A sharp pullback in European defence shares, down roughly 20-40% from early October, has raised an obvious question: is this the moment to take another look at the sector?
Citi’s latest note argues that the sell-off looks overdone and that Europe’s defence budgets are likely to keep climbing regardless of whether the war in Ukraine cools. For UK-listed names such as BAE Systems, Babcock and QinetiQ, that backdrop matters.
Citi’s analysts frame Europe’s changing mood through a familiar idea: deterrence. In their view, even a ceasefire in Ukraine would merely start the clock on Russia rebuilding its capabilities.
They lean on three priorities they believe guide the Kremlin: tightening control at home, extending influence into former Warsaw Pact countries and undermining NATO’s credibility.
A scenario they highlight underlines the stakes. In recent months, Russian jets have entered Estonian airspace, triggering Article 4, the mechanism for urgent NATO consultations.
The report sketches one possible escalation: a limited Russian move into Narva, an Estonian city with a largely Russian-speaking population. Estonia would likely invoke Article 5, NATO’s mutual defence clause.
While each country can choose what “necessary” action means, a disjointed response would risk fracturing the alliance’s credibility.
The EU has its own mutual defence clause, Article 42.7, which the European Parliament considers at least as stringent as Article 5. Breaking it, the analysts note, would test not just security commitments but the cohesion of the bloc itself.
This is one reason Brussels and Berlin have been vocal about raising defence spending, with Germany aiming for 3.5% of GDP by 2029, well ahead of NATO’s 2035 benchmark.
For markets, the direction of travel is what matters. Citi expects European defence budgets to continue rising to that 3.5% level even if peace talks progress or fiscal pressures bite.
That is a supportive backdrop for contractors exposed to procurement growth and for investors deciding whether recent share price weakness is a buying opportunity.
The note includes a chart comparing expected profit growth to procurement budgets across major contractors up to 2035.
For UK stocks, BAE Systems PLC (LSE:BA.) and Babcock International PLC (LSE:BAB) stand out for relatively modest “multipliers”, meaning the extent to which profit growth must outpace procurement budgets to justify current valuations. BAE’s implied multiplier is 1.0x, while Babcock’s is 1.1x.
In practice this means neither company is priced for heroic outperformance. QinetiQ sits lower still with a 0.7x multiplier, helped by conservative market expectations for its earnings.
These are dry metrics, but the point is straightforward. The market is not assuming a boom in profits. That gives some cushioning if budgets rise more slowly than expected and leaves room for upside if governments accelerate programmes or shift a greater share of spending to domestic suppliers, something Citi suggests could happen.
Investors will know that the sector’s fortunes can swing with geopolitics. But defence spending moves in long cycles, and Europe appears to be entering a more sustained one.
For UK-listed contractors, diversified BAE, turnaround-minded Babcock and the test-and-evaluation specialist QinetiQ, the environment looks more supportive than share prices imply.
The sell-off may have been triggered by hopes of peace, but the budgets that underpin this industry seem unlikely to retreat with it.
