Rheinmetall leads slump after European defence sector's record run

Aerospace and defence index down 3%

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Goldman sees downside risks for valuations

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Sector is highly popular among global funds

MILAN, April 9 (Reuters) - Germany's Rheinmetall led European defence stocks in their biggest one-day drop in a year on Tuesday, with traders turning nervous about the sector's record-breaking run and analysts pointing to potentially stretched valuations.

Defence stocks have been among the best performers in Europe for more than three years as portfolio managers piled into the sector, betting on rising military spending after Russia's invasion of Ukraine in February 2022.

Goldman Sachs said in a note released on Tuesday that European defence stock valuations now likely presented more downside than upside risk going into 2025.

"While our Portfolio Strategy team are relatively constructive on the European Defence outlook, they are not recommending EU Defense given the challenging valuation premium and recent outperformance," the note said.

The investment bank, however, added that the sector was in the middle of a super-cycle and expects Europe will meet NATO's target of spending 2% of GDP on defence next year.

"Nothing goes up in a straight line and the leading European defence names have had an exponential run recently, so they are vulnerable to profit taking from time to time," said Nick Cunningham, managing partner at equity research firm Agency Partners.

"The reality is that European rearmament is only just getting going, and these stocks have a long way to go yet in terms of growth," he added.

A gauge of European aerospace and defence stocks was down more than 3% by 1137 GMT, on track for its biggest single-day fall since March 2023. The index has doubled in value since Ukraine's invasion, hitting a string of record highs.

Rheinmetall was last down 6.6%, set for its biggest one-day fall since April 2023, having dropped more than 12% at one point. It was still up more than 80% this year.

Sweden's SAAB, Italy's Leonardo, France's Thales and BAE Systems in the UK were also among the biggest losers on the European STOXX 600 index.

Traders blamed possible profit-taking, including by investors who are rotating into sectors that have been hit by rising interest rates in Western countries and China's slowdown.

"Defence is one of the sectors where overweight reigns supreme and if you want to cut something you go and cut that," said Angelo Meda, head of equities at Banor SIM in Milan.

At 20 times expected earnings, defence stocks trade at a 45% premium to the broader European equity market, versus a historical discount of 10%, according to Goldman Sachs.

Republican presidential nominee Donald Trump has warned that the U.S. would

only help protect

NATO members from a future attack by Russia if European members raise defence spending, adding to expectations that defence stocks could rally further as the Nov. 5 U.S. election nears.

"We're just at the start of the increase in armament spending. The war in Ukraine is burning an avalanche of armaments," said Carlo Franchini, head of institutional clients at Banca Ifigest.