Back to the future

European defence wakes up to new reality

The peace dividend is shrinking. Conflict in Ukraine marks the end of an era of falling western European military budgets that has lasted 25 years. Defence sector share prices already reflect the new reality.

After 1989, it looked like a wasteful anachronism to keep vast territorial armies to defend Europe's borders against an external aggressor. Out-of-area missions were seen as the military's core task. Defence budgets, expressed as percentages of GDP, shrank. The United States aside, Nato members cut their spending in half, data from the Stockholm International Peace Research Institute shows. In 2013, only a small minority of Nato's 28 members spent at least two per cent of GDP on defence, as the alliance suggests they should, according to SIPRI.
 
Until very recently, further spending declines seemed imminent as campaigns in Iraq and Afghanistan came to a close. That raised the importance of the civil businesses of defence specialists such as BAE Systems, EADS, and Thales.

But Russia's annexation of Ukraine has challenged Western Europe's security assumptions. The NATO summit on September 4 and 5 saw members spending less than the threshold agree to halt any decline in expenditure and to move it towards the target within a decade. NATO countries close to Russia are already ramping up military spending. Poland is going to spend 18.5 per cent more in 2015 than this year, driving its defence budget to an all time high of 2.3 per cent of GDP. The Czech Republic, Lithuania and Latvia are also planning increases. Western Europe's response may be less pronounced but it too is unlikely to ignore the fact that Russia is among the countries with the fastest-growing defence budgets.

The Euro Stoxx Aerospace and Defence index is up almost eight per cent since early August, and has outperformed the wider market. That's partly because the shares were, and still are, trading a discount to the market average. But it also rationally reflects a revaluation of defence priorities in the coming decade.