Uncertainty, Corporate Diversification and Misallocation

In the environment of high uncertainty, corporations may choose to diversify their business. Using data on U.S. public firms at the segment and deal levels, I empirically document that 1) Firms respond to rising cross-sectional uncertainty by stretching into new business lines and allocating assets to non-core business; 2) Diversification initiated during periods of high uncertainty is accompanied by lower post-diversification growth, equity value and credit capacity; and 3) At the aggregate level, diversification amplifies resource misallocation channel of uncertainty shocks, leading to persistent decline in aggregate productivity. I explain these facts by building a heterogeneous-firm model with endogenous diversification and external financing constraint. In the model, a cross-sectional uncertainty shock prompts a diversification wave, which redistributes cash flow and credit away from high productivity sectors, leading to inefficient reallocation of resources and decline in aggregate TFP. The misallocation effect is amplified in competitive equilibrium where negative externality of diversification choice on other firms' value is not internalized. This novel channel enables a cross-sectional uncertainty shock to generate a recession with synchronized declines in aggregate activities, in line with empirical evidence.