After the Putin Rally, Europe’s Defense Stocks Get a Trump Bump

After years in relative obscurity, stocks such as Germany’s Rheinmetall and Sweden’s Saab rallied when Russia invaded Ukraine in 2022. There was a lull last summer when Ukraine was making good progress on the battlefield, but this winter they have rocketed again. Rheinmetall shares are up almost 60% since the start of the year.

It isn’t just that the momentum in Ukraine now seems to be behind Russia, nor that war has also broken out in Israel. A critical factor in the latest rally has been U.S. isolationism. In campaign rallies last month, presidential hopeful Donald Trump attacked the North Atlantic Treaty Organization, which guarantees American support for European security, repeating a mantra he developed in office. Meanwhile, an aid package for Ukraine is stuck in Congress.

After the energy independence push of 2022, security independence is now the talk of European capitals. European Commission President Ursula von der Leyen told a Brussels news network last month that EU member states were projected to spend 350 billion euros on defense this year, equivalent to roughly $380 billion and up from just €240 billion in 2022.

Companies have stoked investor confidence too. Rheinmetall reported Thursday that its revenue increased 12% last year, and, more importantly, said it expects growth of almost 40% in 2024. Saab last month gave guidance for top-line growth of roughly 15% annually on average through 2027—a big increase compared with its previous target of 10%.

Both companies have been early to benefit from increased military spending because they sell a lot of munitions—shells, missiles and rockets. These products are “early cycle" because militaries need to buy them upfront, says Sash Tusa, aerospace and defense analyst at equity-research firm Agency Partners. Firms such as Italy’s Leonardo, which last week laid out plans to double cash flows by 2028, are only just beginning to see a pickup in orders. Leonardo makes helicopters, radars, defense electronics and the like.

Even companies not traditionally associated with defense are suddenly touting their exposure. At an investor day on Thursday, Italian truck manufacturer Iveco, part of the old Fiat empire, pointed to a sudden acceleration in defense orders—admittedly helped by work in the U.S., where it is partnering with British defense contractor BAE Systems to supply the Marine Corps with new amphibious tanks.

One of the sector’s attractions to investors is that it has high-quality companies. Weapons are specialist products where quality matters more than price and barriers to entry are high, making the business solidly profitable when demand is strong. Rheinmetall expects to make an operating margin of between 14% and 15% this year, up from 12.4% last year.

Historically, some investors shied away from arms suppliers for moral reasons: “Ethical" investing, the predecessor to today’s environmental, social and corporate-governance factors, known as ESG, is rooted in the pacifist Quaker tradition. Defense still attracts worse ESG ratings than other sectors, but Citi says the sustainable-investing community is warming to it anyway as public and political opinion swings behind national security.

The key risk might be that growth doesn’t live up to the expectations baked into earnings multiples, which now lie above historic averages. Rheinmetall stock trades at 21 times and Saab at 27 forward times.

While large order backlogs justify such valuations in the short to medium term, any indication that the security environment is relaxing would cast a pall over the longer-term outlook. The German government’s aversion to debt is also a concern. It got around the “fiscal brake" that caps its budget deficit by setting up a €100 billion special fund for the armed forces in 2022, but it needs a longer-term solution.

One way to view European defense stocks is as a hedge against geopolitical risk, a bit like gold. Europe’s growth has been held back by higher energy prices since Vladimir Putin cut gas flows to the region, with companies such as German chemical giant BASF particularly affected. Arms suppliers are rare beneficiaries of the Russia problem, with little exposure to the macroeconomy.

Still, the trend toward higher military spending in Europe seems robust—whoever ends up in the White House. While Trump’s NATO threats are particularly provocative, President Biden’s withdrawal from Afghanistan also dismayed European leaders. The rise of China and domestic shale energy have shifted Washington’s priorities, and the change looks permanent. Europe’s arms suppliers have their work cut out filling the gap.

Write to Stephen Wilmot at stephen.wilmot@wsj.com