“Higher for longer” is the market’s new mantra. The question isn’t whether costlier money will put strain on households and businesses — the stress is by design, after all — but where the pressure will be felt most acutely.
For now, the biggest and most cash-rich companies seem to be doing just fine. They were able to lock in low rates during the pandemic, and because of this companies’ net interest payments actually declined in 2022, as M&G pointed out in a Monday blog post.
Smaller businesses face a different landscape. This year, the effective rate of interest on corporate debt jumped to the highest since 2012 for the smallest half of companies in the S&P 1500 (also from M&G, citing SocGen).
In a recent note, Goldman Sachs’ economists took a look at the very smallest of businesses. They analyse the debt burden of businesses that aren’t incorporated, meaning firms that are owned either by one individual or a partnership. It’s important to note this is a fairly narrow group: A business can still qualify as “small” by the US Small Business Administration’s (SBA’s) standards if it earns up to $47mn in annual revenue or employs up to 1,500 people, depending on the sector.
Still, it is helpful to look at sole proprietorships and partnerships because more of these businesses have formed since the pandemic. And preliminary data show that an outsized share of the increase may have come from companies that don’t expect to employ anyone besides the owners, according the Fed’s Ryan Decker and University of Maryland’s John Haltiwanger:
GS’s analysis includes — but isn’t limited to — these one- or two-man bands.
And the full note is certainly worth a look, as it analyses the financing needs of consultancies, building contractors, law firms, medical practices and the like. These companies “produce 15% of US GDP and pay out roughly 15% of employee compensation,” according to the bank’s economists.
GS provides a helpful breakdown of their sectors:
And what about these small companies’ debt?
Well, debt costs are already more burdensome for small businesses, adding up to 6 per cent of revenues in 2021, compared to 2 per cent for large businesses. Roughly half of the credit extended to small businesses is floating-rate, compared to just one-fifth for larger companies.
GS also argues that small businesses also get term loans that have average seven-year maturities when issued, which would offset the pressure. But their chart showing the term-loan maturity data cites the SBA . . . and as we mentioned above, the SBA’s definition seems to include larger companies that could have easier access to banks’ loan books. And the full paper the analysts cite to back up that maturity profile isn’t especially comforting about small companies’ credit access.
But sure, let’s go with it, data analysis is an art and not a science, etc. What does all of this mean for small businesses’ interest payments? With Alphaville’s emphasis:
Combining the results of these two approaches, we expect the small business interest payments to reach around 8% [of gross output] by the mid-2030s—above the pre-pandemic share of 6.8% but similar to that of the mid-1990s (Exhibit 6). This amounts to a roughly 40% increase in overall business interest expenses as a share of gross output since 2021 . . .
In all, we estimate that the effective interest rate on small business loans is likely to rise by a cumulative 3½-4pp . . .
This is because the interest rates on small businesses’ short-maturity variable-rate loans move closer with more volatile short-end rates than with long-term yields. With a 60-65% ratio between small business debt and the sector’s gross output, this increase in interest rates implies a roughly 2.2pp rise in interest payments as a share of revenues.
Presumably, that number will be larger if anything too crazy happens to small businesses’ revenues as individuals and larger businesses also grapple with higher interest costs.
Still, there are some other factors that should offset the rise in small-biz interest costs.
This 2.2pp increase is larger than the 1.2pp cumulative increase we estimate for the corporate sector but might initially seem small relative to the rise in the fed funds rate.
It is not larger for two reasons. First, because small business loans make up only around 65% of the sector’s gross output, so a given percentage-point increase in interest rates translates to a smaller increase in interest expenses as a share of gross output. Second, because nominal small business gross output grew by 15% and 12% in 2021 and 2022, respectively—substantially faster than the 3% and 6½% growth rate in these businesses’ loans. This in turn partially offsets the increase in interest expenses that we estimate took place in 2022 relative to prior years.
What’s more, small businesses were already paying up to access bank credit, and weren’t able to load up on debt to the same extent as larger companies when interest rates were zero, as GS points out.
Of course, credit is tougher to access for small companies because they are seen as less resilient in downturns. Their revenue sources are often more concentrated, meaning times get tough quickly if, say, a large local employer leaves town, or an unusually rainy season kills foot traffic around a retailer’s store.
Moreover, we expect the strong financial footing of small businesses to partially offset the hiring and investment drag from higher interest payments. We estimate that the small business sector is running a financial surplus worth 9.1% of sector revenues and 2.5% of economy-wide GDP. This indicator is a statistically significant predictor of business investment and argues for a tailwind to capex growth of as much as +4pp in the sector. The sector’s balance sheet is healthy as well, with cash ratios and net worth ratios both near 40-year highs and interest income set to rise roughly 0.4pp cumulatively as a share of revenues, reflecting higher short-term interest rates.
The investment part makes sense. Why not replace some aging dental equipment with extra cash on hand? (Assuming that inflation is in fact cooling, and that the surplus won’t be spent trying to keep up with rising operating costs.)
But as for hiring . . . we’d love to know the share of non-corporate businesses today that do any hiring (ie workers that aren’t also owners). Alas, the most recent US business census is from 2020, and the data for 2022 won’t be out until next year.
What does all of this mean for the broader US economy? Frankly not very much, GS’s economists say. With our emphasis:
Combining these interest cost headwinds with our standing estimates of the modest sensitivity of employment and capital spending to interest rates, we estimate that the GDP growth drag from small business borrowing costs will peak this year at just 0.1pp. In our baseline, we forecast this growth headwind will wane in 2024 before rising modestly later in the decade as term loans are refinanced.
As we discussed at the start of this post, there is a very wide gap between multinational megacap companies and the types of small businesses discussed by GS economists here. So while these ultra-small businesses are interesting and certainly important, they may not have that much of an effect on the broader US economy, no matter how they’re doing.
And there could be real consequences of higher small-biz debt costs that don’t necessarily show up in aggregated national accounts . . . like, for example, more independent medical practices in underserved communities getting rolled up by private equity and/or closing.
