Business conditions in the real economy deteriorated in the final quarter of the year, with the main RSM U.S. middle market business index falling 12.5 points to 124.2 from 136.7.
While the reading is still at a level that indicates expansion and reflects the resilience of the broader economy, two years of price increases clearly took a toll on overall business conditions and expectations for revenue, net earnings and hiring.
In the seasonally adjusted index, the latest quarterly change is significant at both the 0.10 and 0.05 levels.
While the mid-market index doesn’t signal a recession – we think readings below 110 tend to indicate that – a range of economic indicators point to a slowdown in the US economy towards the end of the year. This slowdown underlines our estimate of a 65% chance of a recession over the next 12 months.
Persistent inflation, which has spread to the services and housing sectors, has led the Fed to raise policy rates sharply. At the end of the hike, the Fed will almost certainly increase policy rates by more than 500 basis points within 15 months to restore price stability.
The U.S. economy is not slowly slipping into recession. Instead, it tends to fall off a cliff. We believe the lagged impact of rate hikes has already led to significant financial tightening, with a sharp decline early next year becoming apparent after the traditional holiday spending period ends.
We estimate that middle market companies need to prepare for a significant slowdown in demand in the near term.
It is important that businesses continue to make critical investments in capital expenditure during this period to boost productivity in the coming period of economic weakness and inflation starting to fall.
We recognize that during economic downturns, increased uncertainty about revenue and net income tends to discourage investment. Still, the economy hasn’t reached that point yet. About 50% of respondents to the MMBI survey said they intended to increase capital spending in the next six months; after eight consecutive strong quarters, the majority said they intended to do so. The data is encouraging and represents a much-needed reality check for all middle market companies.
The divergence between businesses’ expectations of a downturn and their intentions to continue investing follows a developing narrative of “second-hand pessimism.” It argues that businesses feel bad about the economy, yet they continue to hire, raise wages and invest as if the economy was in solid shape. This difference between feeling and acting helps keep the economy going because actions speak louder than words when it comes to growth.
However, this prospect may not last. Businesses facing increased uncertainty will tend to withdraw critical investments in their companies and people.
This would be a major sub-optimal business decision and result in lost productivity and output.
Improving innovation and technology capabilities during an economic downturn is a necessary part of doing business; avoiding these investments simply won’t work.
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All 10 components of the RSM U.S. Middle Market Business Index declined from the third quarter to the fourth quarter, reflecting growing pessimism about the economy.
This shift in outlook is the result of a recent deterioration in business conditions. The sharp rise in the number of respondents reporting a quarter-on-quarter decline in revenue and profits should be a harbinger of companies starting to prepare for the end of the business cycle.
Persistent and high inflation erodes the purchasing power of consumers and undermines business confidence. We can observe the current erosion of the outlook for the economy, hiring, income and net income.
The staffing outlook for the fourth quarter also deteriorated. More than half of respondents said they planned to increase hiring in the next six months, the lowest level since mid-2020.
The percentage of planned layoffs rose to 14.1% in the fourth quarter, also the highest figure since 2020, from 6.5% in the third quarter. The period of above-trend job growth fueled by the COVID-19 recovery is coming to an end.
MMBI respondents indicated that pricing pressures did not intensify in the fourth quarter. Fifty-three percent of respondents raised prices from the third quarter to the fourth quarter, the lowest percentage since the first half of 2021, when surging and concentrated consumer demand quickly overwhelmed global supply chains. Respondents reported similar easing when asked about the prices paid for inputs used in their operations.
Perhaps the biggest takeaway from the pricing data is that the ability to pass on price increases to consumers is starting to wane. Some 53% of respondents said prices received had increased, down from 69% in the third quarter.
We previously noted that the ability to pass on price increases was likely the main catalyst behind the improvement in top-line sentiment in Q3. At the same time, executives told RSM that being able to pass on these higher prices is unsustainable and will end at some point.
The end seems to be approaching.
Hybrid and remote work options appear to be permanent
During the height of the COVID-19 pandemic, middle market companies appeared to permanently adopt remote and hybrid work practices driven by safety measures, MMBI data shows.
Nearly three-quarters (74%) of executives surveyed said their companies have introduced hybrid work options, an increase of 9 percentage points from Q4 2021. Meanwhile, 33% of midsize businesses let employees work remotely in the fourth quarter of this year, according to responses to a special question in the survey. Those who hadn’t done so before the health crisis were down just three percentage points from 36% a year ago, according to responses to a special question in the survey.
More than half (54%) of businesses have made remote work a permanent option for some full-time employees, up from 48% a year ago. Only a quarter of respondents said their organization asked remote workers to return to the office.
Culturally, shifts in work patterns appear to have had a positive impact (39%) or no impact (38%) on most businesses, while 24% reported a negative impact.