Macroeconomic uncertainty makes firms more profitable in the short-term, but the bill comes due later.
The Covid crisis has left the world's economy blanketed in uncertainty. The media provide daily reminders that businesses are suffering and that unemployment is at historic highs. If past crises are any indicator, such economic uncertainty triggers swift initial reactions. On the demand side, consumers delay large purchases and reduce discretionary expenses. On the supply side, managers draw up cost-cutting plans - and often hurriedly implement them - with the survival of their firm in mind.
From a managerial perspective, the question is whether such cost-cutting is a good move, or whether it possibly could be an overreaction. To answer this question, I looked at the association between macroeconomic uncertainty and quarterly corporate profitability for a vast sample of around 10,000 US firms from 1988 to 2018. To measure macroeconomic uncertainty, I used the Economic Policy Uncertainty Index (EPUI), which spikes in response to uncertainty shocks, such as the Gulf Wars, 9/11, and the Lehman Brothers collapse.
I found that increases in macroeconomic uncertainty indeed lead to both lower revenues and lower expenses for firms in the short run. As expected, consumers initially decrease consumption to build up precautionary savings and hedge against potential or actual income loss, but resume spending once uncertainty is resolved, approximately six quarters after the initial economic shock. Also as expected, risk-averse managers anticipate and counteract lower consumer demand by cutting costs.
The surprising part is how much the reaction of managers overshoots that of consumers.
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