Fears of economic downturn temper optimism in the middle market

Drew Yergensen 

Heading into the third quarter of 2022, the economic headwinds felt strong in the middle market. U.S. inflation levels were climbing to record highs and the Federal Reserve was moving forward with a series of interest rate hikes. In its June survey of 400 owners and executives of middle market businesses, defined as those with $10 million to $2 billion in revenues, KeyBank found that most remain optimistic about their companies’ prospects in the coming months.

Historically, middle market business leaders have expressed greater confidence in their own companies’ financial prospects than in the U.S. economy at large. This trend persists in the most recent survey, but respondents were significantly more pessimistic on both fronts.

Asked to characterize their overall outlook for the U.S. economy in the next 12 months, more than one-third of middle market business owners and executives (36 percent) selected fair or poor, a significant increase over only 24 percent selecting fair or poor in April.

Drivers of negative sentiment include higher rates of overall inflation and higher costs of raw materials. These concerns were especially pronounced among respondents with less-optimistic outlooks for their own businesses.

Given the dip in sentiment around the broader economy, it’s not surprising that company outlook has also declined among some market business owners and executives, although most are still optimistic about their companies’ financial prospects over the next 12 months.

Going into the third quarter, 11 percent characterized their company outlook as fair or poor, an increase from 5 percent in April. Meanwhile, the number who describe their company outlook as excellent or very good declined from 78 percent in April to 72 percent in June.

In addition, more than three-quarters of middle market business leaders anticipate an economic downturn by the first half of 2023. Among those who expect a downturn in this timeframe, 75 percent expect it to have a negative impact on their own business.

Interestingly, a growing sense of pessimism is not universal across the entire middle market; executives with larger companies and retailers were generally more optimistic than others. Owners and executives of companies with $500 million or more in annual revenue are more optimistic, with 85 percent expressing an excellent or very good company outlook for their next 12 months. Business leaders in the retail sector also report a rosier perspective, with 84 percent characterizing their company outlook as excellent or very good. Both groups of respondents are also more bullish on the overall U.S. economy.

In June, U.S. inflation reached a 40-year high of 9.1 percent, reflecting sharp increases in the prices of food, energy and housing. Middle market businesses are feeling inflation in the form of higher costs for raw materials, manufacturing and overhead. To a lesser degree, business owners and leaders also report higher employee wages, tighter margins, higher borrowing costs and decreased revenues.

In late June, 45 percent of middle market business owners and executives said that higher oil and gas prices were currently having a negative impact on their operations, an increase over 36 percent in April. Thirty-eight percent expect elevated oil and gas prices to continue to be a challenge over the next 12 months, and about the same number (37 percent) predict that high prices for raw materials and commodities will pose challenges. Even more middle market business owners and executives (43 percent) expect higher energy costs to have a negative impact on their operations over the next year.

Among middle market executives with a less optimistic economic outlook, higher rates of overall inflation are particularly concerning. Of those who characterize their U.S. economic outlook as fair or poor, 83 percent cite inflation as a contributing factor. Higher costs of raw materials and commodities (81 percent), a potential economic recession (77 percent) and higher energy costs (74 percent) are the other most-cited concerns among this group of respondents.

Conversely, roughly 80 percent saw some positive effects of inflation within the past six months. These “silver linings” include the ability to increase prices, increased consumer spending and increased productivity due to investments in automation and other process improvements. Owners and executives of middle market companies in the healthcare and retail sectors are more likely to report these positive effects, whereas manufacturing companies are less likely to report any upside as a result of inflation.

For many middle market businesses, energy and material costs are closely linked with supply chains. Nearly half of middle market business leaders (48 percent) in June said that supply chain developments have had a negative impact on their businesses in the past 12 months. In contrast, only 39 percent reported negative supply chain impacts in April. Difficulties in obtaining raw materials because of higher costs, lower availability and longer wait times are the top challenges cited among companies struggling with supply chain issues.

Company outlook continues to be correlated with supply chain sentiment. Only about one-third of respondents with an excellent or very good company outlook report negative supply chain impacts. Among those with a less optimistic company outlook, however, 89 percent report that recent supply chain developments have negatively affected their businesses. Looking ahead, it’s a positive development that just under one-third (31 percent) of all respondents anticipate that supply chain disruptions will have a negative impact on their business over the next 12 months.

Despite economic concerns, 44 percent of middle market companies plan to add employees in the next six months, and many are feeling confident in their ability to attract and retain talent. Just over half (55 percent) of middle market business owners and executives anticipate that it will be easy to find qualified workers to fill job openings through the end of 2022, while the number who say it would be very easy increased to 24 percent from 19 percent in April. Similarly, of the 62 percent who do not anticipate difficulty retaining employees through the end of 2022, about a quarter (26 percent) say it will be very easy to maintain their workforces.

Of the 45 percent of middle market business leaders who anticipate difficulties in recruiting and retaining talent, half of those respondents plan to implement or enhance programs designed to make workers happy. These measures include health and wellness benefits, competitive wages, bonus programs, flexible work hours and more paid time off (PTO).

Compared to earlier this year, significantly more companies now are investing in competitive compensation and PTO to attract new employees.

At the outset of the third quarter, most middle market business owners and executives are anticipating an economic downturn, with some believing one is already underway. To weather the storm, companies are enhancing operational efficiencies, identifying new ways to increase revenues and searching for alternate suppliers and materials.

Despite inflation, supply chain disruptions and a potential recession, business leaders in the middle market remain optimistic about their own companies’ futures. Many are investing in growth and uncovering new opportunities to strengthen their organizations.

Drew Yergensen is the market president and commercial banking leader with KeyBank in Utah.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice. Please consult with legal, tax and/or financial advisors.