Capital Markets Update #9
We were alerted to the state of small businesses by the fact that over 65% of the Russell 2000 has beat profit expectations thus far, which, if maintained, would represent the index’s best profit performance against analyst expectations since Q2 2021 (bloomberg). For reference, roughly 75% of S&P 500 companies routinely beat expectations (Factset). We’re not entirely sure whether all Russell 2000 companies meet the sub-500 employee threshold to qualify as a small business, but let’s assume they’re close enough.
A few quick facts you may not know about small businesses. 99.9% of businesses in America qualify as a small business. By definition, small businesses employ less than 500 workers, with an average of 25, and account for about 46% of the domestic private labor force. Overall, small businesses provide approximately 39% of total private sector income, create about 44% of US GDP and generate approximately 36% of private sector receipts / sales (2023 US Small Business Administration data). Monthly new business formations have jumped from 200,000/mo in 2010 to 293,000/mo in 2019 to over 500,000/mo today (FRED). Yet, we don’t get great data on this universe. It’s obviously challenging to poll such a broad and diversified market with real accuracy, but trends are observable and helpful to understand.
The NFIB research center has conducted what amounts to be the most comprehensive small business survey for the last 50 years known as the Small Business Optimism index. This survey aggregates present and future datapoints, including outlook, new orders, inventory, financial conditions, employment conditions, sales, prices, etc. What’s most interesting is trying to figure out which complementary data series has the highest correlation to small business optimism. Basically, what’s driving any observable trend in small business optimism writ large. We looked at retail sales, consumer net worth, unemployment rate, wage growth, inflation, the smoothed S&P 500 price level, and other potential datapoints. Interestingly, the data series with the strongest correlation we could find was actually the Effective Fed Funds rate. Honestly, look it up, it has the same shape. This is a function of two realities. First, businesses (both large and small) traditionally do better during widening periods of inflation. In effect, if the consumer expects to pay more, businesses will inevitably oblige. Pre-GFC, inflation trended slowly upward from a call it 1.20% annualized CPI in 2000 to call it 4.0% annualized CPI by 2006 (FRED). Over the same period, forward margins in the S&P 500 moved from 8% to 10.5% (Yardeni), small business earnings momentum rose to its then highest ever level and the second highest cyclical peak in the survey history (NFIB), while small business prices gapped upward to the tune of about 20% (NFIB). Similarly, as inflation jumped from near 0.0% in 2015 to 2.9% by Q2 2018, small business earnings momentum rose to its highest level ever and S&P 500 forward margins increased from 10.5% to 12.5%. S&P forward earnings margins today are 14.7%, which is slightly skewed given Nvidia represents about 7.3% of the S&P 500 market cap and operates at a 75% gross profit margin (Nvidia earnings). By the way, we note S&P margins as a reference because it’s the most accurate tracking of aggregate business margins we could find. The second and complimentary reality is that the Fed usually only widens rates during a period of generically positive economic outlook, bolstered by a stable labor market. This is the labor prong to the Fed’s dual mandate and why small business optimism fits the Fed Funds rate much better than CPI alone. If labor market conditions signal underlying weakness to employment, it’s very difficult to gain consensus around a Fed rate hike. So, periods in which the labor market is stable to strong, while inflation (including wage inflation) remains comparably high, translate to an environment where an employed consumer is generally, albeit begrudgingly, able to purchase more goods and services. Think about pandemic travel expenses or prices at restaurants today. We might not have liked what hotels and plane tickets cost, but we paid the price. Accordingly, the Fed hiked rates, punished the bottom line of any company with serious floating rate debt exposure (that’s basically all levered small businesses) and companies were forced to react by either dropping their labor costs and / or charging lower prices to sell more goods. Both solve the same inflationary impulse. As companies lower prices, margins compress, small business optimism declines and the fed lowers rates as the inflationary sting is taken out of the economy. It’s interesting how correlated these two datasets are.
On an all-in basis, current small business optimism is historically strong at 99.3. While optimism spiked in 2019 as the Fed halted its rate hike and balance sheet runoff regime, 2010 – 2018 optimism generally variated in the low 90’s compared to highly stable small business optimism of about 100 from 1980 – 2006 (NFIB Data). So, by historical standards, small businesses presently see a generically positive outlook on the horizon, setting side a few outstanding datapoints.