Geopolitical Risks: Implications for US Consumer and SME Credit

Geopolitical Risks: Implications for US Consumer & SME Credit

Aytekin Satiroglu 31 March 2022

Geopolitical risks are key determinants of economic decisions and significant sources of concern for many investors. The current Russia-Ukraine war represents an extreme geopolitical risk event causing tremendous human and economic hardship. The war led to a surge in food and energy prices, adding pressure on inflation and economic growth globally. In this article, we discuss the implications of such geopolitical risks for US Consumer & SME Credit using the discounted cash flow (DCF) model.

Geopolitical risk is defined as the “threat, realization, and escalation of adverse events such as wars, terrorism, and any tensions among states and political actors” [1]. The ongoing Russia-Ukraine war, along with its disastrous humanitarian outcomes, is the most important geopolitical risk event in this quarter’s agenda.

Policymakers, investors, and media often cite geopolitical risks as key determinants of economic decisions [2]. The Wells Fargo/Gallup Survey (2017) [3] shows that three-quarters (75%) of investors are concerned about geopolitical risks. The war in Ukraine magnifies the existing economic challenges caused by the COVID-19 pandemic.

This article examines the implications of geopolitical risks for US Consumer & SME Credit. Private credit is less liquid than most other asset classes, hence the impacts on valuations are not directly visible. Therefore, we use the discounted cash flow (DCF) model to assess the effects.

The fair value of an asset equals the present value of discounted future cash flows in the DCF model. E[CFₜ] is the expected future cash flow at time t, rf is the real risk-free rate, π is the rate of inflation expected over the life of the asset, and k is the risk premium [4].

We first look at the implications of the war for expected cash flows through inflation and economic growth impact. Later, we investigate the implications for the discount rate by delving into its components.

Expected Cash Flows: Inflation Impact

Inflation has been rising globally since the beginning of 2021 due to strong post-pandemic demand, surging energy prices, and supply chain bottlenecks [5]. US consumer prices increased 7.9% year-on-year in February 2022. Figure 1 shows that this marks the highest annual inflation since the 80s.

Figure 1: US Inflation - Consumer Price Index & Producer Price Index by Commodity, Percent (%) Change from Year Ago


Figure 1: US Inflation - Consumer Price Index & Producer Price Index by Commodity, Percent (%) Change from Year Ago. Source: U.S. Bureau of Labor Statistics, retrieved from FRED

Gasoline prices increased 6.6% from the past month in February 2022, accounting for almost a third of the increase in the February 2022 CPI [6]. Compared to last year, food and shelter prices rose 7.9% and 4.7% respectively [7].

Figure 1 also shows the increase in producer prices: US Producer Price Index by Commodity rose 20.06% annually in February 2022. However, this does not fully capture the more recent spikes in commodity prices. Global oil prices increased 67% since the start of 2022, with Brent hitting a 2008 high at $139 a barrel following the outbreak of the war in Ukraine. [8]

Food prices also came under pressure since Ukraine and Russia are large exporters of wheat, corn, and sunflower oil. Overall indices of commodity prices rose 26% from the beginning of 2022, indicating the biggest commodity shock since 1973 [9].

Energy, food, and rent expenses constitute a large part of household budgets, particularly for lower-income households. Soaring inflation squeezes consumers by pushing down disposable incomes and real wages.

For businesses, high inflation translates into higher input costs, declining profit margins, and investments. We have discussed in our previous article that high inflation tends to increase delinquency and default rates on consumer and SME loans leading to a decline in expected cash flows [10].

Expected Cash Flows: Economic Growth Impact

US GDP growth projections are downgraded after the escalation of the war in Ukraine [11]. Increases in geopolitical risks tend to be followed by higher inflation, lower employment, and lower consumer sentiment.

Plunging real incomes and lower consumer sentiment decrease personal consumption, which accounts for 65% to 70% of the US GDP [12]. The US GDP growth could be dampened more if the war and sanctions deepen, and commodity prices rise further.

What could increasing geopolitical risks and lower GDP growth mean for the expected cash flows on consumer and SME loans? To illustrate the relationship, we use the US geopolitical risk index (GPR Index) by Caldara and Iacoviello (2021) [13]. The GPR Index measures the frequency of articles in leading US newspapers discussing adverse geopolitical risk events.

Figure 2 plots the US GPR Index and the charge-off rates on US consumer and business loans. We observe that high geopolitical risk events such as the Invasion of Kuwait (1990), Gulf War (1991) and 9/11 Attacks (2001) coincide with the US recessions. The Global Financial Crisis (2007-2008) is, however, an exception, as it was not a geopolitical risk event.

