Looking beyond “Big Business” in the US

The general message from the IMF meetings is not particularly cheerful, with a downward revision in global GDP forecasts primarily driven, as per the Fund’s Chief Economist communication, by the expectation of more prudent lending behaviour by the banking sector. Yet, exactly as the economist crowd gathered in Washington DC were voicing their concerns – which your humble servant shares – the US equity market ended a fourth episode of weekly gains in 5 weeks. 

The relationship between equity prices and GDP is never straightforward. True, in theory, if the share of profits in GDP is stable, the overall change in corporate earnings should be tightly correlated with GDP growth. However, for some key sectors – and Tech in particular – it’s more expected profits over the long-term, rather than actual ones, which move valuations (we quantified this in a note with our colleague Hugo Le Damany last year, see the link here). They can weather cyclical downturns if trend growth is not affected. Exogenous shocks can also have strong compositional effects. High energy prices push GDP down but raise profits in energy companies. The magnitude of the net effect on the index will depend on the relative weight of energy-producing companies versus energy-dependent ones. Interest rate sensitivity is another issue. If a looming recession is seen as triggering a monetary policy loosening, this can benefit companies which are very sensitive to the discount rate because their profits will emerge only in the distant future – Tech again. 

To explore this, rather than slicing the Standard & Poor’s (S&P) into sectors, we can take the simpler and more radical approach of looking at performance per capitalisation size. Indeed, there is a strong concentration of Tech companies in the “large cap” bucket. The smaller the companies, the more “traditional” they tend to be in terms of activity sectors. The message from Exhibit 1 is very clear: over the last year, within the first 1,500 names in the S&P index (in its broad definition), there has been a strong positive relationship between the market size of companies and their performance. While the top 10 names (with 8 of them in the tech industry, and one in energy) have managed to stay flat on average, the bottom decile in terms of size lost roughly a quarter of its value. In other words, while the market has been kind to the top of the US corporate structure, down the ladder, in the “belly” of the US economy, market conditions have been tough. The market is thus not blind to the macro risks. Compositional effects blur the signal when looking at the aggregate index. 

Exhibit 1 – Digging into the last 12-month equity performance: size matters

We explore this “big” versus “small” approach beyond pure market developments by looking at business confidence data. In Exhibit 2 we compare the survey on “economic trends” in small companies conducted by the National Federation of Independent Business (NFIB) – with the more frequently used, all-encompassing ISM surveys. The difference is striking. Economic confidence has been standing below its long-term average in the NFIB survey since the beginning of 2022, roughly a year before it happened in the ISM surveys, and the level in March 2023 is much more deeply negative, at 1.6 standard deviations below average. “Small America” has been in trouble for a while.

We looked at previous episodes of economic slowdown in the US. Such divergence between the NFIB and the ISM survey is not a permanent feature. For instance, in 2008 the ISM survey “saw the recession coming” earlier than the NFIB. We are tempted to attribute the currently strong size effect to the inflation shock. The input price structure of the Tech industry is more dependent on “intangibles” – e.g., the regular amortization cost of R&D – than in more traditional sectors. More generally, size is normally positively correlated with market power. Large companies on average are probably in a better position to impose a transmission of their input costs to their final prices, or more simply have more capacity to swiftly re-organize their production patterns to dampen the impact of the rise in their input costs. 

Whatever the underlying reason, the fact that smaller businesses are currently in a more fragile position than what aggregate indicators would suggest takes a particular salience in the context of the looming tightening in credit conditions. True, the latest Federal Reserve (Fed)’s weekly data suggest that the banking turmoil is under control in the US, with less recourse to central bank refinancing. The peak in banks’ borrowing and hoarding cash came in the week of March 15. We remain however convinced that the issues which have emerged in regional banks and a generic aversion to risk in the banking industry will have a lasting impact on banks’ appetite to lend. This will have a disproportionate impact on small companies whose access to direct market funding is limited. We note that the “availability of credit” component of the NFIB survey has already fallen below its long-term average (see Exhibit 3). This component is already lower than at any point during the “mini-recession” of 2001 and in line with what was observed during the early 1990s recession. 

Exhibit 2 – If you’re smaller you’re lower

Exhibit 3 – Small businesses already feeling the credit pinch

Still, there is an area in which small and big businesses are converging: employment resilience. While the NFIB headline confidence indicator has fallen markedly below trend, hiring plans remain robust, standing in March 2023 roughly half a standard deviation above their long-term average. For small businesses as well, labour hoarding seems to be rife. Despite “feeling the pinch” and feeling more pessimistic about future demand trends, they are still raising headcounts. To get a sense of the disconnection between the assessment of the economic situation and hiring intentions, we created a “predicted path” for the hiring plans in the NFIB survey using the strong historical relationship, estimated over 1980 to 2019, between the “headline” and the “hiring plans” components. This shows where hiring intentions by small businesses “should be” given their assessment of the economy. The spread with actual hiring intentions is massive (see Exhibit 4).

Exhibit 4 – Still hiring though

This gets us to a simple point: the labor market is likely to be the “last shoe to drop” in this current, atypical cycle. Employment is always a lagged indicator, but the transmission delay between firms perceiving a decline in demand and acting on headcounts could well be longer than usual. There is no doubt in our view that the monetary policy tightening is working its way through the economy, triggering en passant some unpleasant episodes of financial instability. If one looks beyond the US’ biggest corporations, the mood is souring quite quickly. But we haven’t yet reached the point when hiring is materially affected, which will delay inflation landing. This is consistent with the Fed remaining reluctant to “lower its guard” too quickly despite the accumulation of dark clouds.