00:00:00 - Daniel Morris
Hello, this is Daniel Morris and welcome to Macro Waves. I'm the Chief Market Strategist with BNP Paribas Asset Management. I'm here with William De Vijlder, Chief Economist at BNP Paribas Group.
William de Vijlder
Hello, Daniel.
Daniel Morris
Hello, this is part two of our podcast series on geopolitical uncertainty and economic consequences.
In part one, we talked about geopolitical uncertainty at a high level, why it matters, how you measure it, how things have evolved over the last decades, what kind of crises we've seen. Now, we want to take it a step further and try to think a bit more about what are the implications and why does geopolitical uncertainty matter to firms or to households or to markets.
So perhaps, William, we can start with the implications for firms. There is some geopolitical shock, we're uncertain. Fine. What are the ways that that has an impact on firms' behavior?
00:01:09 - William de Vijlder
Yeah, I think the question is about the transmission channels, how our firms are impacted. The first thing that springs to mind is what is this going to do to my turnover if uncertainty materializes and if the much-dreaded event occurs? But you could also have a negative impact on turnover simply if people become more cautious, of course, so without the realization of the uncertainty event.
So turnover is important. Another question is what's happened to the cost base? If you think about geopolitical risk that could end up impacting the price of oil, gas or other commodity prices, you would immediately see, at least for some firms, an impact on the cost base.
It could also be that you could end up having geopolitical events that are very profound and that could mean, for instance, that companies would have to stop their activities in certain countries. This is what we have seen, actually, with the war in Ukraine and the sanctions against Russia that were impacting Western companies that were operating there.
Another transmission channel is the cost of financing. It could be that interest rate increased because inflation increases following geopolitical risk event. It could also mean that investors, for instance, become far more cautious and demand a high-risk premium and that would then mean that the cost of corporate borrowing increases.
Or you could have a situation that simply accessing financing is becoming more difficult because markets are de facto shut down or bank-based financing could also become more difficult because of increased caution by banks. So when you put all these elements together, it's about turnover costs.
It's also about, is it going to be a write-down of certain assets and then the financing, both the costs and the access to financing.
00:03:10 - Daniel Morris
And now if you're a CEO or a CFO and you're faced with this uncertainty, to some degree there's always the uncertainty about the future, but given your job, you have to take a decision. How does this uncertainty play into the decisions, again, that could be taken and whether or not they can be reversed later on?
00:03:30 - William de Vijlder
Yeah, that's of course the fundamental question that companies are facing. The easy answer would be is when you feel uncertain, simply stop and watch until uncertainty drops. But you can have situations that your political uncertainty almost lasts forever.
So there is a value in waiting because you avoid that you would have to take losses when an uncertainty event materializes, when it occurs. But there's also an opportunity cost in waiting because if your competitors, for instance, are less reluctant to take decisions, or you could say are more courageous, or if you want to be cynical or more naive, well, they will have an edge compared to the company that has been more shy and has been in risk avoidance mode.
And that's really the balance that needs to be struck. There's another point that needs to be kept in mind, that is that when you think about investment projects that are underway, I would expect that most companies would simply continue in finalizing them.
But if you think about investment plans, then indeed, there will be an inclination to put them in the fridge and wait a little bit because it's very difficult to come back once we have started. So the irreversibility of these decisions is such that then you have an incentive to wait.
But that decision in turn, one is a difficult one to take, but it also is very much driven by certain, I would say, parameters. So one element that is very important in that respect is, do you actually have a view on when the uncertainty will be resolved?
This is a fundamental point. So if you think that uncertainty will be resolved in one year's time or six months' time, waiting will not be that expensive. If you think it could last years and years, then the opportunity cost may become dominant compared to the net present value of possibly making a loss.
And then companies may actually may decide to go ahead and do the investment, even though they are faced with uncertainty. The uncertainty is less intense because it would probably drag on and on. That's for instance why the reaction to say elections, elections that come with uncertainty would be different compared to another source of geopolitical uncertainty that would be longer lasting.
But also matters of course is how likely is it that there would be a bad outcome? That is completely judgmental because you don't have any force simply right away, statistical distributions, historical distributions to make that assessment. And then another tough one is that as a company, we'd need to make an assessment of in case of a bad outcome, how much would I lose?
And this is also a very tough one, of course. So all in all, dealing with uncertainty is fairly complex. But if you think about the elements which I've mentioned, I think they do allow you to kind of come to a decision that is based on a careful analysis of what really matters.
It will still be judgmental, but at least you have really reviewed all the relevant elements which are when will uncertainty be resolved, the likelihood, the loss and the reversibility or irreversibility of my decision.
