Europe Wants to Massively Increase Defense Spending, but Investors Should be Careful

Ursula Von Der Leyen, the President of the European Commission has proposed that Europe increase its defense spending by 1.5% GDP over the average 2.0% GDP European countries are currently spending on defense. She fears that Europe has to defend itself and she understands that the United States probably will not act as a savior if Europe gets into trouble. President Trump's administration is already signaling a big change in NATO. In future, according to reports circulating in Washington, NATO should be headed by either a British or French general (supposing Germany does not have any generals!). Over the years, the top NATO general always was an American. Washington wants to change that.

Ursula von der Leyen

On the whole, the European Commission proposal would amount to € 843 billion. To help member states navigate the proposed increase in spending, the EU would float loans of around €150 billion, raised on capital markets. Who would get these loans, what would be the terms and conditions, and what economies can support servicing them, is unclear.

European defense stocks surged on the news. But there is a huge gap between expectation and realization. European countries these days face serious economic problems compounded by the huge rise in energy prices in most of Europe. Germany is already in a recession and it is quietly moving some of its industry abroad, particularly to the United States.

The bigger problem, however, lies beneath the surface of Europe's defense companies themselves. Most of them are hardly competitive and the cost of defense hardware is unrealistically high, as a report by the respected European think tank Kiel Institute for the World Economy says. The Von Der Leyen proposal follows exactly the Kiel proposed increase in spending needed in Europe.

A singular problem is that more tanks and guns presupposes more troops, probably between 300,000 to 500,000 boots on the ground. Such a force simply does not exist in Europe and there's almost no prospect for building up such a force. Having warehouses full of equipment without any operators is a non-starter. Building an army requires raising and paying one. There is zero momentum in that direction in Europe. It helps explain one of the reasons why Zelensky claimed Ukraine could supply the soldiers Europe needs, but in truth Ukraine does not have the manpower, most of which is tied down in fighting the Russians and taking heavy losses. Even if peace in Ukraine is arranged, it will take a couple of generations and lots of money to recruit an army that mostly does not speak any European language. Moreover, if the reports are true about North Korean forces fighting with Russia in the Kursk region (e.g., on Russian territory), it is a bad idea as a practical matter. Why would a Ukrainian be motivated to defend Paris or Warsaw?

As a former President of the North American division of Italy's largest defense company, I know that European defense companies are inefficient, slow and rarely support the hardware that comes out of their factories. Moreover, European defense companies typically fight with each other over the doling out of production shares, further delaying manufacturing and deployment. Stuffing these companies with lots of money is likely to put them in a tailspin of greed, instead of an outflow of hardware.

Obviously there also are questions about what kind of hardware, how much, and who will make it. Not all European equipment has proven as good as advertised. One of the obvious disappointments was the Leopard tank that was not the game changer in Ukraine everyone expected. Another deficit is air defense. Europe is behind in modern air defenses, especially defenses against long range ballistic missiles. Oreshnik proved they have reason to be concerned. Looking to fix the problem, the Europeans go outside, either to the US (AEGIS Ashore) or Israel (Arrow 3). Will the new defense spending targets include imports? Probably they will have to do so, as lots of subsystems Europe needs are produced outside the EU. Should the Europeans actually raise the money the EU Commission proposes (which means each country must increase its defense spending and draw the money from its national budget), US and Israeli defense companies should get a lot of business.

U.S. Navy and other personnel at the Aegis Ashore missile defense system facility under construction outside the town of Redzikowo, Poland, in June 2019. The facility could become fully operational this spring. (Photo by U.S. Navy Lt. Amy Forsythe, Public Affairs Officer, Naval Support Facility Redzikowo)

There also is a worrisome specter of imports to Europe from problem sources, namely China. Europe is mesmerized by Russia, but not by China where they, like some of their American counterparts, are always seeking business. Already a lot of components used in military drones come from China. There is a danger that in future China could be a cheap supplier of hardware, rockets for example, and electronic subsystems (where Europe’s manufacturing base is inadequate).

In the end, proposals to significantly increase defense spending in Europe are unlikely to happen. The last 50 years of leaving the real job to Uncle Sam is over, but Europe is almost totally unprepared to act as a collective force. Some countries, Poland comes to mind, are spending on defense because they realize they must do so. Others, not so much. Big talk, low performance.

Investors in Euro-defense stocks should take note.