00:00:13 - Daniel Morris
Hello and welcome to Macro Waves. This is Daniel Morris. I'm the chief market strategist for BNP Paribas asset management. I'm joining today William De Vijlder, who is the chief economist for BNP Paribas group. Hello, William. How are you?
00:00:28 - William De Vijlder
Hi, Daniel. Good to see you.
00:00:31 - Daniel Morris
The topic for the podcast this time is geopolitical uncertainty and the economic consequences.
I think it goes without saying this is a timely topic. I think we would like to imagine that we could have at least some period of time without a crisis. And frankly, if you go back to 2008, and we called it the global financial crisis, as if that would be the biggest you could possibly have, because it was already a global crisis
and in retrospect, that seems quite a long time ago. And there's been more than enough stuff that has happened since. And I think we probably resigned ourselves to the view that we're going to probably continue to have crises and turmoil indefinitely.
So one perhaps have to get used to it, but also need, therefore, to be able to assess what that means from an investment point of view, what does it mean for economics? So maybe the first thing to touch on, if I could ask you, William, when we think about macroeconomics, let's start with the uncertainty that's engendered whenever you have a geopolitical crisis.
We all have mathematical backgrounds, if you will. And we like to have numbers and equations and put figures in spreadsheets that are very exact. But if we talk about geopolitics, that clearly is a lot more difficult. So maybe you can help us understand what that uncertainty or the implications of that uncertainty for the macroeconomic perspective.
00:01:58 - William De Vijlder
I agree with you that we have gone over the years through many crisis situations and waves of uncertainty that come and go and disappear. And then you have other parts of the world where there is uncertainty popping up, be it economic or, like more recently now, geopolitical.
And really what it implies is that the trust in predictions about future key economic variables goes down. People feel less confident when they make predictions. Predictions can be very implicit. It can be based on, do I expect that my income will be at the same level in one year or two years' time?
Or as a company, do I expect that my sales numbers will be in line with what I have assumed in drafting my budget? So when uncertainty increases, there is concern that these projections or assumptions will not turn out to be true. There's also in particular a concern about tail risk.
I think when uncertainty increases, people focus on the downside risk and in particular on extreme downside risk, what statisticians call tail risk. And it also means that it's, of course, boosting risk aversion. So all this has a profound impact on behavior.
It's quite possible, as we will discuss later on in the podcast, that companies will scale back investment plans, for instance, or that households will also react to this increase in uncertainty.
00:03:37 - Daniel Morris
When I think we've seen, unfortunately recently, the pattern that you've talked about with what's happened in the Middle East, initially or soon after you see a risk-off moves into the market issue, you tend to think about, well, what's the worst that could happen?
And immediately you see these predictions of $150 per barrel oil prices and what that would do for global growth and so on. And yeah, I think there is certainly a kind of a knee-jerk reaction in these situations to go to the worst-case scenario, which, as always, we hope turns out to be unnecessary and that things come out somewhat better than they were than when we started.
We've mentioned, I guess, uncertainty in general. And clearly, uncertainty can take a lot of forms. And frankly, one aspect of uncertainty that we've had to deal with more through the pandemic is certainly around the economic uncertainty, given that we've been in an environment that is so unusual compared to history.
I think this time, though, we want to focus a bit more particularly on geopolitics. What are the implications when the uncertainty we're dealing with is geopolitical?
00:04:40 - William de Vijlder
Yeah. I think your reference to pandemic is a really good one. As economists, we tend to think about macroeconomic uncertainty, macroeconomic uncertainty, for instance, with respect to how is the business sector going to evolve and any kind of shocks that can hit the economy but that are rooted in economic developments.
And then came the pandemic. And although the impact on the economy was, of course, profound, as we all recall, the origin was completely outside the economy and was creating big challenges for economists and market analysts, big challenges to come to grips with that.
Now, with geopolitical uncertainty, I would say it's a bit similar because when you think about economic uncertainty, you always try to find stylized facts in history. So if in history, in the past, this happened, A happened, B tended to follow. So that's a stylized fact.
