Why Rheinmetall & Lockheed Martin Lead Our 2026 Defence Allocation: The Transatlantic Case

The 2025 NATO Hague Summit produced the most consequential shift in European security financing since the original 2006 2% guideline. The new commitment — 5% of GDP by 2035, divided into 3.5% for core military expenditure and 1.5% for defence-adjacent spending including critical infrastructure, cyber, and resilience — represents not an aspiration but a binding political commitment backed by annual national plans with "credible, incremental paths" to the target.

The structural gap between today's spending levels and the 2035 target is enormous. In 2025, European NATO members collectively spent approximately 2.3% of their combined GDP on defence. Reaching 3.5% (let alone 5%) requires sustained multi-year budget increases across governments facing heterogeneous fiscal constraints. Germany — the most important market for Rheinmetall — has already committed to €117.2 billion in 2026 and €162 billion by 2029, having reformed its constitutional debt brake to exempt defence spending above 1% of GDP from fiscal limits. This reform effectively removes any legislative ceiling on German military procurement.

The Baltic states and Poland represent the most committed spenders by GDP percentage. Lithuania plans to allocate 5–6% of GDP to defence between 2026 and 2030. Poland already spends 4.48% of GDP. Estonia, Latvia, and Lithuania all exceed 3%. These countries — which share borders with Russia and Belarus — are driving the most urgent near-term procurement demand for ammunition, armoured vehicles, and air defence systems: precisely the products in which Rheinmetall has invested most aggressively.

The EU's €150 billion SAFE (Security Action for Europe) rearmament loan facility — established to allow member states to jointly borrow for defence procurement — is a second structural accelerant. SAFE enables fiscally constrained governments (France at 113% debt-to-GDP, Italy at 135%, Spain at 102%) to access lower borrowing costs for defence investment, effectively expanding the addressable market for European defence contractors beyond what sovereign balance sheets would otherwise permit. EU escape clauses excluding defence spending from deficit calculation rules further reduce the political cost of sustained military investment.

European rearmament is not a single procurement programme — it is a multi-decade restructuring of military capability across five interconnected categories. Each demand pillar creates a distinct set of revenue opportunities for European defence contractors, and understanding which companies are best positioned within each pillar is the starting point for portfolio construction.

The US defence industrial complex is the most structurally advantaged in the world. The four companies below collectively hold over $570 billion in order backlog, supply the most combat-proven systems operating in live conflicts, and are the primary beneficiaries of both rising US defence appropriations and European government procurement through the Foreign Military Sales (FMS) programme. Critically, FMS contracts allow allied nations to bypass domestic tariff complications and procurement timelines — making US defence companies the path of least resistance for European governments that need capability urgently.

The Trump administration’s proposed $1.5 trillion FY2027 defence budget — a roughly 40% increase over the current appropriation — reflects a defence-first agenda that shows no signs of reversal. Even if Congress appropriates only 60–70% of the proposed amount, it would represent one of the largest peacetime defence budget expansions in US history. For Lockheed Martin, the budget increase structurally de-risks the 2026 guidance range of $77.5–80 billion: both the PAC-3 multi-year framework (ramping from 600 to 2,000 interceptors annually) and the F-35 Lots 18-19 contract ($24 billion for up to 296 aircraft) are anchored to appropriations the administration has explicitly prioritised.

The conviction hierarchy below covers five major European defence equities. The primary screening framework uses three variables: (1) order backlog as a multiple of current revenue — a proxy for forward revenue certainty; (2) geographic diversification of the customer base — single-country exposure creates political risk; and (3) valuation relative to the sector forward P/E average of approximately 28×. Companies rated High Conviction clear all three screens. Companies rated Selective fail one or two screens but retain a compelling partial thesis. Companies rated Monitor require a materially better entry point before initiation is warranted.

The defence allocation framework below is designed for diversified European private portfolios with a 3–7 year investment horizon. Investors should establish an Investment Policy Statement to codify sector limits, ESG constraints, and currency hedging policy before initiating positions. A Black-Litterman allocation model can then formalise the conviction views below into mean-variance optimal weights, blending analyst views with market equilibrium to avoid overcrowded sector concentration. The framework distinguishes between a core position (high conviction, hold through volatility) and a satellite position (selective, entry-price sensitive). Investors with shorter horizons or lower risk tolerance should size the allocation toward the lower end of the ranges specified and express the thesis exclusively through BAE Systems, which offers the most defensive combination of growth visibility and valuation.

The total defence allocation for a diversified private portfolio — combining core (RHM + BAES) and satellite (LDO) positions — should sit in the range of 4–6% of total portfolio value. European investors with existing exposure to aerospace and dual-use technology (Airbus, Safran, Dassault) should reduce the defence allocation proportionally to avoid concentration in the European industrial sector. The allocation should be reviewed at each NATO summit cycle (next: Ankara, Turkey, July 2026) and at each major earnings release cycle for RHM and BAES.

Investors should model three scenarios for the position: (1) a base case — rearmament continues, order books are executed, and the sector re-rates modestly from current levels on earnings growth; (2) a bull case — conflict escalation or US defence budget withdrawal accelerates European procurement and drives multiple expansion; and (3) a bear case — a Ukraine ceasefire or Iran de-escalation compresses sector P/E multiples by 15–25% even as order books remain intact. The thesis survives the bear case on a 5-year horizon if order books are treated as real. The risk is in investors who entered with 12-month horizons and exit on peace headlines before earnings materialise. Quantify the probability-weighted return distribution across these three paths using the Monte Carlo simulation framework →

A well-constructed investment thesis must include the conditions under which it is wrong. Six risks are material enough to affect the conviction hierarchy or position sizing recommendations in this report. The first three are sector-wide. The remaining three are specific to US or European exposures.