Episode Details

Morgan Stanley Research looks at how the European defense industry might respond to military spending pressure from the Trump administration.

----- Transcript -----

Paul Walsh: Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's Head of Europe Product.

Ross Law: And I'm Ross Law, Head of the European Aerospace and Defense Team.

Paul Walsh: Today, we're discussing the outlook for European defense amid renewed pressure for more military spending from the Trump administration.

It's Monday, the 27th of January, at 9.30am in London.

Now Ross, the new Trump administration is now in place, and shifting NATO's defense burden to Europe is a top priority for President Trump. In fact, President Trump has made several comments throughout his campaign and after taking office. He has suggested that Europe should increase defense spending to 5 per cent of GDP. And just for reference, right now, many European countries are at or above NATO's target of spending 2 per cent of GDP on defense.

What's your reaction? Are President Trump's demands of 5 percent realistic?

Ross Law: In short, we don't think so. In a perfect world, yes, 5 per cent is exactly where Europe should be, to make up for the huge underspend that we've seen over the past three decades since the end of the Cold War, which we've calculated at around the $2 trillion mark. There's also a desire in Europe to reduce its reliance on the US, particularly under a Trump presidency. But we see the 5 per cent spending level as unrealistic on multiple fronts.

Firstly, from an economic perspective, given the lack of fiscal headroom in Europe; and for reference, 5 per cent would require an additional $600 billion of spend annually. Secondly, from a political perspective, given multiple pockets of uncertainty, and the fact that a rise in defense spending may mean a cut to spending elsewhere. And lastly, from an industry perspective, given the multi-decade underspend I mentioned, we don't think the industry could absorb anywhere close to such a strong increase in demand, at least near-term.

So, while we do see upside pressure to European defense spending, our base case is that 3 per cent could be a more reasonable target. Not only would this be a compromise between the current 2 per cent target and Trump's 5 per cent demands; it would also allow Europe to match the spending levels of the US, which is expected at around 3.1 per cent in 2024. Even still, this would represent a 50 per cent increase or around $200 billion per year in additional European spent. This would, of course, further improve industry fundamentals and why we remain very positive on the sector.

Paul Walsh: And as of now, Europe is heavily dependent on the U.S. for its defense. According to various data sources, more than 50 per cent of European arms imports came from the U.S. in 2019 through 2023, and that's up from 35 per cent in 2014. Given this, what steps would Europe need to take to reduce its dependence on the U.S.?

Ross Law: The first step is to invest in the defense industrial base. Europe buys equipment from the U.S. for several reasons. Firstly, because the U.S. develops some of the most advanced technologies in the world because it has consistently invested in its defense industry. Secondly, because the U.S. equipment is often cheaper due to the benefits of scale. And thirdly, because it supports the very unique relationship between Europe and the U.S., which has essentially provided a security umbrella for the past three decades.

So, Europe needs to invest, both to develop capabilities and technologies to rival U.S. peers, and also to expand capacity so that we can meet our own equipment needs. This, of course, all requires investment and also time. So, Europe will remain reliant on the U.S. for ma