00:07:29 - Daniel Morris
And I think even probably caveats about knowing that these are just estimates and judgments. If a company can in some way try to quantify, as you said, what's going to be the opportunity cost of not taking the decision versus what we think the cost might be if we take the decision and things go badly.
But I think that already is a big step forward. Could you talk maybe a little bit more about what are some of the decisions that might be affected by this, whether it's go or no-go? What are some of the parts of the business that would be affected?
00:08:01 - William de Vijlder
Yeah, that's an important question because there is a risk of arriving at a conclusion where you have a big jump in geopolitical uncertainty and actually there's not a lot that's going to happen. Why? Because projects on the way are finished. I mean, one continues as if nothing has happened.
And then the others, well, you can just put them on hold, but that is very much dependent on how long the uncertainty will last. But I think in the meantime, what companies also do is they will have a reaction of saying, well, there are decisions that I can take today and that protect my bottom line and that can be easily stopped and I can easily go back to what I was initially planning.
So one example, for instance, is marketing budgets. Okay, I'm a macroeconomist. I have nothing against marketing, far from that. But you could very easily decide that a marketing campaign would be temporarily put on hold and that way you save money. Typically, you would also have a very careful look at the use of external advice of consultants, for instance, and to critically assess, do we need it or can we just stop that for a while? And also, even hiring decisions can also be put on the back burner. Company could simply say, well, we're going to cut back our hiring, slow down the pace and then re-accelerate thereafter once uncertainty would have dropped.
So these decisions are easily reversible and allow a company to react. And that's also why I am concerned that at the current juncture with this increase in geopolitical uncertainty that in these areas you would have a rather quick, say, a reaction, a quick effect of this heightened uncertainty on company decisions.
00:10:05 - Daniel Morris
We've talked a lot about, if you will, the kind of a theoretical analysis of the impact on firms, geopolitical uncertainty. Has there been much research that's been done to really try to assess what it does to firms' decision making?
00:10:18 - William de Vijlder
Yeah, well, fortunately, in recent years, there has been quite a lot of research on the impact of uncertainty, but also, I would say even more fortunately, about the specific impact of geopolitical uncertainty or geopolitical risk. So there has been one analysis conducted for the US covering the period 1985 until 2019.
Published in the American Economic Review and the authors there found that the shock to geopolitical risk induced a persistent decline in investment, in employment and in stock prices. And actually, these declines in activity, they were due both to the threat and to the realization of adverse geopolitical events.
So the threat is already, I would say, a sufficient condition to have a visible detrimental impact. Now, as I mentioned earlier, there is the element of the reversibility of decisions and there has been research by the Federal Reserve Bank of Dallas that specifically analyzed how macroeconomic uncertainty, which admittedly is a broader concept than geopolitical uncertainty, how that has influenced the labor market and specifically how that influenced the hiring decisions of US firms.
And what they found is that increased macroeconomic uncertainty forced US companies or triggered a reaction by US firms to reduce hiring. Actually, firms also let people go more quickly than otherwise they would have done. And that actually may be related to the attitude of households.
So when firms are faced with disappointments in terms of their sales numbers, because households are becoming more cautious, then they will produce less, hence they need less staff, so that we have a feedback loop between households' reaction to uncertainty and firms' reaction, which then in turn circles back to households.
Now, research covering European companies has come to similar conclusions. So when uncertainty in Europe is high, firms tend to reduce hiring or not to renew temporary contracts. So what you could say is that the theoretical analysis, the a priori you would have, has actually been confirmed in recent empirical research.
00:13:04 - Daniel Morris
You talked about the impact on households. Maybe we can go into that in a little more depth. Obviously, ultimately, a firm's activity is going to depend quite a bit on what households are doing. And you mentioned a feedback loop. Can you address some of the ways that this uncertainty can impact households and how they think about spending or not spending?
00:13:24 - William de Vijlder
I think one element is what I would call the more almost generic reaction to uncertainty, when every time you switch on your TV or you check your news on social media and you're kind of are confronted with geopolitical tensions, I think at the end of the day, you start to wonder, what is this?
How can this impact my own situation economically, et cetera? So I think this is a convoluted way of saying is that people will have doubts about the future income evolution. So income uncertainty increases. And then there is indeed, as I've mentioned, the feedback loop, which I already described.
And what you will see is that households' reaction will also very much depend on what is happening to key economic variables. Think of energy prices. For instance, when you look at August 1990, when we had the invasion of Kuwait by Iraq, jump in oil prices, you had an immediate drop in household confidence.
