Sinking Ships: Liquidity Constraints and Return Predictability in Recessions

Using the context of the dry-bulk shipping industry, I document that future returns on real assets are strongly predictable and negatively related to current asset prices, earnings, and investment during recessions. However, there is no such relationship outside recessions. This evidence points to significant liquidity constraints faced by firms during downturns, resulting in cash-in-the-market pricing of capital and rising expected returns for buyers. It is puzzling, however, why firms would not exploit opportunities to buy assets cheaply in recessions, e.g. by pre-arranging credit lines. I build and estimate a model of a competitive industry with credit frictions that can quantitatively account for return predictability during downturns, even though firms can use state-contingent contracts to preserve liquidity for when they need it most. Firms’ relative impatience limits their risk management, meaning that even well-capitalized firms can become constrained following adverse shocks. This results in significant asymmetric amplification of shocks in equilibrium.