Index Summary
Business in the American real economy imply no recession in the third quarter as the middle market remains on a path for growth, even as the market grapples with elevated inflation. Top-line sentiment among midsize company executives improved to a seasonally adjusted index reading of 138.5, up 7.3 points from the second quarter. That change is significant at both the 0.10 and 0.05 levels. An economy displaying such a robust reading, along with business conditions that have produced 3.4 million jobs over the first seven months of the year and unemployment of 3.5%, is not consistent with a recession.
The major economic narrative emerging from the data is that robust overall activity continues to support strong business sentiment. This upside, however, is clearly tempered by elevated prices and rising wages that have likely soured firms’ outlook on the economy now and over the next six months. Even so, with revenues and net earnings still solid, and a majority of MMBI respondents indicating they should improve, the prospect of a recession has probably been pushed into 2023.
Of the 10 underlying components that make up the MMBI, seven increased from the second quarter to the third, while three declined. The three declining componts asked respondents their expectations for the next six months, and their downbeat outlook aligns closely with macroeconomic data elsewhere; businesses and households are feeling increasingly pessimistic about risks linked to inflation and the economy.
Despite two consecutive declines in quarterly gross domestic product in the first half of 2022, business conditions appear impressively resilient just over the horizon. Forty-eight percent of respondents said gross revenues improved in the third quarter, and 60% stated they expect them to do so over the next six months. Half of survey participants indicated net earnings improvement in the third quarter, and 59% said they expect improvement in the near term.
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48%
said gross revanues improved in the third quarter
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41%
increased productivity enhancing capital expenditures
Passing price hikes downstream
Perhaps more importantly, a majority of survey respondents indicated they are passing along price increases—and for now, the ability to do so is clearly bolstering revenues, net earnings and forward-looking expectations of both. Only 7% of respondents said they had difficulty passing along price increases, which is remarkable given the inflation shock still cascading through the economy. That figure constitutes good news, given the very difficult straits that middle market firms are navigating at the current time.
On net, respondents reported increases in revenue and profit from the previous quarter, with both at their highest rates in a year. Some of this growth, particularly the reported increase in revenue, was driven by higher selling prices. More than 7 in 10 survey respondents, the highest on record, reported hiking their average selling prices. In our estimation, middle market firms’ ability to pass along these price increases without creating conditions for demand destruction downstream underscores the resilience in the real economy.
Just as important, and a continued source of optimism inside the middle market and real economy, are responses around capital outlays. Forty-one percent of survey participants increased productivity-enhancing capital expenditures during the third quarter, and 53% indicated they expect to do so over the next six months. It is critical that middle market firms increase their investment in both technology and their people to boost efficiencies and output during a time of tight labor supply and high inflation.
Wage pressure and tight labor
For service-providing industries, which have an outsize presence in the middle market, the primary source of inflationary pressure comes from wages. The share of respondents reporting an increase in employee compensation rose to 2 in 3, representing a record high. Wage hikes are compelling businesses to pass along rising input costs to their customers. According to the government’s employment cost index, wages were up 5.2% in the second quarter compared to a year earlier. Wage pressure will continue to keep business decision- makers on edge, underscored by the declining share of MMBI respondents, on net, who said they intend to increase hiring levels over the next six months.
Wage increases and higher input prices, from our perspective, are why only 30% of survey respondents stated that the economy improved in the third quarter and only 39% expect it to do so moving forward.
Cautious optimism
Data related to recent employment trends, however, remains buoyant. Nearly 6 in 10 MMBI respondents reported an increase in staff over the last three months, the highest share on record; meanwhile, those reporting a reduction in head count showed a three-year low in the third quarter.
Through July, total employment in the U.S. economy has returned to pre-pandemic levels, and we continue to make the case that labor market dynamics in the near term are likely to be characterized by a tight labor market and higher wages compared to the past generation. Any notion of labor market conditions returning to those of the jobless recoveries of the 1990s or the period following the global financial crisis of 2007-09 should be closely scrutinized and directly challenged.
Looking forward, 41% of respondents said they planned to increase borrowing over the next six months; given the expected increase in interest rates over that time, this finding requires monitoring with respect to the underlying health of the real economy.
Finally, 48% of organizations surveyed said they increased inventory levels during the third quarter, and 55% stated they expect to do so in the near term, reflecting both the upcoming holiday season and the need to meet still-brisk demand for goods and services. We remain optimistic that upper-income consumers will retain the capacity to clear those levels. However, businesses with exposure to down-market households need to proceed cautiously with respect to inventory management, even as the apex of inflation is likely now in the rearview mirror. In our estimation, for the next two years inflation will not fall back anywhere near the 2% level that defines price stability.
