The economic uncertainty caused by the UK’s vote to leave the EU has sent shockwaves through the business world. Within 48 hours of the referendum on 23 June 2016, global stock markets lost more than US$2 trillion in value as panicked investors scrambled to offload their risky assets. It was the single largest day drop since 2007.
While some markets have subsequently rallied, many investors, analysts and economists remain cautious about the long-term economic effects of Brexit. No one knows what will happen, fanning the flames of uncertainty and feeding the growing sense of nervousness.
For many, the immediate fallout following the EU referendum was no surprise – markets never react well to ambiguity. But the received wisdom that most companies cut their spending in times of change is not strictly true, according to Raja Patnaik, a PhD graduate in finance from London Business School.
In his paper 'Competition and the Real Effects of Uncertainty', Patnaik explores the impact of market volatility and instability – caused by uncertainty about future weather conditions – on investment. He also looks at how the spending pattern of organisations from several sectors changes depending on the degree of competition within their particular industry.
“Higher uncertainty results in a decrease in spending for firms, in more concentrated industries, that prefer to defer investment until uncertainty declines again,” Patnaik says. “The effect is stronger for firms that face higher costs associated with reversing investments. This finding is in line with irreversible investment – the degree to which capital cannot be recovered once spent – models that predict a negative relationship between uncertainty and investment.
“In contrast, firms in highly competitive industries increase investment in response to higher uncertainty, supporting the argument that competition can erode the option value of deferring investment. In that case, other industry and business characteristics such as operational flexibility can result in increased investment in response to heightened uncertainty.”
Under the weather
Patnaik uses El Niño – a climate cycle in the Pacific Ocean that affects global weather patterns – to see if uncertainty about adverse weather encourages companies to increase or scale back their investments. He focuses on US public companies across all sectors that are affected by the El Niño-Southern Oscillation (ENSO) cycle. This cycle is an irregularly periodical variation in winds and sea surface temperatures, which affects much of the tropics and subtropics.
He also looks at how the spending habits of organisations in highly competitive and less concentrated industries change when they are faced by El Niño uncertainty. Patnaik then turns his attention to firms that face different levels of investment irreversibility and operational flexibility to investigate the underlying mechanisms for the effects of uncertainty.
Patnaik’s empirical approach is based on an intuitive idea. “An El Niño episode is good news for some industries and bad news for others. However, an increase in uncertainty about future El Niño activity represents an increase in economic uncertainty for all firms in affected industries, regardless of whether the effect of El Niño is positive or negative,” Patnaik says. “This simple intuition allows me to disentangle the effect of uncertainty on a firm’s investment from the impact of changes or expected developments in economic conditions.”
Using historical El Niño data, Patnaik can identify which industries are positively and negatively affected by weather changes based on their average stock returns. For example, weather changes had an adverse impact on South America’s copper mining industry in 2015, when the region was hit by the strongest El Niño episode for almost 20 years. Deutsche Bank Markets Research issued an alert saying that higher rainfall in the region would have a negative impact on the copper mining industry, but could boost the production of bauxite, nickel and tin.
“These El Niño episodes resulted in torrential rain and flash floods in Chile, forcing several of the world’s largest copper mines based in that region to temporarily cease their operations,” Patnaik says. “These supply chain disruptions then led to changes in commodity prices, which had a secondary effect on sectors that use these commodities as inputs and outputs.
“El Niño can also affect energy prices. In the US, past El Niño episodes have often resulted in milder winters, especially in the northern parts of the country. We then see less demand for heating, which is reflected in the price of energy commodities such as natural gas.”
Despite hitting some sectors, adverse weather conditions can have a positive effect on others. “Some US industries such as construction are often boosted by an El Niño episode, because they can continue to operate throughout the year without being affected by cold winters,” Patnaik says. “Moreover, adverse weather damages buildings and repairs are then needed, leading to greater demand for construction firms.”
While studying historical data to see which companies are affected, and how, by El Niño induced weather changes, Patnaik mainly relies on forecasts for his research. He draws on weather predictions from the US’s Climate Prediction Center and other meteorological offices that cover the year ahead to assess how businesses in various industries react to uncertainty.
“It’s difficult to identify changes in uncertainty that occur independently from changes in economic conditions,” Patnaik says. “Take Brexit: it’s difficult to spot and separate the effect of uncertainty on investment and the UK economy from the effect of general changes in economic conditions and expectations. El Niño uncertainty provides an external source of economic uncertainty for firms affected by this weather pattern, so we’re talking about changes in uncertainty that aren’t caused by changes in economic conditions or a firm’s behaviour.”
Bucking the trend
That some companies benefit from an El Niño episode goes some way to explaining why they maintain or even increase their investment in the face of varying weather conditions. But what about businesses in industries with many competitors, or concentrated sectors featuring just a handful of organisations?
“In highly concentrated industries, companies tend to decrease investment in periods of uncertainty, regardless of whether they are positively or negatively affected by ENSO conditions,” Patnaik says. “If companies are unsure about the future and cannot easily reverse investments, the option of deferring investment becomes more attractive. As a result, they tend to wait and see how uncertainty resolves before making any investment decisions.”
Patnaik says companies operating in crowded markets often cannot afford to defer investments when facing uncertainty.
“Once you introduce more competition, the fear that one of your competitors might invest first and take away your investment opportunity renders the option of waiting and deferring this investment less valuable. This, combined with other factors such as operational flexibility, can then lead to mechanisms where investment is encouraged in response to an increase in uncertainty.
“As a result, firms in highly competitive industries generally maintain or increase their investment in response to increased uncertainty. The increase is driven by companies that have higher operational flexibility, allowing them to more easily expand to fully exploit good outcomes and contract to insure themselves against negative conditions. This means the potential benefit from the upside when times are good is greater than the potential loss on the downside when times are bad. Accordingly, these companies might desire a mean-preserving increase in uncertainty.”
Patnaik’s paper suggests that the relationship between uncertainty and investment strongly depends on industry and business characteristics. While some firms curb spending in the face of uncertainty, others maintain or even increase investment levels.
The lesson for policymakers and executives studying Patnaik’s research is simple: there are always winners in business, no matter what the economy – or the weather – throws at them.
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