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T.J. Thornton:
Hello and welcome to Global Research Unlocked, where we discuss what's rising from growth industries to rising risks and opportunities in global markets. I'm T.J. Thornton, Head of Product Marketing at BofA Global Research, and we're recording this episode on Tuesday, July 8, 2025.
Ron Epstein:
When you think about something like Golden Dome, you have to think about it like an onion. There's a core of the onion in all the layers. At the lowest level, you're dealing with drones; at the highest level, you're dealing with hypersonic threats coming in from space. So it's this multi-layered system. Some of those layers for sure will be from existing systems; some of those layers will have to be developed. Probably the most complex piece and the most expensive piece will be the piece that's in space, dealing with threats from space.
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T.J.:
Between NATO's spending commitments and the one Big Beautiful Bill, it's clear that overall defense spending in the U.S. and Europe is accelerating. But looking at a sampling of defense stocks in the U.S. and Europe, it's also clear that while the tide may be rising, it's not doing so to the same extent in every bay and harbor. Some European stocks are up threefold in a year, while some U.S. stocks are flat, and there are lots of stocks somewhere in between. We're joined today by Ron Epstein, Managing Director covering Aerospace and Defense at BofA Global Research. Ron will discuss what increased NATO spend will mean for U.S. defense and how defense spend in an era of drones, AI and cyber is shifting. He'll also discuss whether defense spending growth is peaking and if so, what that could mean for the stocks. So thanks, Ron, for joining us.
Ron:
Yeah, thank you. It's a pleasure.
T.J.:
First question, on the thing that is probably most topical and in the headlines, and it is NATO: the recent agreement of the NATO allies to spend 5% of GDP on defense by 2035. Ben Heelan, who covers European Defense for us, makes the point that France has a robust enough defense industry where they could be 100% self-sufficient. What do these spending commitments mean for growth rates for U.S. defense companies specifically?
Ron:
Yeah, T.J., that's a good question. When you think about Europe's spend on defense, there's been an agreement to go to specifically 3.5% of GDP on defense and another percent and half on things that support national security, not necessarily defense equipment. But even if you get to 3.5% for defense for NATO, that's a large climb in what they're currently spending. Most countries in Europe today spend somewhere between, call it a percent and a half and 2%, so that's not quite a doubling of spending but almost. Now, some of that spending today is used for U.S. equipment and a lot of that U.S. equipment fills in holes in the European portfolio. Europe for a long time has wanted to be self-sufficient but there just wasn't an urgency there. There is now, and the sense we get from just having gone to the Paris Air Show a couple weeks back that European nations do really want to be self-sufficient, so over time, they'll fill in those holes in their portfolio. One example of a system that would be a very difficult hole to fill in — they could, but it can take at least a decade if not longer — is the F-35. The F-35 is a fifth-generation fighter, and fifth generation fighters are marked by things like advanced stealth and other systems on the airplane. That's not to say that Europe couldn't come up with a fifth- or sixth-generation fighter, but that's probably 20 years away. Between now and then, I would imagine that they would continue to buy things like the F-35. However, there's other systems that you can develop in a shorter period of time they'll become self-sufficient on, and there's systems that exist today. Some of that increase in defense spending will most certainly spill over to U.S. contractors, but I would imagine over time it'll be less and less. Now, there's maybe one exception to that. There are defense contractors, U.S. contractors that do have a footprint in Europe, not just a sales office, actual factories where they build things that are specific to the European market. They'll probably benefit from this, but that's not the majority of companies.
T.J.:
Another topic that's come up is drones, and they were particularly useful in one surprise attack that Ukraine made on Russia, but they've also just generally been, I think, successful probably from both sides in what's going on over there, so that's led to some questions about the future of warfare and traditional weapons. What type of weapons do you think will be in greater demand and less demand going forward? And do you think the market might be getting anything wrong in terms of how it sees the future for defense? Maybe too much optimism about drones and too little optimism about other things?
