interest, especially the focus on disruptive technologies, which is a prominent trend in Europe – reflected by the increasing value of equities in these investments,” concludes Herbert.
“We’ve seen, give or take, a 100 billion EUR increase in the equity value of European defense equities.”
Ken Herbert, Senior Aerospace and Defense Analyst
Investor outlook: re-prioritizing defense tech over legacy systems
Markets are preparing for a cut in defense spending in the US. “Secretary of Defense Hegseth called for an 8% cut in existing defense spending to make way for investment in new areas. Companies with more exposure to legacy defense spending are at more risk of some slowdown here,” says Herbert.
The pivot away from some legacy programs, such as ground-based systems, is an attempt to free up money to invest in higher priority areas such as space autonomy, cyber, and nuclear modernization.
“Disruption in the legacy defense industry ultimately translates to procurement reform, while the structural shift in risk appetite or burden is yet to be determined.” Herbert underscores the positive performance of smaller cap defense stocks that lean into new technologies. “Disruptor companies in the industry are likely to be the net benefactors in the shifting US defense equities market,” he concludes.
