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By Danilo Masoni and Samuel Indyk
MILAN/LONDON (Reuters) - Europe's rush to boost funding for military spending has sent defence stocks on a tear, though investors are now wondering how much more they're willing to pay for exposure to the region's biggest rearmament buildup since World War Two.
Shares in arms makers including Britain's BAE Systems and Germany's Rheinmetall had a volatile day on Tuesday, briefly extending Monday's surge, which followed the clearest sign yet Europe's leaders were racing to boost spending and help secure peace in Ukraine.
Monday's surge lifted several defence shares by over 20-30% at one point, with the force of the rally surprising several fund managers. The move followed an already record run for the sector, which has more than doubled in value since Russia invaded its neighbour more than three years ago.
As a result, many defence stocks now trade a record-high valuation multiples, in some cases surpassing those of their American peers and moving closer to those more traditionally associated with high-growth sectors, such as luxury or tech.
Investors bet European governments could lift defence spending more permanently to 3% of gross domestic product from the current NATO target of 2%, helped by Brussels loosening its fiscal rules. Some members, such as Italy and Spain, are still below that 2% threshold.
Meanwhile, German leaders may reform the so-called "debt brake", which limits borrowing, during the current legislature that ends this month. This would pave the way for a big injection of new funds into a 100-billion euro fund already set up in Europe's biggest economy.
Recent developments have seen investment banks scrambling to raise their profit estimates and ratings, which looks justified given the significant boost to expected spending.
But among fund managers some prudence is creeping in.
Rory Dowie, portfolio manager at Marlborough, wants to understand the earnings impact and sustainability of increased defence spending, particularly if a Russia-Ukraine resolution emerges under the Trump administration.
"We would be cautious to chase the rally," he said.
The STOXX Aerospace and Defence index rose as much as 1.6% to a new record high before turning lower on Tuesday. By 1553 GMT, it was down 1.5%. The index is now worth $514 million in market cap, having risen around 170% since the invasion of Ukraine.
PAYING THE PREMIUM
According to Nordea senior strategist Hertta Alava, aggressive buying of defence ETFs might have contributed to Monday's surprise rally and given how high valuations are, a pullback was possible.