The latest conflict in the Middle East only reinforced a trend that gained momentum in 2025. Investors are leaning into a full-blown rearmament supercycle, bidding up defense names and pricing in years of steady government demand.
Yet, the International Monetary Fund (IMF) sees the issue, warning that the same spending boom could destabilize the support for those valuations in the first place.
“While the resulting defense buildups can boost economic activity in the short term—lifting consumption and investment, particularly in defense-related sectors—they also temporarily increase inflation and create significant medium-term challenges,” the IMF noted in the latest outlook.
Per their estimates, average fiscal deficits worsen by about 2.6 percentage points of GDP while public debt increases by around 7 percentage points within three years of the start of a build-up.
In wartime scenarios, the fiscal impact becomes more acute. Public debt can rise by around 14 percentage points of GDP, while social spending declines in real terms. Such fiscal shifts are powerful enough to change the entire cost structure of the economy.
The mechanism is straightforward, but the implications are not. Governments don’t fund rearmament out of thin air; they must borrow. And when sovereign borrowing ramps up, it competes directly with private capital demand. Interest rates rise, tightening financial conditions and pushing up the cost of capital across the board.
Overlooked Inflationary Effect
Defense spending typically falls under the stimulus classification, but unlike infrastructure or productivity-boosting investment, it adds demand faster than it expands the supply. For the IMF, this dynamic is inherently inflationary, cornering central banks into a tougher position.
If policymakers face a fiscal impulse pushing in the opposite direction, then rate decisions become more complex, potentially prolonging restrictive policy and keeping real yields elevated.
In other words, the very conditions equity markets are currently trying to look through may persist longer than expected.
The Supercycle Premium
A look into top defense names shows the market pricing mechanism at work. Lockheed Martin (NYSE:LMT) currently trades at a 24.3x P/E ratio -at a supercycle premium. However, its forward valuation of 17.4x suggests the earnings catch-up is already priced in.
For Northrop Grumman (NYSE:NOC), the situation is the opposite. Forward P/E at 20.7x is above the current (18.2x), suggesting weaker near-term earnings visibility. It is a company more exposed to large lump-sum projects (B21, space) and thus has less predictable cash flows.
Meanwhile, RTX Corporation (NYSE:RTX) trades at 33.3x P/E and 30.5x forward earnings. However, the firm is not a pure defense name; it also has significant exposure in commercial aerospace.
Thus, valuations aren’t uniformly stretched—but they are starting to bifurcate, with hybrid names like RTX trading closer to industrial growth multiples, while most are sitting near the top of their historical ranges.
Elevated valuation, even after a notable decline over the last weeks, reflects the “supercycle premium.” It reflects confidence that governments will keep spending regardless of the macro cycle.
The Structural Paradox
But that assumption is doing a lot of heavy lifting. If the IMF’s fiscal math proves even directionally correct, rising debt burdens could eventually force trade-offs—either through higher taxes, spending cuts elsewhere, or, in more stressed scenarios, reduced defense outlays themselves.
There’s a structural paradox here. The stronger the rearmament push, the higher the probability it undermines the fiscal capacity that sustains it.
More defense spending leads to wider deficits. Wider deficits push up yields. Higher yields tighten financial conditions and weigh on valuations. And in extreme cases, they force governments to reconsider spending priorities altogether.
Markets, for now, are focused on first-order effects such as rising budgets and expanding backlogs. The second-order effects—crowding out, persistent inflation, and fiscal strain—remain largely unpriced.
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