How AI Is Disrupting Defense

0:00Arushi Agarwal:Welcome to Thoughts on the Market. I'm Ross Law from Morgan Stanley's European Aerospace and Defence Team.

0:06Ross Law:And I'm Arushi Agarwal from the European Sustainability Research Team.

0:11Arushi Agarwal:Today, a topic that's rapidly defining the boundaries of sustainable investing and technological leadership, the use of AI in defence. It's Tuesday, July 8th at 3pm in London. At the recent NATO summit, member countries decided to boost their core defense spending target from 2 % to 3.5 % of GDP. This big jump is sure to spark a wave of innovation in defense, particularly in AI and military technology. It's clear that Europe is focusing on rearmament, with AI playing a major role. In fact, AI is revolutionizing everything from unmanned systems and cyber defense to simulation training and precision targeting.

0:51Arushi Agarwal:is changing the game for how nations prepare for and engage in conflict. And with all these changes come serious challenges. Investors, policymakers and technologists are facing some tough questions that sit at the intersection of two of Morgan Stanley's four key themes, the multi-polar world and tech diffusion. So, Arushi, to set the stage, how is the concept of sustainability evolving to include national security and defence, particularly in Europe?

1:21Ross Law:You know, Ross, it's fascinating to see how much this space has evolved over the past year. Geopolitical tensions have really pushed national security much higher on the sustainability agenda. We're seeing a structural shift in sentiment towards defense investments. While historically defense companies were largely excluded by sustainability funds, we're now seeing asset managers revisiting these exclusions, especially around conventional and nuclear weapons. Some are even launching thematic funds specifically focused on security and resilience. However, in the absence of standard methodologies to assess weapon-related exposures, evaluate sector-specific ESG risks, and determine transparency, there is no clear consensus on what sustainability-focused managers can hold.

2:11Ross Law:Greater policy focus has created the need to identify a long-term approach to investing in this sector, one that is cognizant of ethical issues. Investors are now increasingly asking whether rapid technological integration might allow for a more forward-looking, risk-aware approach to investing in national security.

2:30Arushi Agarwal:So it's no news that Europe has historically underspent on defence. Now the spending goal is moving to 3.5 % of GDP to try and catch up. Our estimates suggest this could mean an additional$200 billion per year in additional spent, with a focus on equipment over personnel, at least for the time being. With this new focus, how is AI shaping the European rearmament strategy?

2:55Ross Law:Well, AI appears to be at the core of EU's€800 billion rearmament plan. The Commission has been quite clear that escalating tensions have not only led to a new arms race, but also provoked a global technological race. Now, to think about it, AI, quantum, biotech, robotics, and hypersonic are key inputs not only for long-term economic growth, but also for military preeminence. In our base case, we estimate that total NATO military spend into AI applications will potentially more than double to$112 billion by 2030. This is at a 4 % AI investment allocation rate. If this allocation rate increases to 10%, as anticipated by European deep tech firms, then NATO's AI military spend could grow sixfold to$306 billion by 2030 in our bull case.

3:49Ross Law:So Ross, you were at the Paris Airshow recently, where companies demonstrated their latest product capabilities. Which AI applications are leading the way in defense right now?

4:01Arushi Agarwal:Yeah, it was really quite eye-opening. We've identified nine key AI applications reshaping defense, and our application readiness radar shows that cybersecurity, followed by unmanned systems, exhibit the highest level of preparedness from a public and private investment perspective. Cybersecurity is a major priority due to increased proliferation of cyber attacks and disinformation campaigns, and this technology can be used for both defensive and offensive measures. Unmanned systems are also really taking off, no pun intended. mainly driven by the rise in drone warfare that's reshaping the battlefield in Ukraine.

4:37Arushi Agarwal:At the Paris Airshow, we saw demonstrations of wingmen, crewed and uncrewed aircraft. There have also been several public and private partnerships in this area within our coverage. Another area gaining traction is simulation and wargaming. As defence spending increases and potentially leads to more military personnel, we see this theme in high demand in the coming years.

4:58Ross Law:And how are European aerospace and defense companies positioning themselves in terms of AI readiness?

5:04Arushi Agarwal:Well, they're really making significant advancements. We've assessed AI technology readiness for our A &D companies across six different verticals. The number of applications, dual use capabilities, AI pricing power, responsible AI policy, and partnerships on both external and internal product categories. What's really interesting is that European A &D companies have higher pricing power relative to their US counterparts, and a higher percentage are both enablers and adopters of AI. To accelerate AI integration, these companies are increasingly partnering with government research arms, leading software firms, as well as peers and private players.

5:44Ross Law:And some of these same technologies can also be used for civilian purposes. Could you share some examples with us?

5:51Arushi Agarwal:The dual use potential is really significant. Various companies in our coverage are using their AI capabilities for civilian applications across multiple domains. For example, geospatial capabilities can also be used for wildfire management and tracking deforestation. Machine learning can be used for maritime shipping and port surveillance. But switching gears slightly, if we talk about the regulatory developments that are emerging in Europe to address defence modernisation, what does this mean, Arishi, for society, the industry and investors?

6:22Ross Law:There's quite a lot happening on the regulatory front. The European Commission is working on a defence omnibus simplification proposal aimed at speeding up defence investments in the EU. It's planning to publish a guidance notice on how defence investment will fit within the sustainable finance framework. It's also making changes to its sustainability reporting directive. If warranted, the Commission will make additional adjustments to reflect the needs of the defence industry in its sustainability reporting obligations. The sustainable fund reform is another important development. While the Sustainability Fund regulation doesn't prohibit investment into the defence sector, the Commission is seeking to provide clarification on how defence investment goals sit within a sustainability framework.

7:10Ross Law:Additionally, at the European Security Summit in June, the European Defence Commissioner indicated that a roadmap focusing on the modernisation of European defence will be published in autumn. This will have a special focus on AI and quantum technologies. For investors, whilst exclusions easing has started to take place, pickup in individual positioning has been slow. As investors ramp up on the sector, we believe these regulatory developments can serve as catalysts, providing clear demand and trend signals for the sector.

7:43Arushi Agarwal:So finally, in this context, how can companies and investors navigate these ethical considerations responsibly?

7:51Ross Law:So in the note, we highlight that AI risk management requires the ability to tackle two types of challenges. First, technical challenges, which can be mitigated by embedding boundaries and success criteria directly into the design of the AI model. For example, training AI systems to refuse harmful requests. Second challenges are more open-ended and ambiguous set of challenges that relate to coordinating non-proliferation among countries. and preventing misuse by bad actors. This set of challenges requires continuous interstate dialogue and cooperation, rather than purely technical fixes. From an investor perspective, closer corporate engagement will be key to navigating these debates.

8:36Ross Law:Ensuring firms have clear documentation of their algorithms and decision-making processes, human-in-the-loop systems, transparency around data sets used to train the AI models, are some of the engagement points we mentioned in our note. Ultimately, I think the key is balance. On the one hand, we have to recognise the legitimate security needs that defence technologies address. And on the other hand, there's the need to ensure appropriate safeguards and oversight.

9:04Arushi Agarwal:Arushi, thanks for taking the time to talk.

9:06Ross Law:It was great speaking with you, Ross.

9:08Arushi Agarwal:And thank you all for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

9:18Ross Law:The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.