Europe's Rearmament:
The New Investment Megatrend

1. Introduction: The End of the Peace Dividend

For three decades after the fall of the Berlin Wall, European nations systematically reduced their defense budgets, channeling the so-called "peace dividend" into social spending and economic development. Between 1990 and 2020, European NATO members' defense spending as a share of GDP fell from an average of 2.8% to just 1.5%, well below the Alliance's 2% target. Armies shrank, equipment aged, and defense industrial capacity atrophied. Germany, Europe's largest economy, did not meet even the 2% NATO threshold until 2024 — the first time in more than 30 years.

That era is definitively over. Russia's invasion of Ukraine in February 2022 served as the initial catalyst, but the acceleration in 2025-2026 — driven by the failure of peace negotiations, rising tensions with Iran, and a more transactional U.S. approach to European security under the Trump administration — has transformed European rearmament from a political aspiration into an industrial and financial reality of historic proportions.

At last year's NATO Summit in The Hague, European allies made a pivotal commitment: raising core defense spending to 3.5% of GDP by 2035, with an additional 1.5% earmarked for broader security-related investments, bringing total defense-related spending to 5% of GDP. To put this in perspective, for Germany alone this implies annual defense expenditures rising from €86 billion in 2025 to potentially €250+ billion by 2035 — a transformation in European fiscal priorities not seen since the early Cold War.

For investors, this shift is no longer speculative. It is backed by constitutional amendments, multi-year procurement contracts, and record order backlogs. The question is not whether European defense spending will increase, but how fast, how much, and who benefits most.

2. Germany's Zeitenwende: The €108 Billion Signal

Germany's transformation is the clearest expression of Europe's rearmament. Three days after Russia invaded Ukraine in February 2022, then-Chancellor Olaf Scholz announced a "Zeitenwende" — a turning point — and established a €100 billion special fund to modernize the Bundeswehr. To do so, Scholz had to amend the Basic Law, Germany's constitutional framework. The significance of this step cannot be overstated: a country that had defined its postwar identity around pacifism and fiscal restraint was fundamentally rewriting its social contract.

The initial €100 billion fund, while welcomed, proved insufficient. Under Chancellor Friedrich Merz, who took office in early 2025, Germany has gone much further. The 2026 defense budget totals approximately €108.2 billion — comprising €82.7 billion from the regular budget (a €29.4 billion increase over 2025) plus €25.5 billion from the Zeitenwende special fund. This represents roughly 2.8% of GDP, nearly triple the level of just four years ago.

The procurement pipeline is staggering in its scope. According to official documents and defense reporting, Germany plans to acquire up to 1,000 Leopard 2A8 main battle tanks, 3,500 Boxer armored vehicles, 5,000 Patria 6×6 trucks, new Patriot/MEADS air defense batteries, long-range missiles, and 35 F-35A Lightning II strike aircraft from Lockheed Martin, with the first deliveries expected in 2026. The budget allocates approximately €15 billion for ammunition alone, and €8-9 billion annually for Ukraine assistance.

Crucially, German defense manufacturers are the primary beneficiaries. Of the total procurement spending, €182 billion is earmarked for German companies. Rheinmetall AG alone will receive orders worth €88 billion, including 687 Puma infantry fighting vehicles, up to 3,500 Boxer armored vehicles, and 561 Skyranger 30 anti-aircraft systems. Diehl Defence is expected to supply €17.3 billion worth of IRIS-T surface-to-air missiles. Only about 10% of new procurement is expected to come from U.S. manufacturers — indicating a deliberate effort to strengthen the European defense industrial base.

Chancellor Merz's stated goal is unambiguous: to make the Bundeswehr "the strongest conventional army in Europe." Germany has also announced plans to spend nearly €650 billion over five years to hit the NATO spending target. The constitutional debt brake — long considered sacrosanct — has been suspended for defense spending above 1% of GDP. A separate €500 billion infrastructure special fund provides additional fiscal flexibility. These are not incremental adjustments; they represent a generational transformation of Germany's fiscal framework.

3. The Broader European Picture

Germany is not alone. Across the continent, defense budgets are surging. Poland has emerged as NATO's most aggressive spender, allocating over 4% of GDP to defense — the highest in the Alliance. The Baltic states, Finland, and Sweden (which joined NATO in 2024) are all investing heavily in military capabilities. France has committed to its Military Programming Law (LPM) of €413 billion for 2024-2030, and the UK has pledged to reach 2.5% of GDP by 2027.

The European Commission has also stepped in with institutional support. The EU Readiness 2030 plan explicitly identifies capability gaps across air and missile defense, artillery, ammunition, drones, and technologies of strategic importance — AI, quantum computing, and space capabilities. The European Investment Bank has tripled its defense loan scheme from €1 billion to €3 billion, while major European banks have signaled their willingness to increase defense industry allocations.

