Insight

The focus of the next decade will be security, not just defence

The focus of the next decade will be security, not just defence
Key takeaways
1
The focus of the next decade will be security. Not just defence security, but energy, food, and supply chain security.
2
National and commercial resilience needs to be re-built, meaning increased fiscal spending, investment, and capital expenditure.
3
Commodity sensitive assets and stocks with resilient margins could be the best performers.

The Covid-19 pandemic and the Russian invasion of Ukraine have shown the fragility within parts of the global economy. Governments and companies need to address the challenges this will present.

Security will become the new buzzword, but not just in terms of defence. The need for greater resilience encompasses the energy sector, the food sector, and the supply chain model.

Why is defence security important?

Most European nations have been spending well below the NATO target on defence - a source of tension with other nations for many years. The first war in Europe in over 70 years has quickly flipped attitudes.

Already German chancellor, Olaf Scholz, has announced €100bn will be released to immediately strengthen the country’s armed forces. Greater defence spending is likely to be sustained in the coming year and other nations could follow.

So far, the Russia / Ukraine conflict has largely been fought in a conventional manner. But a greater bifurcation in the global economy and internet infrastructure means the risk of cyber-attacks is growing.

Spending by governments and corporates on cyber defences is likely to increase. Some of the investment implications are obvious.

Defence contractors are a clear beneficiary as their earnings should increase. Other sectors, like certain software and semi-conductor companies as well as metals and mining firms, could also benefit.

Many of these firms have been excluded from ESG (Environmental, Social & Governance) funds in the past. Yet now there is talk that the S in ESG could stand for ‘Security’ and ‘Social’.

That’s because the exclusion of defence by many ESG funds is being challenged. There is a realisation that relying on others to defend democracy is less socially acceptable.

Figure 1. Defence spending could rise

Source: Macrobond as of March 2022

How important is energy security?

In recent years, the EU has announced ambitious energy transition goals. In fact, the Next Generation European Union program has earmarked funds for greening the economy and reducing oil and gas consumption.

A 2021 survey of German voters shows that the environment is of prime concern. Events in Ukraine, and the reaction in oil and gas markets, mean this is no longer just an environmental issue but a security issue.

Fewer than two weeks after war broke out, the EU has announced aims to reduce dependency on Russian gas by 80% in 2022. That is a bold aim. But, even if it’s not achieved, it’s clear that European governments could be spending much more on, and reducing barriers to, renewable energy.

Sourcing gas from other parts of the world is likely to require spending on infrastructure. Industrial firms, metals & mining firms, may be beneficiaries.

The EU might seek to reduce the burden on consumers by imposing price caps or windfall taxes on energy firms. While this will limit gains, we believe energy firms could benefit from higher prices as they’ll be allowed to earn a higher and more assured revenue stream.

Commodity groups are a logical beneficiary and, longer term, so are renewable energy firms. The conflict in Ukraine has led to serious reflection on the future of nuclear power generation.

These power plants were being closed on environmental grounds even though they have decades left of usable production. This decision is put into stark focus when set against the desire to have energy security and less reliance on Russian energy supplies. Once again, this shows that ESG considerations are multi-faceted and often political in nature.

How is food security impacted?

Climate change has long been a reason to worry about the stability of food prices. In fact, food prices were rising well before war broke out.

Russia and Ukraine are major wheat and corn exporters, whilst Belarus is a large producer of potash – a key component of fertilisers. This does not bode well for food production and exports.

We can expect to see nations hoarding food and limiting exports. Higher food prices are darkening the inflation picture. In reality, it is lower income households within North Africa and the middle east who will feel the most pain, as they are the biggest importers from Russia and Ukraine.

Rising food prices have led to social unrest in the past – the Arab Spring being the prime example – but outside inflation the impact on financial markets is mixed. Democracies tend to take these events in their stride, but autocracies tend to see falling markets after social unrest breaks out. This is a risk we need to be mindful of when allocating to some emerging markets.

What about supply chain security?

The trade war between China and the US meant increased restrictions on technological transfer and the banning of certain corporations.

There is now a desire in the west to be less reliant on China as the source of many supply chains. Simultaneously, there is a desire in China to be more self-reliant.

The pandemic highlighted countries were beholden to global supply chains. This has led to calls for more resilience and domestic production.

The need for supply chain resilience could accelerate the de-globalisation trend that started to emerge a decade ago. This disrupted the previous globalisation period, and the removal of Russia from the trading universe will underscore this need.

Ukraine’s overall contribution to global trade is small. But it has outsized impact in the Auto industry, agriculture, and neon - Ukraine is the world’s largest producer of semiconductor grade neon.

Companies and countries have recognised that reliance on single sources of production can lead to serious issues and will move towards ‘just in case’ rather than ‘just in time’ production. Greater capital spending, reshoring of production, diversifying suppliers, and holding a greater level of inventories are likely outcomes.

For some companies this will mean lower margins, but others will benefit from that capital spend. Firms that have large and resilient margins will be rewarded.

The crisis has compounded some trends

The Ukrainian crisis has changed the world in several ways, but also compounded some existing trends. European governments and corporates were already expected to spend more on infrastructure and supply chains, and this pressure has intensified.

Fiscal spending tends to be inflationary, and the consumer is likely to face a squeeze on purchasing power. But fiscal spending could offset that squeeze and keep the global economy out of recession. It might also result in the reversal of 30 years of secular stagnation.

For financial markets there could be some key implications:

  • Potential for upward pressure on nominal bond yields
  • Equities could benefit from earnings growth. This could be heavily driven by commodities, industrial and technology sectors.
  • European stocks have been hit hard. Yet medium-term, they could be some of the biggest beneficiaries.

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