Buy the UK DIP? Defense stocks lifted by $20 billion spending boost as gilts come under fire

British defense stocks are marching higher once again after the U.K. confirmed a near-$20 billion military spending boost on Tuesday — but the country's fiscal woes could ultimately slam the brakes on investment, analysts say.

Outgoing Prime Minister Keir Starmer this week announced an extra £15 billion ($19.9 billion) in defense spending over the next four years as part of the U.K.'s Defence Investment Plan (DIP), which will lift annual spending to £79.1 billion by 2029, or 2.7% of GDP.

The DIP is intended to bolster the U.K.'s military capability, its nuclear deterrent and industrial capacity, while making way for greater technical investment in areas like cybersecurity, drones and AI.

The latest boost to DIP spending has lifted the FTSE 350 Aerospace & Defense index by almost 5% since the Tuesday open in London, with the likes of Babcock, BAE Systems and Chemring performing well.

It marked a welcome boost for the sector, which had recently seen a multi-year rally run out of steam amid concerns of faltering European defense spending plans.

BAE Systems CEO Charles Woodburn welcomed the announcement, which he said "provides much-needed clarity for industry and a clear strategic direction for our armed forces."

U.K. defense stocks have enjoyed strong gains over the last five year, amid higher military spending.

The FTSE 350 Aerospace & Defense is up by around 540% over the last five years, compared to a 120% return for the Dow Jones U.S. Select Aerospace & Defense Index over the same period, reflecting a significant increase in defense spending among European and NATO allies.

"The big unknown is how long the new rally will last," Dan Coatsworth, head of markets at AJ Bell, said over email. "Investors had recently grown tired of the 'more defense spending is coming' messaging given it is old news to the market."

"Shares in the sector have already priced in a stronger earnings pipeline, with valuations starting to look toppy for many key stocks. For example, BAE Systems traded on 27 times earnings in March this year versus just 12-times four years earlier."

"Investors will now await details on which stocks will benefit from the extra government spending," Coatsworth added. "Even then, there is no certainty that earnings will emerge as expected. The defense sector is no stranger to project delays and cancellations."

Saxo UK Investor Strategist Neil Wilson highlighted BAE as a winner from the DIP, which will include £8.6 billion over the next four years for the Tempest — a sixth-generation fighter jet, for which BAE Systems is responsible for the overall aircraft design and flight systems

Wilson said: "We also see Chemring – a specialist in sensors, electronic warfare and counter-drone technology, coming out of this rather well."

"See also Cohort, which trades 3% higher on the announcement. Rolls-Royce

gets a lift from nuclear power/Tempest engine considerations, while QinetiQ is one to watch in the field of AI, robotics and autonomous warfare," he added.

High U.K. borrowing costs could put a ceiling on defense spending, analysts say.

However, Wilson cautioned that "fiscal constraints and sluggish economic growth means it's not just a simple question of increasing spending."

"Debt markets will punish extra borrowing – Starmer pointedly ruling out 'war bonds' as just extra debt," he added. "Germany's decision to scrap a new warship program underlined the problem facing governments without the same level of fiscal constraint." 

A recent S&P Global Ratings report highlighted the potential for higher defense spending to "exacerbate existing fiscal strains and pressure sovereign ratings."

The U.K, according to S&P Global, is among the nations whose potential defense spend is "constrained by elevated public debt."  

The U.K., which faces significantly higher borrowing costs than its G7 peers, saw gilt yields tick higher across all durations on Wednesday, despite Starmer's assurances that extra spending would be funded by cuts in other departments.