Some European defense stocks remain attractive despite the present volatility caused by the Trump administration’s tariff programme, according to Morningstar analysts.
Three weeks ago defense companies were surging on renewed defense spending in Europe.
European defense star Rheinmetall RHM, whose shares have more than doubled this year, fell sharply on April 3, finding itself among the worst-affected stocks in Europe. UK aerospace manufacturer Rolls-Royce RR and Italy’s Leonardo LDO, have also been caught up in the turmoil.
Amid this volatility, Morningstar fair value estimates remain unchanged. Rheinmetall, one of the biggest defense players in the table below, is still undervalued and trading in 5-star territory.
Why Has Rheinmetall Stock Done so Well?
In spite of present volatility, Rheinmetall’s stock has had an outstanding run, with shares still more than 100% higher than the start of the year.
It’s one of top defense stock pick in Europe, according to Loredana Muharremi, equity analyst at Morningstar.
Potential demand for its products as a result of fresh European defense spending still provide the company with a significant headwind.
“We maintain our European defense spending projections, reaching 3.2% of gross domestic product by 2030 ($876 billion) and 3.5% by 2032, before stabilizing around 3%,” Muharremi says.
“While equipment spending has averaged 28% of total budgets over the past four years, reaching 30% in 2024, we see this as insufficient to address decades of underinvestment.
“In the midterm, we expect Europe to prioritize inventory replenishment, with equipment spending rising to 50% of budgets in 2025-26 and 40% from 2027-30, before declining to 25% by 2034 as personnel and research and development investments grow. This aligns with Rheinmetall’s simulation discussed during the 2024 earnings call.”
Muharremi maintains her fair value estimate for the company at €2,220.
Will Rolls-Royce Continue to Recover?
British aerospace firm Rolls-Royce is popularly known for its commercial aviation engines, but its work also extends into the defense space. This has given it clear momentum in the past year, with its stock price surging. In the last five trading days it has plunged, losing 10%. Shares are still up on the start of the year and on a year ago.
Muharremi says the company is enjoying a dramatic turnaround. Though its stock price is presently volatile, there is a longer-term story investors have already identified.
“We project [Rolls-Royce’s] defense revenue to grow at an 11% compound annual growth rate in the midterm with operating margins rising from 14.2% to 15.9% by 2029,” says says.
“Additionally, Rolls-Royce has completed major debt restructuring, transforming its financial position from high leverage to a net cash-positive balance sheet while regaining investment-grade status. As a result, we reduced our cost of debt in the weighted average cost of capital calculation to align it with industry peers.
“This financial transformation is one of the most dramatic turnarounds in aerospace. With its strongest balance sheet in a decade and projected robust free cash flow, Rolls-Royce is well positioned to maintain higher shareholder returns and strategic investments.”
Muharremi maintains her fair value estimate for the company at 960p, which is above the current price of 664p.
What Will Happen to Defense Stocks Now?
This level of volatility witnessed in markets is concerning for investors. But Morningstar’s Muharremi suggest the longer-term effects of tariffs will be negative for US defense companies rather than European contractors and their UK peers.
“While it is still too early to fully assess the implications of the proposed tariffs on the defense sector, it’s important to consider the US’s role in the global defense trade,” she says.
“Although the US defense industry is largely self-sufficient in end-product manufacturing, it remains exposed to risks tied to critical raw material imports ... which are vital for systems like fighter jets, helicopters, armored vehicles, and precision munitions.
“If tariffs are extended to defense-related goods, we expect the primary impact to fall on US defense firms—through higher production costs and increased procurement prices for the Department of Defense and allied buyers in Europe.
“Given current geopolitical dynamics and the need for Europe to close its defense capability gap, we see limited likelihood of retaliatory tariffs targeting US defense exports. However, a sustained protectionist stance from the US could diminish the competitiveness of its platforms over time and accelerate intra-European consolidation.”
In the long term, Muharremi anticipates limited direct impact on European defense contractors.
“Firms such as BAE Systems BAE, Rheinmetall RHM, Thales HO, Saab SAAB B, and Leonardo LDO have already established—and in many case expanded—their US industrial footprint, in anticipation of Trump’s re-election. This local presence strengthens access to US contracts and protects against tariff risks.”
Should I Buy Defense Stocks?
Some defense stocks may be undervalued, but there are several considerations investors should build into their thinking.
One is the point made by Morningstar industrials equity analyst, Nicolas Owens: that defense rallies are very unpredictable, so investors looking to make quick money by jumping on a bandwagon with short-term goals in mind may well find themselves in the middle of some significant volatility.
Before the tariffs-related selloff, Owens said:
“Defense companies don’t react to the macroeconomic cycle. They react to geopolitics. [Rallies are] relatively rare, and they’re not cyclical. It’s not like you can predict them every six years, and they don’t ‘flex’ with GDP.”
Those words are ringing true now. As the geopolitical and market fallout from US protectionism unfolds, defense stocks are proving very unpredictable indeed.
Defense and ESG: An Ongoing Debate
A debate has also reignited about whether defense stocks should be included in ESG portfolios.
“Alongside alcohol, gambling, tobacco and pornography, armaments have long been seen by ESG investors as one of the key ‘sin’ sectors,” says Mollie Thornton, senior investment manager at platform Parmenion.
“The ESG risks related to the defense sector are well known: the impacts on human rights; the increased risk of political instability and corruption; pollution and contamination. Defence companies also significantly impact the environment. Through equipment production and dependence on fossil fuels, the world’s armed forces and the industries supplying them are reckoned to cause more than 5% of global carbon dioxide emissions.
“In our view, these remain compelling arguments why ESG portfolios should exclude defense companies. In addition, a significant and intractable problem is that investors cannot control where the weapons sold by defence companies end up. This lack of transparency is perhaps our biggest red line.”
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
