Europe's Rearmament Push Faces Execution Test Amid Supply Chain Woes

After years of surging military budgets, emergency Ukraine spending and soaring defense stocks, Europe's rearmament push must now prove it can turn hundreds of billions of euros into weapons, factories and usable military capability.

The question for investors no longer seems to be one of defense demand or political ambition, but whether valuations have run ahead of the industry's ability to execute.

That test is becoming more critical ahead of next week's NATO Summit in Ankara, Turkey, where leaders are due to review progress since last year's summit and set out a roadmap for delivering on new spending goals to "turn allied commitments into concrete results."

But the path from higher budgets to delivered weapons is proving uneven. Procurement delays, fragmented national programs, labor shortages, and strained supply chains are raising doubts over how quickly Europe can rebuild an industrial base that has been hollowed out from decades of lower defense spending.

The pressure is rising from both sides of the Atlantic. NATO allies agreed on a dramatic rise in defense spending at last year's summit, reflecting growing concern that Europe can no longer live under the protection of the U.S.

Pressure intensified when U.S. War Secretary Pete Hegseth earlier this month announced a review of American forces in Europe and warned that allies failing to meet spending commitments could face consequences. The review, expected to last up to six months, added fresh urgency to a debate already transformed by Russia's war in Ukraine and changing U.S. approach to NATO.

"There is no question that the evolving U.S. geopolitical stance has been a real moment of truth," Hugues Lavandier, a senior partner at McKinsey, told CNBC. It has accelerated Europe's recognition that "the period of the peace dividend was behind us" and that governments needed to reinvest in defense capabilities, he said.

The defense trade evolves

The shift has already transformed investor expectations. European defense companies from Rheinmetall to BAE Systems , Leonardo , Thales , and Saab have benefited from a surging order book since Russia's 2022 invasion of Ukraine, as governments ramp up military spending.

McKinsey calculates that European NATO core defense spending has doubled since 2019 and could reach about 800 billion euros ($912 billion) by the end of the decade. That would put it on the path toward NATO's new core benchmark of each member spending 3.5% of its GDP on defense. Venture funding is also flowing into European defense technology, such as drones and autonomous systems.

Lavandier said the market was in a "price discovery moment." Backlogs were initially the clearest proxy for growth, he said, but investors are now getting a better read on which companies can convert those order books into production, revenue and margins.

Last week, Germany canceled a multi-billion euro F126 frigate program after delays and expected cost increases, and said it would buy eight smaller Meko A-200 frigates from ThyssenKrupp Marine Systems (TKMS) instead. Shares in Rheinmetall, which had been expected to be the lead contractor for the abandoned program, fell sharply.

"This news reminds us that [governments] can and do change their minds," JP Morgan analysts said.

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But Germany's defense budget is still rising rapidly. Lavandier said the cancellation was an example of governments reassessing priorities, such as procurement costs, delivery timelines, and military strategy.

But for investors, Rheinmetall's sell-off is "a stark reminder ... that this sector has form in experiencing delays and setbacks, despite various governments pledging over the past few years to boost defence spending," Dan Coatsworth, head of markets at AJ Bell, said in an emailed comment.

What is holding back Europe's rearmament push

Building the capacity Europe needs to ensure strategic autonomy has proved difficult.

Even though investment in defense has increased sharply, equipment stocks in European NATO countries remain below 2021 levels, reflecting military contributions to Ukraine, the retirement of legacy systems, and long delivery timelines for new equipment, per a February report by McKinsey.

It also found that Europe's platform fragmentation is more than four times higher than in the U.S., with consequences for interoperability, logistics and industrial scale.

The biggest bottlenecks are labor and supply chains, Lavandier said. He added that Europe's defense industry "has not been used to produce at scale in large numbers in a very long time." Beyond the major contractors, the sector depends on layers of suppliers, many of them small family-owned companies, which must all ramp up together.

"If you are missing one or two parts, your new jets cannot be delivered," he said.

How supply chains are slowing defense production

S&P Global Ratings found the same constraint. It said European defense suppliers are often small businesses with limited ability to raise equity for expansion, exposing larger contractors to bottlenecks across complex supply chains.

The credit ratings agency also warned that higher defense spending will be uneven across Europe. Poland and the Baltic states are moving fastest, Germany has more fiscal room to accelerate, while France, the U.K., Belgium and parts of southern Europe face greater debt constraints and competing political priorities.

Higher defense spending could support defense companies' credit quality, S&P said, but may add pressure to sovereign budgets and force politically difficult trade-offs.

It also noted Europe remains structurally reliant on U.S. suppliers for fighter aircraft, air defense systems, precision weapons, electronics, software and strategic enablers such as intelligence, surveillance, airlift and command-and-control.

That means larger European budgets will not automatically create a more independent European defense base.

Lavandier said roughly half of European defense spending currently flows into Europe, with the rest going to suppliers elsewhere, including the U.S., Israel and South Korea. He expects more governments to favor equipment designed and manufactured at home, not necessarily as an anti-U.S. move, but because "if you want the flywheel of productivity to work, you need to reinvest the majority of that money into your home countries."

Stefan Wintels, chief executive of German state-owned bank KfW, told CNBC's Annette Weisbach on Friday that the defense industry's growth was "not a short-term phenomenon," but said Europe needed to scale, price competitiveness and a more supportive policy framework to make the shift work.

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Wintels also said the planned joint ownership of tank maker KNDS was a potential model for deeper European cooperation. France and Germany have agreed to become equal 40% shareholders in the Leopard 2 producer, ahead of a planned Paris and Frankfurt listing.

The hope, he suggested, is that KNDS could eventually become a smaller-scale version of Airbus as proof that Europe can develop national champions into globally competitive defense groups.

But the comparison also underlines the difficulty in such an aim: Airbus took decades to build, and Europe's security challenge cannot wait decades.