Tighter Credit Adds Further Pressure On Small Businesses

Tighter Credit Adds Further Pressure On Small Businesses

April 26, 2023

The economy seems to be humming along OK. Not too hot and not too cold. The raising of rates by the Fed has been very abrupt and due to the pain it has created within the financial system it is what all remember. But, so was the rate at which money was dumped on the US (and other global economies as well for that matter) financial system at stressful points since the Great Financial Crisis yet this was a help so it is not as keenly remembered. At this point, the issue is whether the fight against inflation, which is being spearheaded by the Fed, is being done at a rate that is too aggressive, and consequently, inflation could turn into stagflation /recession. To what extent this becomes the case won’t be known until after the fact. The most glaring wrinkle in our financial system is the effect spiking rates have had on the portfolios of smaller regional banks and from the lending side the effect on dramatically higher commercial real estate loans, better known as CRE’s. We have experienced rising rates in the commercial space before, but never have we experienced this at this speed of ascent and at a time when a massive amount of the workforce has become comfortable with “working remotely.” In the New York Post, it was quoted on Monday that, “cell phone traffic in San Francisco is 3!% of what it was before COVID.” I could only assume that this is the same situation in other cities as well, even more so in cities where traffic is heavy and the time to and from the office is long and parking costs are high. The article went on to say that so many people haven’t just gone remote, but also have completely moved out of the city that they do not expect traffic to come back to pre-pandemic levels at all. 

So, this leaves us looking at a few important issues. To begin with, I wanted to show the yield curve of interest rates as rates have been the nemesis of the equity markets. Warren Buffet, in his CNBC interview last week made a very logical and accurate point, “interest rates at 5% instead of .5% has caused a dramatic revaluation in real estate, stocks, and bonds.”

Please note in the above chart that the yellow dotted line is where rates are expected to go in the next year, and the blue dotted line is the high point. The solid line is where we are currently. I believe that the rates will stay about where they are currently. Residential real estate, multi-unit real estate, food, and restaurant prices all remain stubbornly high. This I believe could be a function of the still huge amount of cash sitting on the sidelines. Note that 1-year or less maturity CDs and US Treasuries are still considered cash instruments. So this means still $5 Trillion in cash on the sidelines. With this much cash still out there, it is a small wonder that discretionary spending and real estate prices remain elevated. 

The place where cracks are existent in the system besides commercial real estate is in the small business sector of the economy. Small businesses are often considered the backbone of the economy because of the amount of economic activity generated by the sector, and it looks like it has turned into a backache.

Small businesses have an incredible impact on both the national and local economy. Small businesses make up the majority of all businesses by count while also employing over 46% of the non-government workforce. It’s not a stretch to say “As goes the small and independent business, so goes the national economy.” They provide their communities with the goods and services their customers have grown to enjoy, in addition to supporting local causes and charities. With this supporting role in local economies comes the need for expansion, a need that is typically fulfilled by community banks. Small businesses tend to prefer banks when in need of credit, more regularly turning to them as compared to larger corporations, who often seek their funding from the capital markets or the money center banks. Approximately 44% of small business financing comes from banks, completely outsizing the next two points of origin, online lenders at 22%, and credit unions at 6%. So if regional banks are having problems and their lending standards have tightened dramatically, and at the same time small business is still climbing their way out of the COVID shutdown, it is no small wonder that they are being hit with a double whammy while bigger companies are somewhat insulated. 

As shown in the chart below, firms are hunkering down as few have expansionary plans shortly. No doubt, tighter credit conditions have impacted those decisions.


  • Small businesses, considered the backbone of the economy, are shrinking hiring plans. Hiring intentions among small businesses declined in March, implying that upcoming job reports will likely be lackluster.
  • Firms are hunkering down as virtually no firms have plans to expand business operations. The number of firms reporting any expansion plans is the lowest since early 2009 when the economy was in the depths of the Great Financial Crisis.
  • Small businesses are reporting more difficult access to credit. The percentage reporting tighter credit is the highest since 2012 as lending institutions tighten up under the uncertainty of the macro landscape.
  • Now, some good news. Inflation was less of a problem in March as firms are more concerned about the overall business environment as the economy slows under tighter financial conditions.

So, this leaves us with the Fed’s ultimate dilemma; should they hold off for a bit on rate hikes to let small businesses catch their breath, or should they soldier ahead to get to their 2% inflation target? Is a function of too much medicine for the patient that kills the patient, but a steady dosage could cure what ails them. One way to measure this is the number of overtime hours worked. As can be seen below, overtime hours have dropped off. Maybe this is being subsidized by our social programs, but I still feel that it is a sign that labor is slowing due to the rate of ascent of rates.


Republican Debt-Ceiling Plan On Deck

Besides the interest rate and recession issue, the newest friction point that is coming down the pipe is the Debt-Ceiling. As I had mentioned in previous letters, Congress, being led by the Republican Kevin Mc Carthy, will attempt to generate pressure on the Biden administration to hold talks on increasing the debt ceiling. Next week, the House will try to increase the pressure of negotiations by considering a Republican plan to increase the ceiling. As can be expected, this plan is almost sure to not receive any Democratic support. The cuts include the repeal of energy tax credits for everything from EVs to wind, as well as reductions in education and food programs. The idea is to return spending to levels established in the budget for Fiscal Year 2022, with approximately $130 Billion in cuts this year. 

This battle is just heating up, but trust me, this is not going to be fun and neither party wants to take any action to upset their constituency. 


What Does It Mean for You?

Businesses appeared to hunker down under the weight of tighter credit conditions and weaker economic growth. The chart above of overtime is a clear reflection of this.  If small businesses are an accurate barometer, recession risks are rising, and the labor market will likely cool in the coming months. Although the economy is slowing, the Fed continues its fight with inflation and will likely hike rates at the next meeting on May 2-3. However, if the economy becomes more unstable, the Fed could pivot to rate cuts by the end of the year.

In closing, the issue now at hand is the battle over the debt ceiling. Neither party will want to do anything to upset their constituency of voters. Pay attention to what is being said. The Republicans inherently don’t want to increase spending, and the Democrats don’t want to stop their giveaways. Who wins? This could be further pressure on economic growth and therefore perceived as a quasi-rate escalation going into the third quarter. I believe that at that point the incumbent party will be adjusting the barometer to try and show economic prosperity to feed their voters and not lose the election in 2024. I will be sure to show you what we feel the tea leaves are saying! 



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