Figure 2: US Charge-Off Rates on Consumer & Business Loans vs US Geopolitical Risk Index


Figure 2: US Charge-Off Rates on Consumer & Business Loans vs US Geopolitical Risk Index. Source: Board of Governors of the Federal Reserve System (US), retrieved from FRED; Caldara and Iacoviello (2021), GPR data downloaded from https://www.matteoiacoviello.com/gpr.htm on March 14, 2022

The Russia-Ukraine war is a salient geopolitical risk for the US GDP growth. Whether it will trigger a recession is yet uncertain. Figure 2 shows that charge-off rates typically peak during recessions. Depending on the damage to the US GDP growth, the war could decrease expected cash flows through increasing defaults and delinquencies.

Discount Rate: Risk-Free Rate

The Federal Reserve has a “dual mandate” of price stability and maximum employment [14]. Changing the federal funds target rate is among one of the Fed’s monetary policy tools to achieve these goals. The Fed influences the federal funds effective rate through open market operations to reach the federal funds target rate [15].

Figure 3 shows the federal funds effective rate, unemployment rate and the annual inflation rate in the US. The US economy had a brief recessionary period after the emergence of COVID-19. During this period, the federal funds effective rate was decreased almost to zero while the unemployment rate kept rising to 14.7% in April 2020.

The unemployment rate normalized to 3.8% in February 2022 but the low interest rate policy propelled inflation to nearly four times the Fed’s 2% target inflation rate.

Figure 3: US - Federal Funds Effective Rate, Unemployment Rate, Inflation Rate


Figure 3: US - Federal Funds Effective Rate, Unemployment Rate, Inflation Rate. Source: Board of Governors of the Federal Reserve System (US), U.S. Bureau of Labor Statistics, retrieved from FRED

According to the FOMC statement on January 26th, the Fed is beginning the monetary tightening cycle to bring down the high inflation [16]. Interest rates were raised by 25 bps in the Fed’s March meeting [17] which marked the first rate hike after more than 3 years. Multiple rate hikes are expected through 2022 [18]. Increases in the risk-free rate increase the discount rate and decrease the valuations.

Discount Rate: Expected Inflation

War, sanctions, and trade flow disruptions will likely lead to upward movements in commodity prices in the near term. We look at the breakeven inflation rates, i.e., the yield differences in nominal and real Treasuries, and observe that higher inflation expectations are already priced in bond markets. Figure 4 shows that the 5- and 10-year US breakeven inflation rates are increasing to new highs which means higher discount rates and lower valuations.

Figure 4: US 5- and 10-Year Breakeven Inflation Rates


Figure 4: US 5- and 10-Year Breakeven Inflation Rates. Source: Federal Reserve Bank of St. Louis, retrieved from FRED

The Russia-Ukraine war could also result in higher inflation over the longer term. Historically, food and energy price inflation tend to have a feedback loop with geopolitical risks. The Arab Spring (2010-2011) and the gilet jaunes protests in France (2018) [19] were associated with higher food and energy prices respectively.

Discount Rate: Risk Premium

The risk premium is expected to increase in the short term given the negative impacts of the Russia-Ukraine war on consumer sentiment, GDP growth, and inflation. However, the increase in the risk premium could also spread to the long term depending on the course of the war, which may trigger persistent changes in the aforementioned macro variables.

Furthermore, the ongoing war presents considerable uncertainties on geopolitical and economic fronts. These uncertainties command a risk premium for uncertainty-averse investors. Overall, we would anticipate increases in the risk premium and hence increases in the discount rate.

Conclusion

Geopolitical risks are key determinants of economic decisions and significant sources of concern for many investors. The current Russia-Ukraine war represents an extreme geopolitical risk event causing tremendous human and economic hardship [20]. The impacts are far-reaching as the war led to a surge in food and energy prices worldwide, adding further pressure on inflation and post-pandemic economic growth.

This article analyses the implications of geopolitical risks for US Consumer & SME Credit with the discounted cash flow (DCF) model. War, sanctions, and trade flow disruptions will likely lead to higher inflation and slower growth in the near term. Historically, these result in higher default rates and thus, lower expected cash flows.

Furthermore, considering the start of monetary tightening and war-related uncertainties, we anticipate increases in the risk-free rate, expected inflation and the risk premium. As a result, we expect the recent increases in geopolitical risks to decrease the valuations of existing US Consumer & SME Credit.