It is almost impossible not to comment on the Ukraine crisis. Excepting the smaller events in the Bosnian war of the 1990s, this is the first major conflict in Europe since the second world war in 1945. There is no doubt that there are immense geopolitical and economic consequences, which need to be evaluated by markets. This will need to be worked through as it evolves, but already the tectonic plates of Europe are moving, and the old structure is being replaced.
In a classic case of the law of unintended consequences, Putin, has made matters worse for himself as NATO has been galvanized and is no longer the sleeping creature it was. Other countries, such as the Nordics, are thinking of joining NATO. The West is now aware of his plans and is showing some gumption.
Over the last twenty years successive decisions by some Western leaders have led to Putin believing the West was weak and divided and, in some cases, notably Germany that he had them on hook as he supplies such a large amount of their energy needs. Obama did nothing when Russia invaded Crimea in 2014. Germany chose to close all its nuclear power stations and buy most of its energy from Russian and Biden’s hasty withdrawal from Afghanistan must all have led to Putin deciding that he was in a strong position.
Now, we are seeing some of the consequences of these decisions on top of the huge suffering of the people of Ukraine. The military strategists will have noted how effective anti-tank weapons have been and how vulnerable the tank is. Is it the end of the tank? Fighter aircraft is yielding the skies to military drones. Lots to think about here.
As far as economic fallout, there are five key outcomes.
First, we see another blow to globalization. The pandemic was the first warning that supply chains in a global world are too long and there are now further threats that call for greater self-sufficiency in key materials. This will benefit UK manufacturing.
We have seen how a shortage of microchips can halt a complete auto line in the West. China will be watching with interest and will see how dependent the West is on Chinese products and components.
Of course, with inflation rising after the Pandemic the energy crisis now seen will further hit inflation numbers.
Several European nations are close to 10% inflation, and we could easily see that level in more during the latter half of year. For any government, that is a gift to the opposition, for a company it is a question of pricing power. Some have it and some do not, I like distributors as it is easy to alter prices as suppliers raise them. Time lags on price increases can be very damaging if the balance sheet is weak and your pricing power is poor.
The energy questions posed are a two way pull. In the short term we need more UK based oil and gas, so expect to see more North Sea exploration that seemed out of court before and similarly a fresh look at fracking as there is more gas under Lancashire than in most parts of the world. The problem is that the long-term solutions with mini nuclear units and wind farms offshore in the Irish sea are years away in providing greener energy in bulk, short term it means more of our own fossil fuels – a negative for the green lobby.
Whenever there is an energy crisis – as in the early 1970s – it is usually followed by a recession. Expect one by the end of this year. For the consumer, life will be tough. The bottom 20% of the nation will not be able to pay their gas and electric bills without external help. The next 20% thought they had accumulated a nice nest egg during the pandemic, but that will quickly evaporate. The richest 20% will not notice too much. So that means slowing consumer spending. which is so important in the UK economy. It will also mean trading down by consumers and greater levels of debt. If I may digress here, here is another example of the law of unintended consequences, where interest rates charged on unsecured loans to the poorest have been huge. So, to protect the borrowers, regulation has been raised and lenders have found it no longer economical, and you can see the development of unregulated under cover lenders as desperate borrowers end up in a more adverse position than before. From an investment view that is a boost for traditional pawnbrokers such as H&T, where the loans are backed by gold and jewellery.
The other change we are certain to see is a significant increase in defence spending in the Western world. The UK is spending around 2% on defence; During the cold war, we spent around 5%. Russia spends 5% now, Germany is spending 1% and will need to step up to the plate. Ironically, when I spoke to a fund manager recently, he told me his performance will be poor in the near term as following his ESG (Environmental Social and Governance) doctrine, he holds no defence or oil stocks! Markets show great resilience, but it is a topsy turvy world, so hold on to your index linked gilts, defence, and oil stocks.