Now, I must immediately add that there was a combination of a jump in uncertainty, but also a kind of a realization of a geopolitical shock. So it's a combination of both that had an immediate impact on household confidence because of what was happening to energy prices.
00:14:53 - Daniel Morris
We can see then clearly, if understandably, people are uncertain about the future and nervous and certainly in this day and age, as you mentioned, social media, it does sometimes seem to be all bad news all the time. Understandably, people would be inclined to spend less, which is going to have an impact on firms' activity and so on.
Is there research that supports that hypothesis?
00:15:16 - William de Vijlder
Yes. What you see in recent, I would say, very high quality research, very rigorous research for Europe and the Eurozone is that when there is an increase in uncertainty, that households react by reducing discretionary spending. So the emphasis is very much on the word discretionary.
That is straightforward in the sense that the necessary items that you need to buy, you will continue buying them, of course. But on the discretionary, this is where you see an impact. So for instance, households cut back their spending on non-durables and on services.
But then non-durables, what does that mean? These are things that are kind of nice to have, but then that means that when they're nice to have, you don't feel too bad if you can simply stop spending money on them. So one example that I remember reading this research was people buy less perfume.
That's one example. Or in terms of services, people go less often to the fitness. But there are also, I would say, more concerning reactions. People tend to go less often to physicians so that they cut back on their medical spend. And then of course, there is a negative impact on luxury goods spending.
People travel less, negative impact on buying package holidays. And you could even argue that if uncertainty is high and remains high, and then in particular, if there is some economic knock-on effect through the reaction of companies and hiring and firing decisions, you would also expect that durable goods expenditures would be impacted.
Think of buying a new car or refurbishing your house and so on. So research confirms this picture.
00:17:23 - Daniel Morris
Of course, those decisions about whether to spend or not to spend is going to have an impact on the companies that are producing the services or producing the goods. And that all, of course, should be reflected in financial markets. So maybe for the last topic, we'll talk about how or what the impact is of this geopolitical uncertainty on financial markets.
What does it mean essentially for investors? Maybe talk a bit about, as an investor, as opposed to being a firm or a household, what are some of the differences and some of the key considerations?
00:17:55 - William de Vijlder
I think the key difference is the level of the transaction costs. So that means that when you're operating in liquid markets, you can very easily scale back your position to a certain instrument at a low transaction cost. And then if you think uncertainty has peaked, then move back in.
So that's a very important difference. So the reversibility of decisions is very high. And that, I think, is explaining why you would expect that you would have more activity in markets as people react to the bad news. From where you're sitting, considering that you're in asset management, is this something that you see with your clients or even with the managers that are taking care of the interests of their clients?
00:18:44 - Daniel Morris
Well, on one end, it feels like we've been talking to clients about, to some degree, having to accept a certain permanent degree of uncertainty. Because again, going back to the global financial crisis, I would argue or suspect that there's been generally an increase in cash levels because the response of investors is to pull away from the market, put money in cash, kind of wait and see until things are clearer or more sure or safer, and then decide.
Except we never seem to get to that sure or safe moment. So it's almost a continuous conversation to say, there is going to be this uncertainty, it's unlikely to go away. You do have to take a decision and then try to take the most informed one that you can.
So absolutely, it's a very frequent topic of conversation with our clients.
00:19:34 - William de Vijlder
When we were talking about companies, I was mentioning transmission channels. I would expect when you look at the portfolio, that you already do clients a big service when you kind of show the risk mapping of their portfolio, how they would directly or indirectly be exposed to uncertainty remaining high or even escalating further.
And by being able to assess where there would be impact, then could it be big or would it be small that is already giving some degree of comfort?
00:20:10 - Daniel Morris
Yeah, exactly. I think we often try to help clients to run scenarios to assess the impact on their portfolios of different outcomes, different scenarios, and whether, again, as we've discussed, spikes in oil prices or other things that could affect the value of portfolios.
Yes, I think it does help for them to see or to focus on the parts of the portfolio that, so to speak, are most at risk if things do deteriorate. This was part two of our discussion, William, on geopolitical uncertainty. On the one hand, appreciating that the best that we can do is to make judgments about how things might evolve, try to quantify the best that we can, what the impacts might be on corporate profits, on economic growth, and then to assess the impact on households, and ultimately, hopefully, help investors take better informed decisions for their portfolios.
Thank you, William. It was a real pleasure being here with you.
00:21:08 - William de Vijlder
Thank you, Daniel. Likewise, I very much enjoyed it.
Recorded the 11/03/2023