With geopolitical uncertainty and also with the pandemic, by the way, that is basically impossible. So it means that you can only build scenarios about if this or that happens, and then you have to find a link through economic variables, how that could specifically impact behavior.
00:06:02 - Daniel Morris
We talked about economic variables, and then that inevitably brings up the idea, well, how do you measure these things? And just in general, how do you measure geopolitical uncertainty? I think we've evolved with the times and we appreciate doing Google searches for start. Or other types of metrics to identify what sentiment, if you will, might be across investors. What are some of the things that you think about when you try to measure this geopolitical uncertainty? And I guess what are some of the risks or the things you need to keep in mind when you'redoing that?
00:06:36 - William de Vijlder
Yeah, I think there's really a fundamental distinction to be made between the measurement of geopolitical uncertainty. I would say, quote unquote, measurement, because you cannot measure it precisely. You can only look at, say, references to geopolitical uncertainty.
And that's quite different from what you would do if you would look at, say, uncertainty in general or economic uncertainty specifically. For instance, one measure that is very often used by analysts is the focus on economic uncertainty. And you look at the dispersion of answers, how many people feel relaxed about the future and how many feel not relaxed about the future.
I'm kind of simplifying the question, of course, that would be asked in this survey. It's such a survey, but that dispersion can already shed some light on the feeling of uncertainty, although it should be emphasized very strongly, I would say, that you can have a situation that everybody agrees, so there's no dispersion, yet everybody is feeling very, very uncertain.
Your reference earlier in this podcast to 2008 is exactly something like that. And the spring of 2020, with the pandemic, same story. You have surveys where there are direct questions asked about uncertainty. The European Commission has developed these surveys and they're quite useful.
And then there are the more sophisticated ones like forecast error-based measures of uncertainty that means that people then look at how small or large are the forecast errors that we have observed. I must say I have some mixed feelings about that because the man in the street does not know these forecast errors.
So I think it's more an expression of how difficult the environment is rather than simply saying, well, the environment is being perceived as being very uncertain. And then there is the media coverage. Media coverage has become wildly popular over the past, well, past 20, 30 years.
And of course, it has benefited a lot from what you mentioned, the internet searches and the fact that you can now use machines to count the number of references in the media, which in the old days was a human effort. And that's very useful and allows you to monitor when the reference to adverse geopolitical developments is increasing.
And this is the key metric that is used by economists, journalists, whoever, to gauge how geopolitical uncertainty evolves.
00:09:21 - Daniel Morris
And talking about internet searches and being able to look at transcripts and so on, but at the same time, I think we're learning more and more the challenges. And on one hand, you have now the ability, I mean, essentially, that computing power is so cheap, you can do things that would have been unimaginable before, but at the same time, garbage in, garbage out.
If you're surveying a bot that's putting out false stories, the information that you can withdraw from that is probably relatively limited. So as always, there's an opportunity, but to use it in a thoughtful way is probably the bigger challenge.
00:09:57 - William de Vijlder
I think that's also the reason why people started looking at this many years ago, by simply looking at newspaper articles, because that was the era that still a lot of people were reading newspapers.
00:10:07 - Daniel Morris
Well, you know, it's kind of an aside, and you mentioned newspapers, and then I think back to the beginning of the pandemic. And, you know, again, whenever we have a crisis or something, we look for historical examples, as you mentioned. And I remember doing a bit of research, trying to think, okay, when if we had something like this, what might it tell us about what could happen with COVID?
And looked at the Spanish flu at the beginning of the 20th century. And what was so surprising to me, was that when you actually looked at the newspapers, at the time, it was hardly mentioned. And so clearly, not only, you know, to what degree the pandemic itself was different or the same compared to pandemics you've had historically, but clearly, society has changed a lot. And so I think our experience was that there was only discussion about the pandemic, whereas for whatever reasons, maybe a war might have had something to do with it. I guess people didn't have the luxury of focusing on it at the time. Well, that actually is a good segue then to the next topic. I was kind of curious if you could talk a bit about some of the major geopolitical shocks we've had, you know, over the last 20, 30 years, and clearly COVID being one of them, but certainly not the only one.
