UK Defence Stocks: Does Defence Spending Review Herald Further Upside?

Regime shifts happen seldom, but we are seeing a strategic realignment of gigantic proportions in terms of European defence spending and posturing. The UK has just released its latest defence review, calling for major investment in key technologies and weapons to make Britain ‘war ready’. It ‘s all part of what many analysts are calling a structural rather than cyclical shift; a European defence supercycle.

Defence Secretary John Healey said "we are in a new era of threat, which demands a new era for UK defence", while outlining his defence spending plans. The UK needs "stronger deterrents" to avoid the huge costs, human and economic, that wars create, he told MPs in the Commons.

The review suggests the UK will need to spend about £68bn to prepare the armed forces for modern warfighting. The government had already pledged to increase the defence budget to 2.5% of GDP by 2027, but the prime minister did not give a precise date for when UK defence spending would hit 3% of GDP. Nato wants members to hit 3.5% as it faces up to rising threats from Russia.

In addition to boosting spending on cyber threats and drones, it also outlines the need for big ticket items such as new fighter jets, attack submarines and nuclear warheads, which could lead to major contract wins for a number of the UK’s largest defence firms.

Stocks Affected

The standout from the review among the services is the Navy, with the government pledging to boost the fleet of nuclear-powered attack submarines from seven to 12. It calls for up to 12 new attack boats developed by the UK’s Aukus partnership with the US and Australia by the late 2030s, part of a strategic shift focused on defending home waters.

BAE Systems, which builds submarines for the Royal Navy, including the Astute nuclear-powered attack class, is among the most obvious names to benefit. Shares have rallied since the announcement. The company also manufactures about four-fifths of the munitions for the armed forces and is likely to benefit from plans to build six new munitions factories in the UK.

Rolls-Royce is another that is exposed to the submarine supply chain as it builds the nuclear reactors that drive the engines. It recently reported interim results that hailed it hitting mid-term targets two years early.

Babcock, which maintains and services all of the UK’s boats, rose sharply on Monday after the announcement on submarines.

Other UK names to consider include military technology businesses Chemring and Qinetiq, as well as aerospace component maker Senior and respiratory protection specialist Avon Technologies. Among these, Chemring has just reported a record order book. The tailwinds are evident but it’s unclear whether the best of the running is already behind us.

More details about the way the spending review will impact companies directly will be included in the defence industrial strategy, which is expected in the coming weeks.

Looking further afield, Lockheed Martin manufactures the F-35 fighter jet, which the review called for more of. Helsing and Anduril may benefit from more spending on autonomous systems such as drones.

The UK’s defence splurge comes at the same time as a major realignment of European Union spending priorties favouring defence contractors such as Rheinmetall, which is Europe’s biggest munitions manufacturer. The European Commission’s Readiness 2030 programme, which is aimed to accelerate rearmament, could unleash EUR 800bn in spending.

Risks to Consider

A potential ceasefire deal in Ukraine could lead to a short-term reversal in the recent rally, though is unlikely to reduce the perceived threat from Russia.

Consider geographic diversification as US defence names are also getting a boost from the Trump administration with a $150bn one-time injection from the tax bill that is currently going through Congress.

UK defence stocks have had a good run of late – valuations are high relative to the market. According to Panmure Liberum, the sector trades at about a 55% premium to the wider market, vs a 21% discount in 2021. The last six months has clearly been positive for a number of the big names.