June 06, 2022
Business conditions in the American real economy remained robust in the second quarter, bolstered by solid demand and strong productivity-enhancing business investment that sent the Middle Market Business Index to 130.6. The gain, up from 126.3 in the first quarter, came despite underlying inflationary pressures that have slightly soured sentiment on the economy.
Despite the risks to the economic outlook linked to inflation, supply chain disruptions and the energy price shock, we expect gross domestic product to expand by 2% for the year, a deceleration from last year’s 5.7% growth.
Recent economic data implies that demand has shifted from goods to services and points toward sustained strong activity in the real economy.
This is borne out by the 44% of middle market executives who said gross revenues had increased during the quarter and the 41% who reported net earnings had improved during that time.
The survey, conducted by the Harris Poll from April 4 to April 25, compiled responses from 404 senior executives from middle market businesses who were asked for their views on business conditions and the economy.
Nearly three out of five executives, or 58%, said they expect gross revenues to improve during the next six months, and 56% expect net earnings to do the same.
In addition, 42% of respondents said they had increased capital expenditures and 51% expect to do so during next six months. Those investments on the margin will increase productivity and dampen inflationary pressures next year as that software, equipment and intellectual capital are put to work.
From our vantage point, this is one of the more encouraging aspects of the second-quarter data on business conditions in the real economy.
Real private final domestic demand expanded by 3.7% during the first three months of the year, and the MMBI data indicates that activity should continue.
- 58%expect gross revenues to improve during the next six months
- 78%indicated they paid higher prices for inputs
But lingering supply chain issues and difficulties in finding labor have resulted in mounting pricing pressures that are creating concerns. Not surprisingly, 78% of respondents indicated they paid higher prices for inputs, while 74% expect to do so in the six months ahead. Respondents were divided on whether the economy had improved, remained the same or deteriorated.
We expect that until there is clear evidence of a return to price stability, sentiment around business conditions in the real economy will remain split.
The policy focus in Washington has changed noticeably in recent months. Price stability rather than fiscal stimulus is now the major policy objective, and the federal funds rate is likely to finish the year near 3%, which is restrictive terrain.
Movement into restrictive terrain will result in a slowing of overall growth even as demand remains solid, which in turn should provide some relief from the pricing pressures that dragged down the forward-looking components of the RSM index.
Of the 10 components that make up the index, seven increased from the first quarter while three stayed the same or declined. Current business conditions improved during the quarter, according to the executives.
The roughly 4 in 10 executives who reported an increase in revenue and profit in the second quarter was little changed from the first three months of the year, though there was a welcome decline in the share of executives reporting a quarterly reduction in sales and profit.
The service-concentrated middle market stands to gain from the shift in consumer spending from goods to services. Real consumer spending on goods has declined for consecutive months while spending on services has accelerated.
Looking ahead, however, executives seemed less sanguine: Their expectations for the economy in the next six months eased. On net, that component was the largest drag on the index from the first quarter to the second. The 42% of respondents expecting things to improve is the lowest since 2020.
Inflation is the most significant factor shaping the near-term outlook. Prices have grown faster than expected for longer than expected. As such, 66% of survey participants reported passing along price increases downstream to clients, and 75% said they expect to do so over the next six months.
Inflation has largely been a function of scarce physical inputs and supply chain bottlenecks caused by pandemic-induced changes in consumer behavior. This dynamic has driven up the price of durable goods faster than that of services for most of the past year.
Within service-providing industries, the primary inflationary pressure comes from wages. Service-sector inflation through April increased 5.4% on a year-ago basis; excluding energy costs, that metric is up 4.9%. Those figures are still lower than the goods-producing sector, which is experiencing a rate of inflation well above the 8.3% implied by the consumer price index.
Businesses are also dealing with the long-term challenge of retaining and recruiting workers. Nearly two-thirds of executives, or 62%, reported raising employee compensation in the past three months, the highest in the index’s history.
Cost pressures are causing middle market firms to pass along higher prices to customers. Nearly two-thirds of executives reported increasing prices in the past three months, also the highest share on record.
On the labor side, 61% of executives expect to increase hiring during the next six months, while 47% of those did so during the second quarter.