The shift in ESG attitudes has been particularly notable. For years, many institutional investors excluded defense stocks on ethical grounds. That is changing rapidly. As the security environment deteriorates, European pension funds and insurance companies are reassessing their investment mandates. The argument that "defense is not ESG-compatible" is increasingly difficult to sustain when democratic nations face existential security threats.

4. The Numbers Behind the Boom

The financial impact on defense companies has been extraordinary. The STOXX Europe Total Market Aerospace & Defense Index gained over 65% in 2025. European defense companies' order books rose by 15% in 2024, with combined free cash flows reaching a record €8 billion, according to Fitch Ratings. European defense M&A deal value reached $2.3 billion in H1 2025 alone, a 35% year-over-year increase.

Rheinmetall exemplifies this transformation most dramatically. The Düsseldorf-based defense manufacturer reported 2025 revenue of €9.9 billion (+30% YoY), with an operating profit reaching a record €1.8 billion (18.5% margin). The order backlog surged 36% to €63.8 billion. For 2026, the company projects revenue of €14 to €14.5 billion — an increase of up to 45% — and expects the backlog to more than double to €135 billion by year-end. Management forecasts operating margins expanding to approximately 19% for 2026. CEO Armin Papperger stated: "The world is changing rapidly, and Rheinmetall is well prepared." Financial analysts surveyed by the company now forecast revenues surpassing €42 billion by 2030 — a projection that would have seemed fantastical just three years ago.

The M&A activity in the sector is also accelerating. Rheinmetall acquired U.S. manufacturer Loc Performance Products for $950 million, gaining access to American military vehicle supply chains. French aerospace firm Safran purchased AI defense startup Preligens for €220 million. German defense AI startup Helsing raised €600 million in a Series D round. Private equity firms are increasingly entering the space, with Tikehau Capital, BOKA, and Marondo launching dedicated defense-focused funds.

5. The Italian Angle: Leonardo S.p.A.

Leonardo S.p.A., Italy's national defense and aerospace champion, is particularly well-positioned in this rearmament cycle. The company operates across four main divisions — Helicopters, Defense Electronics & Security, Aircraft, and Cyber & Security Solutions — giving it exposure to multiple segments of the defense spending wave.

Leonardo is a key partner in several critical European defense programs. The company participates in the Airbus-Thales-Leonardo joint venture for European satellite defense, a strategically important initiative as NATO allies seek to reduce dependence on U.S. space capabilities. In helicopters, Leonardo's AW149 and AW101 platforms are frontrunners for multiple European military procurement programs, and the company has benefited from Italy's own defense budget increases.

Italy's defense spending, while historically below the NATO 2% target, has been rising steadily. The Italian government has committed to reaching the 2% threshold, which would imply annual defense expenditures of approximately €40-45 billion — a significant increase from current levels. For Leonardo, this means both domestic procurement growth and a stronger position in European collaborative programs.

The company also has significant exposure to the cyber defense segment, an increasingly critical area as state-sponsored cyberattacks intensify. The recent pro-Iranian hacker attack on U.S. medical device manufacturer Stryker Corporation — which experienced a "global network disruption to our Microsoft environment" — underscored the vulnerability of Western industrial companies and the growing strategic importance of cybersecurity capabilities.

6. Defense ETFs: Access Points for Investors

ETF	Ticker	AUM	Expense Ratio	Focus	Key Holdings
iShares U.S. Aerospace & Defense	ITA	$13.3B	0.40%	U.S. defense majors	RTX, LMT, GD, NOC
Global X Defense Tech	SHLD	$2.8B	0.50%	Defense technology	Palantir, L3Harris, Leidos
Invesco Aerospace & Defense	PPA	$4.2B	0.58%	Broad A&D	GE Aerospace, RTX, Boeing
SPDR S&P Aerospace & Defense	XAR	$3.1B	0.35%	Equal-weight A&D	Diversified across 30+ names
Themes Transatlantic Defense	NATO	$1.2B	0.45%	US + European defense	Rheinmetall, BAE, LMT
Select STOXX Europe A&D	EUAD	$0.8B	0.50%	European defense pure-play	Rheinmetall, Leonardo, Thales

For investors seeking European defense exposure specifically, the NATO ETF and EUAD ETF offer the most direct access. EUAD is a pure-play on European defense spending, while the NATO ETF provides a transatlantic blend. For those who prefer U.S.-focused exposure, ITA remains the largest and most liquid option with $13.3 billion in AUM. Investors should note that European defense names have already re-rated sharply, while U.S. counterparts like Lockheed Martin, RTX, and General Dynamics remain relatively discounted — a valuation gap that could narrow as U.S. spending accelerates under the proposed $1.5 trillion Pentagon budget for fiscal year 2027.

