BAE and other defence stocks look cheap after 'sell first' pullback, says Morgan Stanley

Morgan Stanley reiterates a positive stance on European defence, saying the buy case is "as strong as ever" as the sector trades ~20% below recent highs and at roughly 20x earnings. This comes amid a strengthening military-spending backdrop and recent weakness that the bank views as an attractive entry point. Consider selective exposure to the sector on dips given valuations and supportive macro/geopolitical drivers.

Analysis

The sell-off has created dispersion risk that is not being priced: large primes with multi-year, funded backlogs and embedded price escalation clauses (think electro-optics, munitions, air defence) will see cash flow visibility materially better than tier-2/3 suppliers that rely on spot raw materials and single-program exposure. Over the next 3–12 months, that should translate into outperformance for names with >3 years of visible orders and strong aftermarket/servicing revenue (higher margin, recurring).

Macro/flow drivers have likely amplified the move: ETF and quant funds trimming defense exposure on momentum and ESG filter reweights can create mechanically outsized down-moves in otherwise stable contractors; that creates an asymmetric short-term entry — technical mean reversion — but also raises the chance of chop if macro risk-off returns. Expect meaningful activity around NATO budget announcements and national procurement calendar dates (3–9 month horizon) which will act as binary re-rating events.

Second-order supply chain winners include advanced electronics and software vendors that can scale across programs (they capture higher margin aftermarket spend) while commodity-focused suppliers (steel, basic actuation) are the first to see margin compression if program timelines slip. Currency and FX hedging will matter: a weaker euro/sterling versus dollar can temporarily inflate reported USD-revenue growth for European primes but also obscure order book translation risk over 6–18 months.

Tail risks that could reverse the setup are politically driven export restrictions, a sudden macro liquidity squeeze that forces de-rating of long-duration defense cashflows, or high-profile program cancellations/technical failures; those would compress multiples quickly and reintroduce headline risk for 1–3 quarters.

Key Decisions for Investors

• Long Rheinmetall (RHM.DE) — tactical 12–18 month trade: buy shares or buy Jun-2027 60/90 call spread (debit structure). Entry rationale: high program visibility in land systems + aftermarket. Target +40–60% in 12–18 months; stop -20% from entry. Risk/reward ~3:1.
• Pair trade: long Thales (HO.PA) vs short Leonardo (LDO.MI) — 6–12 month horizon. Rationale: Thales higher software/avionics recurring revenue vs Leonardo’s program concentration and FX/Italy political execution risk. Size net zero dollar, 60/40 weight (long/short). Take profit if spread narrows >25%; widen stop if headline contract awards reverse the spread.
• Options play on sector re-rate: buy an ETF call spread (e.g., 9–12 month calls on defense/aircraft ETF or basket) to capture a program-approval rally while capping cost. Use strike selection to target a 2.5–3x payoff with defined maximum loss (premium). Watch for NATO/defense budget windows as timing events (3–9 months).
• Avoid broad long exposure funded by high beta shorts: instead, concentrate on names with >3 years funded backlog and identifiable contract milestones in the next 6–12 months. If macro liquidity tightens, be prepared to cut exposures quickly — set hard stops and scale into positions across technical support levels (10–20% stagger).