Ron:
Yeah, again, another good question, T.J. The market tends to think in absolutes and black and white, and it's just not that simple, sadly. I mean to think about the future of warfare, it'll be a mix of both. High-end, more bespoke, more “man in the machine”-driven equipment and also unmanned systems. And those unmanned systems will run the gamut from unmanned aerial systems, drones, but also unmanned systems on the ground and unmanned systems in the water, but they'll also be accompanied by manned systems. There's been a lot of hype about drones in the press lately, and if you look at how they've been used in the Ukraine, they've largely been constrained to an area that you’d use artillery. One weakness with most of these lower-cost commercial-grade drones is, and even some more expensive drones, they have limited range and limited ability to carry a load, and that gives them what we call limited reach. Now, if you look at some of the clever ways that they've been deployed, the Ukraine deployed them by actually sneaking them into the country and deploying them very close to where they need to be deployed. That was a very clever way to get around the lack of range, but you can't always do that. It's kind of a time and place for everything. Now, I would want to remind everybody listening in drones have been around for a very long time. If you go back to World War II and the V-1 rockets and the V-2s, they were drones, right? They were kamikaze drones that the Germans were shooting at the UK, at England, at the time. And some of the drone technology isn't a heck of a lot more sophisticated than that. However, what we do have today is a plethora of commercially available drones and maybe more importantly, commercially available technology, so you can actually build your own drones, and you can do all kinds of clever things. So right place, right time, you can use drones, but you can't use them everywhere because of the shortfall. Now, what I would expect in the future, point of the question, a real balance between the high-end systems and the low-end systems: one of the things that needs to be figured out that smarter military minds than mine are thinking about today is how do you deploy those high-end systems with the low-end systems to get the ultimate effect that you want? And that's research and progress, continued spend on unmanned systems and growing spend on unmanned systems, but not at the exclusion of higher-end manned systems. And the real kind of nexus of that technology will be how do you make the two work together so you can get the real effect that you want?
T.J.:
There's lots of defense spending growth expected in FY26, which is October through next September, but then FY27 the next year is expected to be flat to down, depending on who you talk to. Sometimes stocks can have a tough time performing when we're in the midst of peak growth, so how do you think about that? The fact that maybe growth is in the process of peaking, at least in the next year, and does that impact how you think the stocks will trade?
Ron:
If indeed growth does peak in the next year, in that scenario, it does make it more difficult for stocks to outperform. Now, that being said, that doesn't mean they won't. You can go back in periods of time where you go back to 2013 and sequestration happened with the defense budget or the overall federal budget, which impacted defense spending. Defense spending had a cap on growth. There was still money added to the defense budget through supplemental appropriations — that's money that gets allocated but doesn't go through the full budget process but still ends up in the defense budget. But the budget didn't grow very much, and the defense stocks actually did quite well, ‘cause they deployed their cash flow in a very shareholder-friendly way. That being said, I'm not 100% in the camp that we are seeing a peak in defense spending right now. What makes fiscal '27 more difficult is if you look at the budget structure in fiscal '26, the growth in defense was all done through what's called reconciliation spending. So the growth in defense came from an additional $150 billion that came from what's called reconciliation. There's a baseline federal budget that kind of goes through the typical process, and then there's a whole separate pot of money that's called reconciliation. It prevents a filibuster from happening where you need a supermajority to pass money or anything. That's the way the budget was assembled this year. The baseline is flat, and then you had $150 billion on top of that, and that gets you to the 1-trillion-dollar big number of overall defense spending. Now, the question becomes what happens in fiscal '27? If the baseline budget is flat again, how do you make up that $150 billion? Now you'd have to pass another reconciliation, or you'd have to do some form of supplemental spending. And what I've heard from different participants, different folks in Washington, D.C. and otherwise: there's no clear consensus on this right now in that community. And there's part of the community that says, "Hey, you know what? Defense spending will probably come down in fiscal '27." There's part of the community that says, "No, the baseline will actually go up. They'll change how they structure the budget. They'll be different than this year." And then there's a piece of the community that says, "Actually the budget will go up, the baseline will stay the same, but you'll get another form of supplemental spending either through a supplemental itself or some sort of reconciliation spending." The good news is it's not a foregone conclusion that defense budgets are going to go down in fiscal '27; however, there's not a lot of clarity exactly in which direction defense budgets will go in fiscal ‘27, which can be perceived as a headwind.
