Defense and Security Market Update: Q1 2026 in Review

Iran war sharpens focus on defense and security

Conflict headlines led to market volatility, while earnings updates acted as validation for operational performance.

Persistent geopolitical tensions defined Q1, which brought the start of the Iran war.

Meanwhile, shifts in US strategy following President Donald Trump’s address at the World Economic forum in Davos put the need for sustained defense spending and industrial rearmament in focus across the globe.

Larger order books at defense contractors reflected higher procurement spending, while governments pushed to diversify defense partnerships as the security landscape evolved. Canada deepened its ties with EU countries, and EU nations made moves to expand their security partnerships beyond NATO.

Earnings momentum in late January showed orders and backlogs rising on the back of missile restocking, nuclear modernization and aircraft demand. Volatility from Iran war headlines brought sharp single‑day spikes in defense stocks like Lockheed Martin (NYSE:LMT), RTX (NYSE:RTX), BAE Systems (LSE:BA,OTCPL:BAESF), Rheinmetall (ETR:RHM,OTCPL:RNMBF) and Honeywell International (NASDAQ:HON); however, gains faded as the so-called war premium was priced in and then questioned in March.

Modernization and market performance

Q1 narratives in the defense sector centered on a wide variety of topics, including drones and autonomous systems, missile defense and munitions production, naval modernization, space and satellite defense, cybersecurity and electronic warfare, AI-enabled battlefield systems and data infrastructure.

The Invesco Aerospace & Defense ETF (ARCA:PPA), benefiting from its exposure to mega-cap defense contractors, showed strength among aerospace and defense exchange-traded funds (ETFs), delivering a Q1 return of 5.82 percent. The State Street SPDR S&P Aerospace & Defense ETF (ARCA:XAR) saw a gain of 5.48 percent, driven by the outperformance of mid-cap and small-cap innovators compared to traditional mega caps.

Analysts believe that XAR will benefit from a shift toward modern defense technology.

This type of shift was reflected in SAP (NYSE:SAP) CEO Christian Klein’s comments in March. Klein told Bloomberg that the defense industry has become the company’s fastest-growing business line amidst soaring global military budgets, adding, “There’s high demand for better software, better AI to scale the businesses."

Government contracts and international cooperation

Amid increased defense spending and a trend toward modern defense tech, Q1 saw the Pentagon award a handful of fixed-price contracts for core missions to startups in this space.

Those include Anduril, which landed a US$20 billion agreement with the Army to consolidate the procurement and management of the company’s commercially available technologies, specifically its AI-enabled Lattice suite.

Alphabet (NASDAQ:GOOGL) also announced a collaboration with the US Department of War, providing use of its Gemini Agent Designer feature, which allows users to build custom AI agents for unclassified work.

Simultaneously, traditional heavyweights secured massive industrial orders.

The US government awarded Lockheed Martin a US$4.7 billion undefinitized contract action to accelerate production of PAC-3 Missile Segment Enhancement. A framework agreement was signed between the company and the Department of War on January 6 as part of the administration’s Acquisition Transformation Strategy.

Meanwhile, in a milestone for the country, Canada met NATO’s 2 percent GDP defense spending target, with the federal government’s 2025/2026 fiscal year defense budget surpassing C$63 billion.

Ahead of this news, the first in-person negotiations for the proposed Defense, Security and Resilience Bank (DSRB) took place in Montreal, Québec, with Canada hosting representatives from 18 founding countries to establish a charter for the new multilateral financial institution. The DSRB aims to pool capital to help nations purchase military equipment, as well as to help defense-oriented companies raise capital. The meeting in Montreal was the first of three rounds focusing on the charter, governance and operating procedures.

Major banks, including Canada’s Big Six, have expressed support for the initiative following a defense financing roundtable held in February.

Defense and security market forecast for 2026

According to Franklin Templeton, financial conditions remain supportive of risk assets, but “the margin for error is thin," with geopolitical risk contributing to moderate volatility and resulting in “uneven growth trajectories.”

Credit spreads remain tight due to the significant inflows of capital in recent years, despite uncertainty and concerns about valuation levels, liquidity and the potential for a rise in defaults.

“Should the trend reverse, we believe credit markets have potential for significant downside," the firm notes. The spread between credit risks and prices is wide within groups like software or commodity‑sensitive names.

Funds seeking more diversified exposure could turn to defense. An earlier deep dive by the asset management firm underscores that venture‑backed players have “a role to play” in shaping the next-generation US defense industrial base, as the traditional primes increasingly rely on startups for advanced capabilities.

“VC investment in defense will likely remain a significant growth area,” according to S&P Global Senior Research Associate Iuri Struta, referencing Anduril’s record-high funding rounds, which are expected to continue in 2026.

Reports of a US$4 billion investment round co-led by Thrive Capital Management and Andreessen Horowitz surfaced in March; however, the deal has not been confirmed.

“Meanwhile, strengthened stock prices for traditional defense players could fuel a new wave of deals in the defense sector. Incumbents may target promising startups to quickly boost their technological capabilities," states Struta.

While the longer-term demand backdrop may remain supportive, near-term performance will likely depend on execution, budget clarity and the pace at which investors receive new evidence supporting existing narratives through earnings, contract awards, policy decisions and export approvals.

Investor takeaway

Q1 solidified the defense sector’s position as a focal point for investment.

The period saw strong market performance across traditional aerospace giants and emerging innovators. Furthermore, government initiatives underline a commitment to long-term defense financing and partnership diversification.

For investors, the next phase is navigating the transition from narrative to execution.

Q2 performance will likely hinge on the pace of contract fulfillment, budget clarity and new evidence supporting existing growth stories through earnings, policy decisions and export approvals.

The sector remains a compelling opportunity poised for further evolution, but success will depend on identifying companies that can effectively translate high-demand signals into tangible operational results.