00:11:18 - William de Vijlder
Yeah, well, I'm looking at the geopolitical risk index that has been developed by Matteo Iacoviello and his colleagues on his website. And well, the first one, going back to the mid 80s, the first one that is really appearing on the screen is the invasion of Kuwait by Iraq, which was a short-lived jump in geopolitical uncertainty, short-lived, lasting a couple of months, even less than that.
And then of course, another jump bigger actually, that was in January of 1991. So the invasion was in 1990, early August, then we had Operation Desert Storm in January 1991, also a very short-lived spike in uncertainty. The fact that there were so important spikes is of course understandable because you had a direct impact on oil prices that multiplied instantaneously. And then the one that historically is still the most intense event is 9-11, of course, in terms of the media coverage, followed then by another event in, so that was in 2001 and followed then by 2003 in March with the second Gulf War and the war in Iraq. And then as you mentioned, indeed, we had COVID, so we all remember 2020 and the spring, then the war in Ukraine, February 22, and now the most recent events in the Middle East.
If you look where these are compared to history, we are really at the tail of the distribution. This is like the 98th percentile in terms of the intensity of media coverage. So yeah, we've had quite a number of shocks over the past 30-odd years. And then it begs the question, okay, economically, what does it mean and what can be the consequences?
And how should we try to assess what the consequences could be? Because this is really the challenge. When you look at uncertainty, it is a concern about something that might happen. So it has not yet happened. It's a concern about something that might happen. And how is that concern impacting behavior?
Major geopolitical uncertainty shocks in recent history
00:13:46 - Daniel Morris
What strikes me when I look at the chart, I think you could argue that COVID was less a geopolitical shock than, well, among many things, a health shock and an economic shock. The other one is the distinction between a geopolitical shock as opposed to an economic shock in the supply and demand side.
And that if it's, as you say, if it's just geopolitical, if it's just anxiety, if you will, as opposed to something that we know will definitively affect firms' behavior or household behavior, I think more often than not, the impact on the markets tends to be short-lived.
Unless you end up with a situation where, I think in a lot of these, it does tend to be energy prices. That's the linchpin that can turn what can be a geopolitical shock into something that turns into something that's a macroeconomic.
00:14:35 - William de Vijlder
The short-lived nature, of course, in terms of the impact on markets, I mean, you can have a plateau effect. That is that market pricing readjusts, but then beyond that readjustment, other drivers take over in terms of market influencing developments.
But in a way, the readjustment of market prices or the resetting is a reflection of, okay, a view, an implicit view about the combination likelihood times impact. And once that is kind of priced, it's like moving on to other topics that have an impact.
And what's important with respect to your comment about COVID is that it's also fascinating that you can have events that trigger a huge increase in geopolitical uncertainty, but that, with the benefit of hindsight, did not really have a big economic impact.
And that's one of these elements of complexity of coming to grips with that topic.
00:15:43 - Daniel Morris
Maybe just one last observation. On the chart, it's not labeled, but I see a spike around 2016, which I'm going to assume is Trump's election, which I think qualifies as a fairly significant geopolitical shock. So now we'll be talking more in the months ahead about whether there's going to be a round two of that.
But that's for another podcast.
00:16:03 - William de Vijlder
Yeah, indeed.
But well spotted. Yeah, yeah.
And I think if you look at UK media, you would also have a Brexit effect somewhere.
00:16:14 - Daniel Morris
Thanks very much, William. Yeah, I think it was an interesting discussion about how geopolitical uncertainty is, on one hand, I'd say different from economic uncertainty, and tried to understand, on one hand, what the implications might be for macroeconomics, but also some of the challenges that we face in simply measuring geopolitical uncertainty, let alone trying to understand what the consequent meaning is for markets or for economics.
And in fact, we're going to do another podcast on that. So hopefully, listeners, you will follow up as we try to assess geopolitical uncertainty and the impact on firms, on households and on financial markets.
Recorded the 11/03/2023