T.J.:
I wanted to talk about defense tech, and when I say that, I'm talking about advanced weapons, surveillance equipment, cyber, etc. What does the “Big Beautiful Bill” suggest in terms of spending on defense tech, and what do you expect for growth in defense tech over the next few years? Will it exceed overall defense spending and approximately by how much?
Ron:
If you look at the “Big Beautiful Bill,” it includes $16 billion to accelerate what they call "innovation in technology" such as drones, AI and low-cost weapons. That's a piece of the bill that's been earmarked for quote-unquote "defense tech." I would expect the defense-tech segment to outgrow the larger budget just ‘cause it's smaller, growing from something smaller to something bigger, but yet still small when compared to the larger budget. When you think about defense tech, it's a bit of an amorphous term at this point. When you think about drones: is it hardware or is it software, or is it both? I think one of the more important trends to keep an eye on in defense today is the separation between hardware and software. Is defense hardware becoming something more akin to, say, an iPhone, where you can drop different apps on it? As crazy as that might sound, imagine a missile platform or an aircraft platform where you can actually drop new software on it and increase the functionality, much like you can on an electric car today. If you look at most electric cars, you can do an update of the operating software on the car, and you can change the functionality pretty dramatically in terms of range and so on and so forth. There's an argument to be made that you're going to probably see innovations like that in the defense world, which suggests that you could get a new class of companies that will focus more on software than hardware. So you might have a group of companies that focus specifically on hardware and another class of companies that works on apps and the interconnectivity between all these systems.
T.J.:
Golden Dome, which I guess is another example of defense tech: What do you think that means for spending, just that program alone, and what areas of spend will be most impacted? Also, once it's complete, is it game over? We can spend less because now we're more protected than ever, and depending on the administration could look more inwardly, or do you think it won't have impact ultimately on overall defense spend once it's been completed?
Ron:
When you think about Golden Dome specifically in the bill, there's $25 billion allocated to it. The administration, specifically the president, has said that they'll spend $175 billion total cost on Golden Dome. That's a lot of money, but for a multi-layered missile defense system, it's actually not that much money. So if they can actually do it for $175 billion, that would be great. I'm a little skeptical about that. However, in fiscal '26, there's $25 billion allocated, and Golden Dome itself will probably be a mix of new systems and existing systems. So there's things like the Patriot system and the THAAD system, and there's various anti-unmanned systems, something that can shoot down drones, if you will, or prevent drones from working. And when you think about something like Golden Dome, you have to think about it like an onion. There's a core of the onion in all the layers. At the lowest level, you're dealing with drones; at the highest level, you're dealing with hypersonic threats coming in from space. So it's this multi-layered system. Some of those layers for sure will be from existing systems. Some of those layers will have to be developed. Probably the most complex piece and the most expensive piece will be the piece that's in space, dealing with threats from space, some sort of kinetic system that's counter missile in space, that in and out of itself could cost hundreds of billions of dollars. So, we'll see where it all goes. But, most certainly, when you look into fiscal '26 and the most likely fiscal '27, I would imagine it's going to be more heavily skewed towards existing systems. And then, second part of your question: What impact will that have on defense spending other than you're not spending on it anymore? I really doubt that it would have that much of a negative influence because you don't really know how good your mousetrap is until you have to use it. And ultimately, defense spending is all about hopefully not using the equipment that you're purchasing. It's more about deterrence, a scenario where you've deployed a full multi-layer, reasonably functional missile defense system of the homeland. Your adversaries know that too, and they're always trying to work around it. That suggests that you always have to evolve the system, one, and then two, you can't get too lax about what you have, which suggests that depending on the broader state of the world, you have to spend on defense. Defense spending is typically proportional to what's going on in the world. If the world ends up in a better place, then I would expect that could have a material impact on defense spending. However, if you still have as much uncertainty as we do now, five or 10 years from now, that would suggest that you have to continue to spend. And then ultimately, if you are a national security planner, ultimately it's risk management. And I guess you can't always assume that the world's going to be a peaceful place, so you have to be prepared for that too. I don't think you can just lean back and say, "Hey, we've got this nice force field around us, and we don't have to spend on defense," but it does make you feel a little more secure.
