Small Businesses Are Excited Despite Weak Margins

The biggest story of the year is probably the decline in inflation. The other top stories of a rising stock market with no volatility and the decline in the dollar are all related. Lower inflation allows for stock valuations to increase and the Fed to stay dovish. A dovish Fed hurts the dollar. Earlier in the year, I predicted the decline in inflation months before the Fed saw it. The Fed called it transitory once it saw the disinflation, but now it’s realizing this has been a sustainable trend. The chart below shows one of the reasons I was in the disinflation camp. As you can see, the base effect that oil had which pushed up inflation was temporary in early 2017. The case I made was that unless oil skyrocketed, it would be a drag on inflation, pulling it lower. That happened.

The latest base effect will be a small positive, pushing inflation up slightly. We’re already seeing that happen in the breakeven inflation rate which has risen from 1.66% on June 21st to 1.80% now. The price of oil isn’t the only factor that affects inflation obviously. The recent tick up in hourly wage growth could further push inflation higher. Finally, I think the heating up of emerging market economies can also make inflation increase. This confluence of factors could make the CPI numbers increase in the next few months which could push the Fed to hike rates in December. That’s a bearish catalyst which could affect this goldilocks economy or, as I like to call it, stock market nirvana.

The latest small business survey came out. I like this survey because there’s not as much information on the health of small businesses because they aren’t public companies and because it goes in-depth on the reasons for the changes in responses. The headline NFIB number was 105.2 which beat the consensus estimate which ranged from 102.0 to 104.0 and the prior report which was 103.6. As you can see from the chart, the optimism hasn’t gotten much better than where it’s at now. It is only seven tenths off the peak in January. I predicted the small decline you can see at the end which was based on the idea that Congress wouldn’t deliver on the hype expected from it immediately. In the grand scheme of things, that wasn’t a big deal. Even as the Congress has now underperformed my expectations for a delayed fiscal reform package, the small business optimism continues to roar. I think Trump not tearing up the trade deals and not acting on protectionist rhetoric replaced the tax cut catalyst.

After the election, the small business outlook jumped from 9 in October to 23 in December. Despite the lack of fiscal progress, the index is now at 23. I think that the election made small businesses less worried about any painful new regulations being enacted which was spurred by Trump’s pro-business rhetoric. I don’t have the stats on the exact effects, but there has been a decline in energy regulations and a decline in their breakeven costs; the decline in regulations might be helping these firms’ margins making them more optimistic. The election’s effect on the outlook index was even stronger as the index was -7 in October and +50 in December. That index has tailed off slightly as it’s now at 37. These positive results mean the labor market should continue its strength for the rest of the year which supports positive consumer spending trends.

The index showing actual earnings changes was sequentially flat at -10. This means the number of firms who had lower earnings in the past 3 months outnumbered the number which had higher earnings. That’s normal as many small businesses struggle to improve profit growth. When you think of small businesses, you probably think of success because you are suffering from survivorship bias. You can only see the successful businesses, but the thousands which have failed get forgotten. The reason for earnings declines is broken down. It’s interesting to see that the number of firms blaming increased costs was stagnant despite the tight labor market. This supports the theme of low inflation which continued in July, but might be reversing in the next few months.

The chart below shows the actual sales changes. The index is 0 which is higher than the earnings changes implying that margins are falling. Small business and small cap firms are seeing weak margins while the large caps reach record highs. That might explain why S&P 500 margins have been able to reach a record high. The most interesting part of the chart below is that the post-election optimism wasn’t completely unwarranted. As you can see, the sales increased from -8 in November to positive for most of this year. Keep in mind these results are slightly different from the year over year results used for the S&P 500. It uses the seasonally adjusted sequential quarterly comparison.

We will look at the rest of the NFIB survey in the next article. Now let’s look at the chart below to pour some cold water on the optimism expressed in this article to make it more balanced. As you can see, the consumer credit to PCE ratio is at a new record high. Consumers are borrowing money to spend it at a record pace. It’s interesting to contemplate where the ceiling will be because that would force the economy to rely on wage growth instead of endless debt. I’m more worried about a long-term trend reversal than a cyclical fall because we’ve seen them in previous recessions. How would the economy grow without debt?

Conclusion

Low inflation is the principal cause of the nirvana/goldilocks economy. The great macro conditions have helped small businesses although their margins are weak. They might weaken further as wage growth is about to heat up. It’s interesting to see that despite the strong labor market, the consumer leverage is still high. It’s surprising to see that income growth and debt growth can’t get the economy to a 3% GDP growth handle. The debt trend is supported by the long-term decline in interest rates. A spike in rates would be one catalyst to stop the long-term increase in consumer leverage.