Politics and its Effect on Corporations
Most investors, at one point or another, have considered bets on the VIX because they believe that this time it will pay off. That is volatility’s allure. It’s similar to what drives investors to buy options when they think market volatility will increase, because they know volatility drives up option value. As investors though, we also know there is no free lunch. The higher option value is driven by the wider range of possible prices for the underlying asset, meaning greater uncertainty. As volatility increases, investors tend to sell stocks, shift to more conservative portfolios, etc., and most don’t think about option theory. What’s interesting though, is that companies focus a great deal on real option theory in increasingly uncertain times, and we can see that in the academic literature.
First, let’s define what exactly “uncertainty” means in this context. Companies tend to focus greatly on Economic Policy Uncertainty (EPU), which incorporates everything from tax laws, minimum wage laws, and tariffs to more mundane things like zoning statutes, local business regulations, etc. Typically, these all combine to form a general level of policy uncertainty, but there will, of course, be key provisions within each law or regulation that may affect a specific business or project more than another. However, in the aggregate, it’s best to focus on total uncertainty.
With this definition, Drs. Baker, Bloom, and Davis (BBD) developed an index to measure policy uncertainty over time. This index is news-based, and can be used to isolate policy uncertainty from general uncertainty by controlling with the VIX and several other factors. The BBD Index is comprised of three parts: normalized volume of policy-related news in a given month, the dollar value of expiring tax provisions, and the dispersion between CPI and government spending forecasts. The weights, respectively, are 50%, 16.67%, and 33.33%, which is why the index is referred to as a “news-based index”.
So, while we cannot ask a specific business leader for a quantified answer to “how uncertain is the future?”, we can use this index to predict certain corporate actions, as EPU has a wide array of effects on firm managements. The primary effect is the negative relationship between EPU and corporate investment. As uncertainty grows, businesses make fewer investments, since the outcome of that investment is less certain. However, this relationship is even stronger (more negative) when the investment has a high degree of irreversibility or dependency on government spending. Highly irreversible investments could be building a large, manufacturing plant, or, on a project level, purchasing specialized equipment from a small/illiquid secondary market. Additionally, businesses in the healthcare, infrastructure, and defense industries (to name a few) are good examples of heavily government dependent firms.
While firms decreasing or delaying CAPEX isn’t exactly surprising, some of the other effects are. Firms also tend to hold more cash as a percentage of Current Assets, which consequently means they generally hold lower inventory. BBD and several other papers found a doubling in the BBD index led to a 24% lower Inventory value, and a doubling in just the News portion of the index lowered Inventory by 18.6%. These negative effects are also persistent, suppressing investment levels for about 4 quarters, and taking an additional 2 quarters to return to normal levels. This means that a particularly uncertain event, like a tense presidential or gubernatorial election, a major market shock (a trade war, an oil price hike), or even a Congressional policy battle, could suppress investment levels for up to a year and a half. However, once the company decides to invest in the project, the amount invested is not lower than it would have been if invested earlier, which implies companies value the timing of the investment more than the amount.
EPU isn’t all bad news for the economy and consumers, though these upsides are somewhat difficult to quantify. A study conducted by Bhattacharya et al. found that corporate innovation, measured as patent and citation counts, are not affected by which policy outcome actually occurs. It does diminish during the run-up to highly uncertain times though, which means that the longer an uncertainty goes on, the less innovation will occur. This means that less polarizing political elections or more similar candidates will not lower innovation as much.
As we touched on in the intro, option values increase with greater volatility. Corporations recognize this, and increase Research and Development expenditures (R&D) in times of high uncertainty. This is basic option theory, wherein the greater uncertainty gives the ‘real option’ of R&D a greater value. A paper entitled “Bright Side of Political Uncertainty” has shown that election years (presidential and midterm) see R&D expenditures increase by about 4.6%. The higher uncertainty of business conditions post-election increases the uncertainty (and thus value), just as increased volatility raises the value of financial options in the Black-Scholes Model.
So, as investors, can we take away any lessons from how companies behave in the face of Economic Policy Uncertainty? The answer is, unfortunately, “it depends”. Before making investments in volatile markets, investors must decide a) whether they are speculating or investing long, b) what their investment horizon is (i.e. 1, 5, or 10+ years), and c) their ability to take on risk. This last is not preference-based, but the actual answer to “how would your financial health be affected if this investment lost 50-75% of its value tomorrow?” As always, talking to a financial professional (preferably a fiduciary) is generally best.
Atanassov, Julian and Julio, Brandon and Leng, Tiecheng, The Bright Side of Political Uncertainty: The Case of R&D (February 8, 2018). Available at SSRN: https://ssrn.com/abstract=2648252 or http://dx.doi.org/10.2139/ssrn.2648252
Baker, S. R., N. Bloom, and S. J. Davis. 2013. Measuring economic policy uncertainty. Working Paper, Stanford University.
Bhattacharya, Utpal, et al. “What Affects Innovation More: Policy or Policy Uncertainty?” SSRN Electronic Journal, Aug. 2017, doi:10.2139/ssrn.2368587.
Cassimon, Danny, et al. “Investment, Uncertainty and Irreversibility: Evidence from Belgian Accounting Data.” SSRN Electronic Journal, May 2002, doi:10.2139/ssrn.1692688.
Gulen, Huseyin and Ion, Mihai, Policy Uncertainty and Corporate Investment (June 24, 2015). Review of Financial Studies, Vol. 29 (3), 2016, 523-564. Available at SSRN: https://ssrn.com/abstract=2188090 or http://dx.doi.org/10.2139/ssrn.2188090