(The views expressed here are those of the author, an

investment strategist at Panmure Liberum.)

By Joachim Klement

June 10 - European defence stocks have been on a tear

since the devastating conflict in Ukraine started in 2022, a

trend that has only accelerated since announcements of European

rearmament plans. But the beneficial economic impact of the

European defence supercycle may be heavily dependent on how it's

financed.

The Stoxx Europe TMI Aerospace & Defense index has posted

annualised returns above 40% since February 2022. Earlier this

year, some investors thought the defence rally might slow as a

ceasefire in Ukraine started to seem more likely. But ceasefire

hopes have been dashed for now, and the NATO summit on June

24-25 may see European countries boost their commitments to

defence spending even more.

NATO General Secretary Mark Rutte recently said he expects the

bloc to agree at the summit to increase defence spending to an

eye-catching 5% of GDP, with 3.5% of that directed to 'hard'

defence like weapons, personnel, and infrastructure. The rest

would be dedicated to measures like home defence and civilian

preparation.

But even this 3.5% target is ambitious. Currently, only

Poland meets this target, while the U.S. and Estonia come close

at 3.4% of GDP.

The amount of spending being proposed here is enormous. For

example, if the UK, France, Spain, and Italy were to raise

defence budgets to 3.5% of GDP by the mid-2030s, they would each

have to increase their annual defence spending by about $40

billion. In total, NATO members would have to boost their annual

defence budgets by around $375 billion.

For context, the global aerospace and defence market currently

has annual revenues of roughly $1.3 trillion, and Europe's

defence industry accounts for about a quarter at $330 billion.

SHOT IN THE ARM

Increased defence spending could help Europe overcome its

persistent growth challenge. Going back to 1960, every euro

spent on defence has increased European GDP growth by around one

euro as well. This fiscal multiplier is at the upper end of the

0.6 to 1.0 range that academic studies about the U.S. typically

find.

Moreover, as European defence spending increases, the fiscal

multiplier rises as well because the region's defence industry

capacity remains severely constrained, so contractors are forced

to quickly hire new employees at higher salaries or build new

facilities, amplifying the impact of the fiscal stimulus.

For example, German defence contractors like Rheinmetall and

Hensoldt had to borrow workers and entire factories from other

businesses like Continental and Bosch to keep up with the

increased demand from the Ukraine war.

Importantly, if NATO agrees to further expand defence

spending into the 2030s, even if the Ukraine conflict ends, they

can provide European defence companies with the confidence they

need to build new factories, hire employees, and train

much-needed specialists to overcome these capacity constraints.

AT WHAT COST?

The main challenge will almost certainly not be the region's

willingness to re-arm, but rather how to pay for it.

In the case of the United Kingdom, the British government last

week published its strategic defence review, which sets out a

plan to get the country war ready and increase defence spending

to 3% of GDP in the next parliament between 2029 and 2034.

Unfortunately, barring any major surprises at the 2025

spending review to be published on June 11, the UK government

will continue to stick to its fiscal rules and limit investment

spending to an annual real growth rate of 1.3% until 2030.

The Institute for Fiscal Studies has calculated that by adhering

to these rules, increasing defence spending will have to come at

the expense of non-defence investments.

This means that any boost to growth from increasing defence

spending in the UK could be offset by the negative impacts of

deteriorating civilian infrastructure and public services, such

as healthcare and education.

Another option, which may be more economically beneficial

long-term, is financing increased defence spending with

additional debt issuance, as the EU plans to do with its

Readiness 2030 initiative.

This will mean reforming self-imposed fiscal rules. But if

running larger deficits now can boost growth, this should keep

debt-to-GDP ratios under control, create jobs, and help to

secure Europe's future.

True, increased deficits risk drawing the ire of bond

vigilantes. But the market reaction to the announcement of

Readiness 2030 and Germany's huge infrastructure package

suggests that bond investors are fine with additional deficits

as long as the money is expected to be spent on productive

investments. While government bond yields rose briefly after

these spending plans were announced, they have already reversed

these moves.

The biggest risk is that the spending does not prove as

productive as expected, which could eventually lead Europe into

another debt crisis, but given the enormous economic and

security challenges that the continent faces, this may be a risk

worth taking.

(The views expressed here are those of Joachim Klement, an

investment strategist at Panmure Liberum, the UK's largest

independent investment bank).

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(Writing by Joachim Klement. Editing by Anna Szymanski and Mark

Potter.)