Q4 2022 Middle Market Business Index


December 06, 2022


Index summary

Business conditions in the real economy deteriorated in the final quarter of the year as the top- line RSM US Middle Market Business Index eased by 12.5 points to 124.2 from 136.7.

While that reading remains at a level that signals expansion and reflects the resilience of the broader economy, two years of rising prices clearly have taken a toll on overall business conditions as well as expectations around revenues, net earnings and hiring.

On a seasonally adjusted index, the latest quarterly change is significant at both the 0.10 and 0.05 levels.

While the middle market index does not imply that the economy is in recession—we think a reading below 110 tends to indicate that—an array of economic indicators implies the American economy is decelerating into the end of the year. That slowdown underscores our estimation of a 65% probability of a recession over the next 12 months.

Persistent inflation that has spread into the service and housing sectors is leading the Federal Reserve to aggressively raise its policy rate. By the end of its increases, the Fed will almost certainly have raised its policy rate by more than 500 basis points over a 15-month period as it tries to restore price stability.

The U.S. economy does not descend slowly into recession. Rather, it tends to fall off a cliff. We think the lagging impact of rate hikes, which have already resulted in significant financial tightening, will become apparent in a sharp drop-off early next year, after the traditional holiday spending period ends.

In our estimation, middle market firms need to prepare for a pronounced slowdown in demand in the near term.

It is important that firms during this time continue to make critical investments in capital expenditures to bolster productivity during the imminent period when the economy is weak and inflation begins to ebb.

We recognize that increasing uncertainty around revenues and net earnings during downturns often discourages investment. Still, the economy has not reached that point. Roughly 50% of respondents in the MMBI survey said they intended to increase capital expenditures over the next six months; that solid showing follows eight straight quarters in which a majority said they intended to do so. This data is encouraging and represents a much-needed reality check for all middle market firms.

The split between businesses’ expectations of a poor economy and their intention to keep investing follows the “second-hand pessimism” narrative that is developing. It holds that businesses feel badly about the economy, but they are continuing to hire, raise wages and invest as if the economy is in solid shape. This divergence between feelings and actions is helping keep the economy afloat because actions speak louder than words when it comes to growth.

Yet this outlook may not last. Businesses facing rising uncertainty will be tempted to pull back on critical investments in their firms and personnel.

That would be a significant suboptimal business decision and lead to reduced productivity and output.

Boosting innovation and technological capability during a downturn is a necessary component of business operations; to eschew those investments is simply a non-starter.

Beneath the headline

All 10 components of the RSM US Middle Market Business Index declined from the third quarter to the fourth, reflecting growing pessimism about the economy.

This shift in outlook is a function of the recent deterioration in business conditions. A sharp increase in respondents reporting a reduction in revenue and profit from the previous quarter should serve as a bellwether for firms to begin preparing for the end of the business cycle.

Persistent and elevated inflation has eroded consumer purchasing power and dampened business confidence. We can observe that erosion in the current outlook on the economy, hiring, revenues and net earnings.

The outlook for staffing soured in the fourth quarter as well. Just over half of respondents reported plans to increase hiring over the next six months, the lowest rate since mid-2020.

The share planning to reduce head count rose from 6.5% in the third quarter to 14.1% in the fourth, also the highest figure since 2020. The period of above-trend job growth driven by the recovery from the pandemic is drawing to a close.

Pricing pressures did not intensify in the fourth quarter, according to MMBI respondents. The 53% of respondents who raised prices from the third to fourth quarter is the lowest share since the first half of 2021, when surging and concentrated consumer demand quickly overwhelmed global supply chains. Respondents reported a similar easing when asked about prices paid for the inputs used in their operations.

Perhaps the biggest takeaway from the pricing data is that the ability to pass along price increases to consumers is beginning to ebb. Roughly 53% of respondents noted an increase in prices received, down from 69% in the third quarter.

Previously we noted that the ability to pass along price increases was most likely the primary catalyst behind the improvement in top-line sentiment during the third quarter. At the same time, executives told RSM that being able to pass along those higher prices was not sustainable and at one point would come to an end.

That end appears to be approaching.

Hybrid and Remote Work Options Appear to be Permanent

Middle market companies appear to be permanently adopting the remote and hybrid work practices that were driven by safety measures during the height of the COVID-19 pandemic, MMBI data shows.

Nearly three-quarters (74%) of executives polled said their companies had rolled out a hybrid work option, up nine points from the fourth quarter of 2021. Meanwhile, 33% of midsize firms had employees working remotely in the fourth quarter of this year who had not been doing so prior to the health crisis, down only three points from 36% a year earlier, according to responses to special questions in the survey.

More than half (54%) of businesses had made remote work a permanent option for some employees on a full- time basis, up from 48% a year earlier. Only one-quarter of respondents said their organizations were requiring remote workers to return to the office.

Culturally, the shifts in work patterns seemed to be having either a positive effect (39%) or no effect (38%) on the majority of businesses, while 24% said they’ve had a negative impact.