Why did European defence stocks, bond yields rise on Monday?

European stocks moved higher on Monday, led by a sharp rise in defense shares as governments across the continent signalled an urgent need to increase military spending.

The pan-European Stoxx 600 closed Monday’s session 0.54% higher, lifted by an over 4% jump in the Stoxx 600 Aerospace and Defense index.

The rally was driven by strong gains in major defense contractors.

Germany’s Renk Group surged 16%, while Rheinmetall rose 14%.

Sweden’s Saab added 16%, and BAE Systems in the United Kingdom climbed close to 8%, marking its best single-day performance since July 2022, according to FactSet.

The gains came after NATO Secretary General Mark Rutte stated that member nations would need to increase defense spending to significantly more than 3% of GDP.

NATO comments reinforce the defense stocks rally

Russ Mould, investment director at AJ Bell, noted that the comments from NATO leadership reinforced a trend that has been gaining momentum since Russia’s invasion of Ukraine in 2022.

“Shares in defense companies had already rallied hard since Russia invaded Ukraine as investors took the view that the shocking events would spur governments around the world to fortify their own defenses. Rutte’s comments effectively confirm this line of thinking and have acted as another share price catalyst, even though markets had already priced in a stronger earnings environment for the sector,” Mould said.

“That Donald Trump is keen for European allies to spend as much as 5% of GDP on defense adds to the narrative supporting the sector,” he added.

Investors are now anticipating larger and longer-term contracts for European defense firms as governments look to ramp up arms production and modernize their militaries.

Germany, Sweden, and the United Kingdom are among the countries that have already committed to boosting defense budgets.

In the UK, mid-cap defense firm Chemring also saw gains, benefiting from the broader optimism in the sector.

Political pressure mounts for Europe to strengthen defense

The latest surge in defense stocks coincides with mounting political pressure for European nations to take a greater role in their security.

European leaders are set to meet in Paris for an emergency summit to discuss their response to what they see as a sidelining of Europe in negotiations over Ukraine’s future.

The United States is preparing for direct talks with Russia in Saudi Arabia this week, but European representatives were invited to participate.

The exclusion has heightened concerns in Brussels and major European capitals about their diminishing role in shaping the outcome of the war.

Mediobanca Securities told clients in a research note:

“It is clear to us, that the ability of European countries to influence peace talks will be directly proportional to the additional military support that they will be able to provide to Ukraine.”

UK Prime Minister Keir Starmer, in an article published Sunday in the Telegraph, emphasized the need for Europe to demonstrate that it is serious about defense.

He stated that Britain is prepared to put troops on the ground in Ukraine if necessary and that European nations must increase military spending.

He also acknowledged that former US President Donald Trump was justified in demanding that Europe contribute more to NATO’s collective defense efforts.

At the Munich Security Conference over the weekend, European Commission President Ursula von der Leyen proposed exempting defense spending from the EU’s strict fiscal rules.

Meanwhile, NATO leaders hinted that the alliance is likely to raise its defense spending target at a formal summit in June.

Bond yields rise as markets price in higher military budgets

Investor expectations of increased defense spending extended beyond equities, affecting bond markets as well.

Traders adjusted their positions based on the likelihood that governments would have to issue more debt to finance military budgets.

The UK’s 10-year government bond yield, known as gilts, rose 5 basis points to 4.55%, while the 2-year gilt yield climbed nearly 3 basis points to 4.23%.

In the euro area, the yield on Germany’s 10-year bund, a benchmark for European sovereign debt, increased by 7 basis points to 2.49%.

Italian and French bond yields also moved higher.

Analysts at Deutsche Bank noted that while the need for increased defense spending has been widely discussed in recent years, there now appears to be a greater sense of urgency among European leaders.

The firm added that the ongoing geopolitical tensions between the United States and Europe are also likely to keep military spending at the forefront of economic policy discussions in the coming months.

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