“Forget AI. The big trade last year was to buy the idea that Europe has finally woken up to the need to spend big to defend itself.
But, after the best year ever for German defense stocks, investors now face the question of whether the trade is already over.
For those who haven't been paying attention, start with the case for investing in defense. Fracturing geopolitics and concern about U.S. defense guarantees have combined with events in Ukraine to push European politicians, led by Germany, to commit to massive increases in military spending. The nationalistic shift and threats to supply chains have persuaded Europe to break with its traditional willingness to rely on foreign military suppliers, too.
And not just Europe. "There's been a fundamental shift in priorities away from economic efficiency and globalization towards national security and resilience," says Thomas Mucha, geopolitical strategist at Wellington Management.
Given all the extra money likely to come into defense companies, how could their stock prices not beat the market?
There are two risks: price and politics, where a lesson from the fall of the Berlin Wall should induce caution. Prices have soared, so a positive outlook for military spending is already reflected in the jump in stocks.
Sure, Germany's spending has risen from just over 1% of gross domestic product a decade ago to more than 2% last year, with plans to rise to 3.5% before 2030. But German defense stocks -- dominated by the tank maker Rheinmetall -- more than tripled in the first nine months of last year, before easing a little.
Profits will rise a lot, but they need to. The German sector trades at 38 times forecast earnings, up from 20 times at the start of last year and far above the 15 times of the German market as a whole.
The politics argument is that as governments spend a lot more on defense, they will want to control how much of that leaks out again in the form of profits for shareholders. That's especially the case when companies are likely to be much more reliant on domestic sales than in the recent past.
"We're talking about large public spending which will most likely be under scrutiny," says Vincent Mortier, chief investment officer at Amundi. "The bigger they grow, the more there will be" political pressure on margins, he says.
Here we come to the lesson from the fall of the Berlin Wall. U.S. weapons manufacturers actually performed better in the years since the end of the Cold War than during it. That's despite U.S. military spending plummeting from around 7% of the economy in 1988 to about 3.7% today, as politicians spent the peace dividend elsewhere.
From just before the Wall fell to now, the "guns" sector had the third-best total return out of 49 U.S. sectors defined by Kenneth French, a Dartmouth finance professor. It came in behind software and microchips. Aerospace, where major defense stocks including Boeing sit, also did well, coming in sixth.
But from 1963 to 1988, the double splurge in spending for Vietnam and the Cold War did little to help military stocks. They came in 25th. At the top were the sectors that might be more associated with a peace dividend: tobacco ("smoke" in Prof. French's definition), "fun," "meals" and "soda."
This counterintuitive ranking wasn't because the period included the Swinging Sixties. It's politics. For all the left-wing concern at the time about the military-industrial complex, profit margins were much lower in the 1980s than since 2010. They hit their highest in 2022, in data going back to the early 1980s.
Some of the post-1989 margin improvement is because companies were allowed to merge, although that has been true of other sectors. Some of it is because corporate taxes came down.
But I would argue a lot is because companies increasingly sell to foreign customers that have less ability to extract lower prices by pointing to fat profits. Smaller domestic military budgets also reduce the need for companies to kowtow to politicians by maintaining unprofitable operations in their districts or supporting civilian projects.
Investors betting on how much of the peace dividend will return as spending on defense should also focus on how much of it will be allowed to flow through to shareholders of arms manufacturers, especially in Europe. Guns might be less lucrative than you think.” [1]
1. Streetwise: European Defense Bet Is Pricey. Mackintosh, James. Wall Street Journal, Eastern edition; New York, N.Y.. 02 Mar 2026: B1.
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