What is a Headwind?
In finance, the term headwind is used to describe conditions that impede or inhibit progress and shares the same meaning for impacts to economies, industries, and individual companies. The factors that lead to a decrease in value or growth of the economy or the company are called headwinds. They may include factors such as an increase in the cost of capital, increased competition, decreased money supply, etc.
Let’s understand how the term came into being. Before combustion engines, ships used to run on wind power, which was captured using sails. When the wind struck the sails, it created a force to propel the ship. Obviously, wind can come from any direction.
When the wind came from behind – i.e., the tail of the ship – it was known as a tailwind. It helped propel the ship forward. However, when the wind came from the front – i.e., the head of the ship – it would propel it back. Tailwinds were good for medieval navigators, as they increased the speed, while the headwinds were bad, as they decreased the speed.
Macroeconomic headwinds affect the economy or an industry as a whole and consequently affect companies indirectly. Some of the common macroeconomic headwinds include:
- High interest rates – They lead to increasing the cost of capital for the economy and individual companies. They result in lower borrowing and lesser economic activity.
- Inflation – Inflation is intricately linked to interest rates. Controlled inflation is good for the economy, but increased inflation increases the interest rates and the cost of raw materials, leading to a decreased economic activity.
- Foreign exchange rate – It leads to an increase or decrease in the value of the currency. A decreasing currency value is detrimental to economies that are net importers, such as the U.S., U.K., and France. For China and Germany, which are net exporters, a weakened currency is better, as exports bring in more domestic currency.
- Poor economic growth – It is detrimental to all industries and companies. It is measured by the gross domestic product (GDP). GDP growth is relative, with emerging economies having a higher rate than the advanced economies.
Microeconomic factors affect individual companies and may not affect every company in the industry or the economy. They include factors specific to each company. Detrimental factors to each company can be classified as a micro-economic headwind. Some of these factors include:
- Decreased revenue – It affects the profitability and ultimately the growth of each company.
- Increased raw material cost – It affects a specific company due to economies of scale, transportation costs, and other factors specific to a company. It results in reduced profitability and growth.
- Increased competition – It leads to decreased revenue, profitability, and growth for a company.
- Decreased demand – It also decreases the revenue, profitability, and growth of the company.
- Operational issues – They also reduces productivity and growth
- Management change – It can affect decision-making and decreases growth.
- Legal issues – They can threaten the operations or profits of a company
Applications in Finance
Headwinds are identified as factors that may slow the growth of the economy or a company. At the macroeconomic level, central banks target a policy inflation rate that will lead to proper economic growth. Deviations can occur due to uncontrolled liquidity, foreign investments, interest rate changes, and other factors. Such factors can be both headwinds and tailwinds.
For companies, the microeconomic factors are factored into planning and budgeting. Headwinds, such as reduced demand, may lead to allocating a lower budget for production or purchasing raw materials. Similarly, an increase in interest costs may lead to cost-cutting in the company. Budgets allocated for a specific department are changed to overcome headwinds.
In the case of an equity stock, headwinds can include factors such as:
- Negative news, such as a loss of a contract for the company
- Lower than expected earnings
- Higher than average P/E ratio
- Rising costs, increased competition, etc.
- Economic recession
- Credit crisis
- Anti-trust proceedings
The debt/bonds are affected by nearly the same factors as the stocks. However, some additional factors include:
- Increased yields, which lead to a decrease in bond prices
- Liquidity and credit issues that may also decrease the prices
- Bankruptcy proceedings
- Presence of securities with similar risk and return characteristics
- Decreased diversification of the issuer
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