7. Key European Defense Companies

Company	Country	Market Cap	2025 Revenue	Order Backlog	Key Segment
Rheinmetall	Germany	€45B	€9.9B	€63.8B	Vehicles, Ammunition, Air Defense
BAE Systems	UK	£48B	£28.3B	£77.8B	Naval, Electronic Systems, Cyber
Leonardo	Italy	€18B	€17.8B	€44B	Helicopters, Electronics, Cyber
Thales	France	€38B	€20.6B	€48B	Radar, Space, Digital Security
Saab	Sweden	SEK 250B	SEK 56B	SEK 148B	Gripen Fighter, Submarines, Sensors

8. The Technology Shift: From Hardware to Software

A critical aspect of the current rearmament cycle that distinguishes it from previous periods is the shift from hardware to software. Modern defense is increasingly about AI-enabled systems, autonomous drones, digital command networks, and cyber capabilities. This shift is reshaping the economics of the defense industry.

According to Global X, defense technology companies delivered 29% year-over-year EPS growth in Q3 2025 — nearly twice the earnings growth of the S&P 500. Defense tech operating margins are forecast to expand over 230 basis points in 2025, with another 120 bps expected in 2026. The gains reflect software-driven business models that differ fundamentally from traditional defense contracting, with digital platforms generally carrying higher margins and more predictable recurring revenue.

The war in Ukraine has been a proving ground for these technologies. Drones, in particular, have transformed the battlefield in ways that were not fully anticipated. Germany has responded by investing in Collaborative Combat Aircraft (CCA) — autonomous "loyal wingman" systems — with the aim of fielding this capability by 2029. Companies like Quantum Systems (UAVs), ARX Robotics (autonomous vehicles), and STARK (loitering munitions) are thriving at the civilian-military technology edge.

For the Bundeswehr specifically, the budget reflects lessons drawn directly from Ukraine. The rate of ammunition expenditure in the conflict is significantly higher than under previous operational assumptions. Intelligence and space capabilities have proven critical — the modern battlefield is transparent, with satellite and drone surveillance providing real-time intelligence. Consequently, the Bundeswehr is investing billions in space and cyber capabilities to close capability gaps.

9. Risks and Considerations

Valuation risk: European defense stocks have already re-rated sharply, with the STOXX Europe Aerospace & Defense index gaining 65%+ in 2025 and European defense stocks surging over 260% since Russia's February 2022 invasion. Rheinmetall trades at approximately 26x 2026 earnings. While fundamentals support continued growth, the near-term entry point is less attractive than 12-18 months ago. Janus Henderson notes that "despite strong early-2026 gains, markets continue to underestimate the scale and longevity of Europe's defense spending cycle" — but investors should be aware of the risk of buying momentum at elevated multiples.

Execution risk: Translating political commitments into actual deliveries takes time. Europe's fragmented defense industrial base — dozens of national champions, different technical standards, complex procurement processes — could delay realization of spending targets. The Atlantic Council notes that Germany's procurement system has historically been "complex and often confusing," and while new legislation (the Bundeswehr Planning and Procurement Acceleration Act) aims to streamline procedures, capacity constraints are real. A shortage of up to 10,000 civil engineers needed to implement infrastructure projects illustrates the execution challenges ahead.

Political risk: Defense spending remains politically sensitive in many European countries, despite shifting public attitudes. A German ARD survey in March 2025 found that 66% of respondents supported increased defense spending — but 31% believed spending should remain the same or be cut. If economic conditions deteriorate (especially in a stagflationary environment driven by high oil prices), public tolerance for defense spending could weaken.

Supply chain constraints: Munitions manufacturers across Europe and the U.S. face severe backlogs and limited capacity to scale production. While funds have been allocated and orders placed, the defense industrial base needs time to expand — training workers, building new production lines, and qualifying new suppliers. This is a multi-year process that cannot be accelerated infinitely with money alone.

10. Conclusion: A Theme, Not a Trade

Europe's rearmament represents one of the most significant structural investment themes of the decade. Unlike cyclical defense spending driven by individual conflicts, the current cycle is driven by a fundamental reassessment of European security architecture — a process that will span well over a decade. Global defense spending is projected to increase by roughly a third to $3.6 trillion by 2030, with European spending potentially doubling.

The key insight for investors is that this is not a trade, it's a theme. The multi-year procurement contracts, constitutional amendments enabling sustained borrowing, and bipartisan political support across Europe provide a level of spending visibility that is unusual in any sector. Companies with strong order backlogs, technology differentiation, and exposure to the fastest-growing segments — drone warfare, missile defense, cyber security, AI-enabled systems, and space — are best positioned to benefit.

For Italian investors specifically, Leonardo offers direct exposure to this theme with the added benefit of domestic procurement tailwinds. For broader European exposure, the EUAD and NATO ETFs provide diversified access. The defense sector has transitioned from a tactical trade to a strategic portfolio cornerstone in an increasingly uncertain world. As German Chancellor Merz declared: "Germany is back." The same could be said for European defense as an asset class.