The increase in defense spending will be closely watched by markets due to its impact on public budgets and various asset classes.
As the cost of security independence in the West begins to reach the trillions, investors are cautiously observing the repercussions on budget deficits and future interest rate policies, focusing on the future value of government bonds.
After a year of trade wars, geopolitical risks have risen again, as the start of the war between the United States and Iran in February quickly refocused attention on defense.
In this evolving context, military spending by European allies and Canada (according to NATO defense spending monitoring) has exceeded previous expectations, with a 20% increase by 2025. Pressure on defense spending is now one of the top ten fiscal risks identified for advanced economies and is considered an issue in 24% of countries.
RELATIVE SPENDING IN VARIOUS COUNTRIES
Much of the expected impact is country-specific: Eastern European nations, closer to the Russian border, are spending much more relative to GDP than their western counterparts. Countries with a relatively strong national defense industry, such as France and the United Kingdom, also tend to spend more.
Above all, it is unlikely that the fiscal expansion needed to absorb the spending increase will be temporary in Europe, where defense expenditures tend to be rigid. For now, the activation of national safeguard clauses has given European countries some leeway to bypass fiscal rule constraints, but there remains a risk of structural increases in debt levels if spending is not offset by other policies.
In the United States, estimates of the cost of the war in Iran so far hover around $30 billion and continue to rise, while the latest defense budget proposal for 2027 amounts to $1.5 trillion, a value higher than the GDP of most European economies.
IMPLICATIONS FOR INTEREST RATES
This level of spending represents an increase over previous years’ projections and increases uncertainty about future deficit levels, which are likely not priced into current interest rates.
The increase in spending will affect expectations regarding inflation and interest rates, with investors likely to differentiate between countries with higher fiscal deficits and those with lower deficits. Similarly, the recent oil shock has added another hurdle, although it may be considered short-lived and transitory in a peace agreement scenario.
Meanwhile, the risk of higher rates for a longer period has supported higher premiums on government bonds, particularly for energy-importing countries. This has highlighted an additional burden on public budgets, precisely at a time when fiscal expansion is needed to support more ambitious defense spending goals.
BOOST TO MANUFACTURING
One beneficiary of the spending increase has been the manufacturing sector, which can support future labor market growth in Europe and has led to a rise in aerospace and defense stocks since early 2025. Areas of future growth include cybersecurity, critical minerals and rare earths, as well as energy self-sufficiency.
More efficient and faster procurement processes are needed—especially in Europe—and innovations to cope with rising demand and the modernization of the defense ecosystem.
Consequently, technological innovation and private capital will be crucial in areas such as artificial intelligence, quantum technologies, and next-generation communication networks, which NATO has identified as having the greatest potential to transform future warfare, with cybersecurity playing a central role.
Markets are already pricing in this trend, with the global cybersecurity stock index up 36% since the start of the year. On the other hand, global equity returns in the aerospace and defense sector have been contained after a very strong 2025, in which they posted performance above 50%. However, earnings growth forecasts remain favorable despite higher valuations.
Another sector that has benefited is the rare earth metals segment, due to their use in advanced defense systems, which has driven prices up.
However, greater dependence on the supply and infrastructure of critical minerals broadens the very concept of security and requires diversification of the supply chain to support future growth and investment opportunities.