T.J.:
Last question: AI. Companies across the market are using AI to both become more efficient, and also many are using them to drive revenues, getting paid for your chatbots or making your advertising more effective, the advertising you're selling. How do you think about AI and defense? What are the types of companies that could benefit from bringing AI to defense, whether they're mega cap tech or consulting companies or just AI-specific companies? And otherwise, how does AI help defense on kind of both the top-line and efficiency perspective?
Ron:
There's all kinds of applications for AI in defense. On the more mundane side, it's just operating the companies. They're complex companies. You can have single points of failure. You deal with some industries where you might have “mom and pop” shop that's building A, B or C, so given the fragility and the supply chain and the bespokeness of the industry, various tools that are AI driven can help you manage your supply chain and help you just run the business. The basic blocking and tackling of running an industry can help there. On the other side, though, for just national security, beyond that, defense is on some level all about intelligence and knowing what your adversaries are doing and using both human data and complex sensors to collect that data. You can end up with reams and reams of data across different vectors and how do you make sense of that? How can you use that data to your advantage to help defend yourself or, if you have to, do something offensive, and AI can help with that. And then how systems communicate and work with each other. Just to give you an example: If you put a couple thousand satellites in low earth orbit and they're collecting data, AI can help you with that data. That's just an example of how you could deploy it. But some of this can also be hardware specific. When you think about the future of defense and defense products, part of that software component might be done by the hardware manufacturer, but odds are you'll have interplay in a network of systems, so you can deploy the entire system as one entity intelligently. And a lot of that comes down to sorting through reams of data quickly and figuring out what to do when and how to do it. So if you have a manned aircraft operating with unmanned aircraft, you could have one manned aircraft with say, 10 unmanned aircraft. What's the best way to deploy them? How do you communicate with them? For sure, AI will have a place there. And that's just one simple example. And then maybe one other point: a lot of warfare is about logistics and how do you manage your logistics supply chains and so on and so forth. Even on the more run-of-the-mill side, when you're doing defense strategy, how you manage your supply chains when you're at war, that can also be helped by AI as well. So, I think there's a lot of different vectors that AI can be deployed for national security, both kinetically when you're at war, when you're just trying to sense what's going on and then just as mundane as on the factory floor to help you run your business more.
T.J.:
Thanks, Ron, for joining us today.
Ron:
Yeah, thank you. It was a pleasure.
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T.J.:
Growth in spending at U.S. Defense contractors remains a good theme, but there are some crosscurrents. For one, especially as Europe has agreed to nearly double their defense spending as a share of GDP over the next decade, they also want to buy more of this product domestically. But there are programs like the F-35 fighter jet that will be hard to replace, at least in the next 20 years. And while fiscal year ‘26 spending will grow substantially, there are a lot of questions around fiscal year ‘27, which could actually be down or even up. There's a lot of uncertainty after the big fiscal year ‘26 bump, and we won't learn more for a while. And the prospect of spending with new types of defense companies that can upgrade hardware systems with software are quite interesting. Much like what happens with EVs in over the air updates, the big picture change that could depress defense spend is a safer world. Thanks for joining.
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