Sanctions by Western nations targeting Russia — in response to its invasion of Ukraine as well as the humanitarian and cultural crisis it has created — have geopolitics once again dominating the world’s (and investors’) attention.
From an economic perspective, tough international sanctions imposed by the West and its withdrawal of Russia from global financial trading networks is designed to have a devastating impact on the Russian economy, which will take years, if not decades, to recover. Russia’s central bank recently warned of a “large-scale structural transformation” for the economy and held interest rates at 20% in order to prop up its plunging currency.
Many companies located in the U.S., Europe and elsewhere that conduct business internationally have been impacted by these sanctions. The Yale University School of Management, has collected details from more than 400 major corporations that have withdrawn, suspended or scaled back their operations inside Russia.
Many of the firms documented by Yale operate in the consumer space or in business-to-business transactions. The U.S. defense sector (and firms operating in NATO countries) are largely absent from this list. This makes sense considering the Pentagon has discouraged defense contractors from using Russian raw materials or parts. Still, there are two areas where the sector is exposed: titanium itself and the supply chain for titanium parts.
Titanium and titanium forgings play an important role in aerostructures and engines, as they are resistant to galvanic corrosion (this occurs when two dissimilar materials are connected to each other). In 2019, the U.S. imported 95% of the titanium it consumed. Mines in the U.S. were shuttered between 2016 and 2020 because firms could easily purchase imported material for less than their domestic cost of production.
Globally, there are four major aerospace titanium suppliers: VSMPO (Russia) as well as TIMET, ATI and Howmet Aerospace (all three based in the U.S.). VSMPO produces roughly half the global supply of structural titanium for aerospace. To prepare for supply chain disruptions, aerospace companies have been buying any and all titanium reserves that are available to withstand any future shortages.
Boeing CEO David Calhoun stated that the company, which receives 35-40% of its titanium from VSMPO, is “protected for quite a while, but not forever.” Spirit AeroSystems and Pratt & Whitney have also mentioned publicly they have contingency processes to mitigate this risk and reduce their dependence.
Military aircraft are not immune. While the near-term impact should be muted, production of F-35 fighter jets could feel the pinch of a titanium shortage until the supply chain is able to strategically cope. In 2015, Alcoa won a nine-year deal with an estimated value of $1.1 billion to supply titanium to Lockheed Martin. With the contract approaching renewal, the Defense Department’s Office of Industrial Policy will have to watch this area very closely. It wouldn’t be a surprise if the Defense Production Act is used in some form or if F-35 prices rise accordingly.
Meanwhile, defense orders and future budgets in the U.S. and Europe are seeing significant growth. The budget proposed to the German cabinet included a special defense fund worth €100 billion (U.S. $110 billion), and it is planning to purchase 35 F-35A fighter jets from the United States. Poland increased its defense spending to 3% of its gross domestic product from 2%. French President Emmanuel Macron pledged to increase his country’s defense spending, with Finland, Latvia and other European nations likely to follow suit.
In the United States, President Joe Biden just signed a budget bill that was $30 billion above his initial request for defense spending — providing $6.5 billion in military support for Eastern European countries, including $3.5 billion in additional weapons for Ukraine. This is on top of more than $1 billion the U.S. had already spent over the past year to provide the Ukrainian military with Javelin anti-tank and Stinger anti-aircraft missiles.
With the world focused on security and concerned about how the situation in Ukraine develops (and what follows next), defense stocks and investor interest in the sector have been soaring. The Invesco Aerospace and Defense ETF (NYSE: PPA) has seen its assets under management increase by more than 80% since Russia launched its invasion, and the share price of this fund is at historical highs.
In evaluating individual companies, defense firms with large commercial manufacturing operations that make use of titanium are more exposed to the impact of sanctions (for example, Boeing, Raytheon Technologies and Honeywell), whereas those focused on defense hardware (such as Lockheed Martin, Huntington Ingalls Industries and Northrop Grumman) or digital warfare, information technology and sensor analysis (such as CACI, ManTech, SAIC and Maxar Technologies) are likely more insulated.
We should not lose perspective of the humanitarian and cultural impact that the Russian invasion of Ukraine has had. Still, purely from a business perspective, the bottom line is that the financial impact of sanctions on defense companies is likely to result in little harm, especially when weighed against the increased spending and activity for the sector’s products and services.
Scott Sacknoff is president of SPADE Indexes and manager of the SPADE Defense Index.