European defence firms are riding a wave of investor enthusiasm as NATO members ramp up military spending, but the defence trade looks crowded, and late arrivals risk buying into a market that is already overheated. This surge in defense stocks has been even more dramatic than initially anticipated, with major players like Rheinmetall, Thales, and BAE Systems seeing gains of 15-18%, with the rally catalysed by the clash between President Trump and President Zelenskyy late last week.

Despite military budgets expanding and NATO members preparing for a prolonged security crisis, share prices in the defence sector are already climbing and valuations have become stretched. The sector has outperformed broader indices, with share prices reflecting expectations of sustained military investment, so prospective investors should question whether the bulk of the gains have already been realised. Defence spending commitments take time to materialise into revenue, and increased orders do not always translate into immediate profit expansion. 

Despite the momentum, risks remain, and while war and conflict can fuel short-term gains, peace agreements, shifting government priorities, and economic downturns have historically led to sudden reversals in the sector. Additionally, the European Central Bank has already warned that excessive government borrowing, particularly in the wake of expensive energy subsidies and pandemic-related stimulus, could put pressure on sovereign debt markets. So while countries like Germany, France, and Poland have announced record defence budgets, their ability to sustain this spending amid broader economic pressures remains uncertain. 

Investor enthusiasm for defence stocks is hardly surprising given the geopolitical backdrop, but markets have already reacted swiftly, with a surge in company valuations despite the lag between policy announcements and the actual financial impact on companies remains a critical factor. However, for those still looking for exposure but without the volatility of individual stocks, defence-specific ETFs and sector-focused actively managed funds, could provide more diversified access to the defence market. A number of equity funds have been increasing their defence allocations, positioning their portfolio to capitalise on a long-term military build-up, although the volume of institutional money that has already flowed into these funds suggests that much of the easy upside may be over. 

For now, those betting on long-term military expansion must consider whether they are entering too late into a rally that has already priced in much of the geopolitical uncertainty. The resurgence in European defence spending comes amid growing global economic uncertainty, with inflationary pressures, higher interest rates, and fiscal constraints forcing governments to make difficult budgetary choices. So while defence remains politically untouchable in many NATO countries currently, other economic priorities, such as energy security and technological innovation, could begin to take centre stage in the near future. Furthermore, any unexpected de-escalation of the Ukraine conflict, political resistance to rising defence budgets, or regulatory scrutiny over arms exports could slow the rally, and investors should be wary of the historical boom-and-bust cycle of defence stocks.