By Shashwat Chauhan and Anna Pruchnicka

Jan 8 (Reuters) - Global defense stocks climbed on Thursday after President Donald Trump called for a substantial increase in the U.S. military budget, fueling a fresh rally amid ongoing geopolitical tensions.

U.S. defense companies rebounded after falling on Wednesday following Trump's threat to block American contractors like RTX from dividend payouts or share buybacks until they speed up weapons production.

Trump said on Wednesday the 2027 U.S. military budget should be $1.5 trillion, significantly higher than the $901 billion approved for this year.

"The administration would need to pass any major boost before the midterms and with plenty of last year's reconciliation money still to be awarded, additional funding would prolong growth rather than drive a massive near-term spike in sales," J.P. Morgan analysts said in a note.

While congressional authorization for such an increase could pose a challenge, Trump's Republicans, who hold slim majorities in both the Senate and House of Representatives, have shown little appetite for objecting to the president's spending plans.

U.S. defense companies Northrop Grumman and Lockheed Martin rose around 7% each in premarket trading. Both stocks had slid around 5% on Wednesday.

RTX climbed 4.6% and L3Harris Technologies added 6.2%, while General Dynamics was up 5.5% in light trading.

Smaller defense firms Kratos Defense and AeroVironment climbed 8.8% and 7.7%, respectively.

European defense companies, however, began to lose steam after surging at the start of the session. The index for aerospace and defense companies was last up 1.1%, having jumped as much as 2.1% to hit an all-time high.

The index has rallied sharply since Russia's 2022 full-scale invasion of Ukraine, driven by the prospect of more spending on defense in Europe.

Despite a pullback from October, it gained around 57% last year and started 2026 on a strong footing as sentiment was buoyed by U.S. military action in Venezuela and Trump's comments on Greenland.

"Geopolitics is the inescapable story of 2026 thus far," said Neil Wilson, UK investor strategist at Saxo Bank.

"Clearly defence stocks are the play - along with rare earths."

BAE Systems - Britain's largest defense company - was last up 5.5% after jumping nearly 7% earlier, while Italy's Leonardo, Sweden's SAAB, Germany's Rheinmetall, Renk were up between 1.5% and 2.7%.

LOOMING THREAT ON DIVIDENDS & BUYBACKS

Share buybacks are common among defense firms, and several pay a dividend. Lockheed in October, for example, raised its dividend for the 23rd year in a row, to $3.45 per share. It also authorized the purchase of up to $2 billion of its shares, raising the total amount promised for repurchases to $9.1 billion.

Separately, Trump also wrote in a Truth Social post Wednesday: "I have been informed by the Department of War that Defense Contractor, Raytheon, has been the least responsive to the needs of the Department of War." Raytheon is a unit of RTX.

Morgan Stanley analysts estimate that dividend yields for Northrop Grumman, Lockheed Martin, L3Harris, General Dynamics and RTX averaged around 1.9% and these companies bought back about 1.8% of their respective market caps.

"A limit on capital return is an incremental negative, but the size is manageable," Morgan Stanley analysts led by Kristine Liwag said in the note.

Dividend yield on average for companies on the S&P 500 stood at 1.37%, as per data compiled by LSEG.

Trump's order has significant implications for U.S. defense contractors that may foster a rotation to UK defense companies, Ben Bourne, an analyst from Investec, said in an emailed comment.

BAE Systems, Chemring and Avon Technologies have the highest U.S. exposure, Bourne added, noting that Cohort, Babcock and Qinetiq could also benefit.

(Reporting by Anna Pruchnicka and Shashwat Chauhan; editing by Alun John and Sriraj Kalluvila)