Economic Downturns and Perceptions of Risk

30th June 2020

Have you ever wondered at the relationship between strong economic downturns (even recessions) and investors perception of market risk? Economic downturns are a fact of life occurring periodically, often at the most inopportune times. We are now in a sharp economic downturn which is becoming a recession due to the impact of the COVID-19 pandemic. What affect is this going to have on the investors which form the bedrock of our industry? If investors become risk adverse and more cautious, this could cause a reduction in demand for forest assets and a flow on affect to forest values impacting the entire industry.

The primary government response to an economic downturn is to quickly move to a stimulatory monetary policy, reducing interest rates and pumping liquidity into the system. This may initially appear to lead to lower costs of capital due to the low interest rates.

The following simple example illustrates this:

  • Beginning of February 2020

Cost of equity[1]: Rf+(Ba*Market Risk Premium) =

2.33%+0.55*5.20% = 5.19%

Cost of debt: Rf + premium of BBB corporate debt over risk free =

2.33% + 1.39% = 3.72%

Weighted Average Cost of Capital =

Re*E/V + Cd*D/V*(1-t) = 5.19%*0.8+3.72*0.2*0.79 = 4.74%

where Rf = risk free rate (30-year treasuries), Ba = asset beta, Re = required equity return, Cd = cost of debt, E = equity, D = debt and V = firm value.

  • End of March 2020

Assuming no change in risk premium or corporate debt premium

1.35% + 0.55*5.2% = 4.21%; WACC = 4.21%*.8+(1.35%+1.39%)*0.2*.79 = 3.80%

[1] Simplified example using the basic international CAPM and WACC formula.

All else being equal therefore costs of capital should decrease by nearly 1%. However, during times of increased uncertainty investors would be expected to become more cautious with their equity capital and either hold off investing or seek greater compensation for risk. Figure 1 shows the relationship between the risk-free rate, the market-return, and the implied market risk premium (MRP).

Figure 1: Relationship Between Market Return, Risk Free Rate and Implied Market Risk Premium

Source: and Margules Groome.

The average risk-free rate during normal times is 2.65% which drops to 2.37% during economic slowdowns with spikes as low as 0.64% to date. Meanwhile, the MRP averages 4.4% during normal times and increases to an average of 5.52% during economic downturns. The MRP has spiked as high as ~8% during these tough times while averaging 6.2% to 7.1% during the worst months of these downturns. This suggests, that in the critical periods of economic slowdowns MRPs increase by about 2.2% compared to normal times.

It is not only equity risk premiums that increase during these economic slowdowns, but the premium of corporate debt over the risk-free rate also increases (Figure 2).

Figure 2: BBB US Corporate Index Option-Adjusted Spread

Source:, Margules Groome.

During normal times, the premium of BBB corporate debt over the risk-free rate has averaged 1.55%. However, the impact of COVID-19 caused a spike to 4.88% while the 2015-2016 economic downturn saw a peak of 3.03%. It is not unreasonable therefore to expect a premium of around 150bps higher than normal during slowdowns.

What does this mean for costs of capital? The following example addresses this:

  • End of March 2020 including Risk Premium and Debt Cost Impacts

Re = 1.35% + (0.55*(5.2%+2.2%)) = 5.42%

WACC = 5.42%*0.8 + (1.35% + 1.39% + 1.5%)*0.2*0.79 = 5.01%

This indicates that instead of the cost of capital reducing by 0.94% it has increased by 27bps.

Although this is a small increase, it does illustrate that in times of economic downturns, loose monetary policy conditions (low interest rates) may be insufficient to fully compensate investors for the increased risks they face.

This analysis is not intended to be precise but simply illustrative of the direction of change and its influence on investment trends. For in depth analysis and the impacts on forest investment contact Margules Groome.