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Franklin Templeton Insights: Geopolitical Risks in the United Kingdom

What is Happening in Ukraine?

Tensions have been high between Russia and Ukraine since long before the 2014 annexation of Crimea, underpinning a tumultuous history between the two regions. Accusations of an improving alliance between Ukraine and the Western world have exacerbated these tensions. These hostilities have considerably escalated in recent months, intensified by the amassment of Russian troops along the Eastern Ukrainian border. February’s invasion of Ukraine has sparked global outrage and protest, triggering a barrage of sanctions applied to Russian businesses and individuals, most notably their expulsion from global banking system SWIFT.

As international/Russian economic relations sever whilst the conflict deepens, the Russian central bank has been forced to respond in an attempt to combat the impact of Western sanctions. The Russian ruble had slumped 30% against the US dollar before the central bank doubled interest rates to 20% and committed to unprecedented monetary support to maintain financial stability. With thousands of displaced refugees in Ukraine, and Russian citizens flooding to dispense cash from foreign currency ATMs, the state of affairs across the two nations can be described as nothing less than a crisis on both a humanitarian and an economic level.

What Does This Mean for the United Kingdom?

There are some sectors which the ongoing conflict may disproportionately impact. Naturally, the main exposures are concentrated within large-cap equities, where 70% of the earnings of FTSE 100 Index companies are generated overseas; however, we are seeing at least some impact across the capitalisation spectrum.

Oil and gas accounts for around 9% of the FTSE All Share index, and when we consider this alongside Russia as one of the largest exporters of oil in the world, the interrelationship becomes evident. As concern grows over the supply of oil from Russia to the Western world, the price per barrel has soared to as high as US$105, which provides a tailwind for the UK-listed oil giants. We have closely monitored BP’s decision to dispose of its 19.75% stake in Russian state-owned oil firm Rosneft, and sanctions aside, we would suggest that divestment has been a long-time consideration as BP repositions itself as a green energy leader.

We have also seen some shifts in the aerospace and defence sector as Russia’s invasion of Ukraine has prompted a review of European defence budgets. Thus far, Germany has vowed to invest €100 billion in its military this year in a response to a new era of Russian hostility, and investors are expecting other global powers to follow suit.

Conversely, Russia is a large supplier of titanium into the Western aerospace and defence industry, and this could potentially create some major supply chain issues should Russia retaliate to sanctions applied by the Western world. Within the UK-listed miners, we are seeing supply chain constraints feeding through to commodity prices. As doubt is cast over the future supply of commodities, the consequent price spike provides a tailwind for mining stocks. As with most commodity price increases, we must consider the flip side of the coin and who ultimately bears the brunt of the spike.

Higher commodity prices are likely to cause cost pressures on a number of industries, and we must be mindful that this could also feed through to consumer spending. We have already seen this year the extent to which rising energy and food prices can squeeze household budgets. As uncertainty clouds future supply chains, the pressures for companies operating in Europe are likely to have a knock-on effect across the value chain. This compromises the policy outlook for central banks, which are faced with a dilemma on whether to increase interest rates to combat inflation in the midst of such a geopolitical crisis, thus heightening the risk of an incorrect policy call. Consequently, forecasting to any degree of accuracy remains testing, so we believe that retaining our long-term discipline in quality companies trading on reasonable valuations will support our navigation through periods of volatility.


 

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