European defence stocks suffered their worst drop in five years in March while the iShares US Aerospace & Defence ETF saw nearly $1 billion of outflows in the week ending 24 April.
Many defence companies now sit below where they stood before the war in Iran began at the end of February 2026.
While this may seem counterintuitive, there are reasons why investors have gone cold on companies which ordinarily might be seen as beneficiaries of rising geopolitical tensions.
Coming into the Middle East war the defence sector had already been one of the hottest areas in the stock market, delivering strong returns following the invasion of Ukraine in 2022.
It is perhaps not surprising to see investors take profits as they weigh strong price gains against high valuations. The sector’s forward PE (price to earnings) ratio recently breached 30 times, a new all-time high, representing a 72% premium to the broader MSCI World index.
It is a classic case of stocks travelling on anticipation of good news and investors selling once that news is perceived to be fully factored in by the market.
Can expanding orders be turned into profits?
While global defence spending has seen its steepest increase since the Cold War and the US recently proposed an historic 50% increase in spending to $1.5 trillion, it can take time to turn orders into profits.
Large order backlogs are usually good, but when they stretch many years into the future, investors start to worry about rising costs eating into fixed-price contracts.
The war in Iran has reportedly seen the US burn through around 1,000 Tomahawk missiles, a rate which is equivalent to around 20 times the annual production of missiles.
According to analyst Rob Epstein at Bank of America, growth at US defence company Raytheon (owned by RTX), which makes the Tomahawk missile, is likely to be impacted by supply constraints.
To mitigate this risk the US administration has recently held talks with US car makers to discuss how they could contribute to weapons supply chains.
These developments suggest defence contractors may not capture all the potential upside from increased defence budgets.
In another sign of expectations getting ahead of reality, French defence giant Thales recently reported a 75% increase in first quarter orders, which fell short of analysts’ consensus forecasts.
The earnings report sparked a wave of analysts’ downgrades across defence firms like BAE Systems and Rheinmetall.
Threat from structural shift in warfare
There is a growing realisation that conventional military equipment which is expensive to make and involves long lead times could be threatened by cheap drones and autonomous munitions.
For example, using a $2 million patriot missile to shoot down a $20,000 drone is financially unsustainable.
This suggests the large defence contractors could miss out should the war pivot towards the next generation of lower-cost defence strategies.
Martin Gamble: Shares and Markets Writer
Martin Gamble is Shares and Markets writer at AJ Bell. He was previously the Education Editor of Shares Magazine. He has been with the business since 2019.
Martin graduated from the University of Kent in...
