The complications of war

The obvious price and effect on humanity quite rightly takes centre stage, however, there is often significant damage to a nation’s infrastructure and its economy. If conflict escalates, the ripple effects can broaden out into surrounding countries and even to the global economy. For Russia and Ukraine think of the rising cost of Natural Gas in 2022, which pushed energy prices across Europe up 350% at one stage. That fed into wider production costs, pushing up inflation, as the production costs for businesses increased, leaving the consumer to foot the bill. This heightened demands for increases in salaries from consumers to their employers, who in turn put their prices up to cover increase in labour and the extra cost of supplying goods. This is fine if the business can maintain the same sales volumes by putting prices up. If they can’t, then profits fall, and the business weakens. If they can, then the consumer faces extra costs on an ever broadening basket of goods, and so the circles continue until something breaks.

Putting to one side the obvious humanitarian tragedy, the Middle East is an area of concern from two perspectives, one is the price of oil, the other is if surrounding logistics routes which are key shipping routes for trade linking East to West. On the face of it, neither Iran or Israel  make up a significant part of global business and/or trade, but from an investment perspective, we are always mindful of the ripple effects. Sometimes things that on the face of it are directly immaterial, can broaden out into bigger waves once the indirect costs are also born.

The initial ripple in markets has seen a spike in the oil price, with Brent Crude moving from $63 per barrel on 30^th May, to $77 as of 20^th June. A 22% increase in just a few weeks is significant, and also surprising given Iran’s oil production is just 4% of global supply.

If sustained, higher oil means higher inflation, which in turn makes it harder for Central Banks to reduce interest rates as they otherwise would have done, therefore reducing the chance of stronger economic growth. So suddenly you can see the case where, indirectly, every business in the UK could feel the impact of the Israel-Iran conflict, not dissimilar to Russia Ukraine, even though a fraction of the supply chain is affected by contrast.

Another key implication of the various geopolitical conflicts is that it reinforces the growing push for further defence spending. As recently as last week, during Rachel Reeve’s spending review, the Chancellor once again increased the UK’s commitment to defence, as she aims to increase it from 2.3% of GDP each year to 2.7% by 2027. Unfortunately for the UK economy, the spending review is unlikely to yield much by way of productive growth to improve our fiscal deficit, and so unless the cost of borrowing comes down sharply in the coming months, Reeves will have to increase taxes again in October. Again, the ripples are gathering momentum. If rising oil prices mean inflation remains sticky, borrowing costs are less likely to come down, the consumer will have to dig deeper with higher taxes and higher borrowing, squeezing both businesses and consumers. Who would have thought that the Israel-Iran conflict and Rachel Reeve’s spending review are actually intrinsically linked!

So, we continue to have a challenging economic backdrop, with conflicts adding to that mix. It is important to say that it doesn’t mean it isn’t a good time to invest. In June, our Low and Very Low risk portfolios have just reached new all-time highs, so it shows our cautious stance is slowly paying dividends. This also reinforces that we continue to expect our portfolio income to underpin our returns, irrespective of the backdrop. More of this in our next blog which is our quarterly investment review and outlook, though for now, just as we thought the environment couldn’t get more complicated… it did.