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Investing.com -- European defence stocks have pulled back from their recent highs, but Morgan Stanley analysts think that the investment case for the sector is "stronger than ever," noting that the sell-off has been driven by sentiment rather than fundamentals.
Every stock in the EU defence sector is trading below its peak over the past year, by an average of around 20%, with most of the decline coming from a valuation derating rather than any deterioration in earnings, the bank highlighted.
The sector’s forward price-to-earnings (P/E) multiple has fallen from 23x to roughly 20x — "at the bottom of the 20-25x range, which we think most accurately reflects fundamentals," analysts led by Ross Law said.
"This does not match up with our view that fundamentals for the sector continue to improve. Recent geopolitical events (including Iran, Greenland, Venezuela) reinforce a case for increased European defence spending and greater strategic autonomy," they noted.
"As such, we believe the investment thesis underpinning our positive view on the sector remains firmly intact and would use the recent lacklustre performance as an attractive buying opportunity," the analysts added.
Morgan Stanley identifies four main drivers behind the recent weakness, all of which it views as temporary. First, the sector got caught up in broader equity degrossing tied to the Middle East conflict, particularly among hedge funds, which hold large positions in defence names but typically face no ESG restrictions.
Second, the growth outlook for U.S. and Asian defence has improved in recent months, diluting Europe’s relative appeal.
Third, the Middle East conflict has rekindled debate over conventional versus modern weaponry, prompting some rotation toward names with greater U.S. exposure. The analysts argue this debate is "misplaced for Europe," where the primary threat is land-based and would require substantial investment in both conventional and modern military capabilities after more than three decades of underinvestment.
Finally, order delays in Germany and ongoing fiscal pressures across Europe have created what the bank calls "thesis fatigue" among investors. The analysts view these as "largely timing related and not reflective of underlying demand."
Meanwhile, Morgan Stanley sees the geopolitical backdrop as reinforcing, not undermining, the long-term case for European rearmament. U.S. military attention and resources are increasingly being diverted toward the Middle East, potentially weakening support for Ukraine, it noted.
Transatlantic relations have deteriorated, with senior U.S. officials questioning NATO’s value and signalling that Europe must assume greater responsibility for its own security. The easing of sanctions on Russian oil, the bank estimates, could generate an additional $150 million per day for Moscow, prolonging Russia’s capacity to sustain operations in Ukraine.