Random Thoughts November 13

Some comments on US small businesses and on inflation expectations.

a) I have written previously about the difficulties for small businesses (see for example Small is beautiful dated November 3) amid the lack of external financing and how this would likely be a key reason for a lower flexibility/innovation power in the economy and with that reduce trend growth. Macroblog in its latest post (Small businesses, small banks, big problems?) makes the connection between losses on commercial real estate and the financing environment for small firms in the US (also referring to a speech by Atlanta Fed president Lockhart earlier this week):
"What are the connections between CRE and small business? An obvious direct link running from small businesses to CRE is that small businesses are an important source of demand for many types of commercial space. A link from CRE to small businesses is that CRE problems in banks could potentially affect credit availability for small businesses....The dependence of small businesses on banks is particularly problematic if the banks facing the most severe CRE problems also are a significant source of loans to small businesses. It turns out that much of the CRE exposure is concentrated among the set of 6,880 or so smaller banking institutions (banks with total assets under $10 billion). Based on the June 2009 Bank Call Report data, these banks represented 20 percent of total commercial bank assets in the United States but hold almost half of the CRE loans.
It seems reasonable to assume that the banks with high exposure to CRE (say, those with CRE exposure as measured by a CRE loan book that is more than three times their tier one capital) are likely to take a conservative approach toward additional loan growth. The bad news is that the banks with the highest CRE exposure also account for about 40 percent of all commercial loans under $1 million–the types of loans most likely used by small businesses."
This suggests that the difficult financing environment for small firms will likely persist for a prolonged time. In turn, one should not expect that small businesses overall will have the means to significantly increase investment as well as hiring. Remember, in the recession at the start of this decade, US small businesses were responsible for only 9% of all job losses but for a third of job growth in between 2003 and 2007. In between the end of 2007 and 2008, however, small businesses accounted for 45% of all job losses!
I am convinced that the macro-economic challenge this issue poses remains underestimated by the public as well as by the investment community given that layoffs by small businesses usually do not get media coverage and given that small businesses are not quoted on the stock exchange.

b) A quick comment on inflation expectations: Much has been written about the rising inflation expectations, especially in the US. Yes, the break-even inflation rate implied by US TIIs has risen significantly and reached a new high for the year (see chart below).

10y US break-evens have reached a new high for the year

Source: Bloomberg, Research Ahead

Still, I am not overly worried about this development. First, as the chart also shows, 10y EUR break-evens have not moved out of this year's trading range. Therefore, it is mostly a US phenomenon than a global one and should also be seen in context with the weaker USD which lost 10% over the past six months.

Trade-weighted USD and break-evens have been closely correlated during the financial crisis

Source: Bloomberg, Research Ahead

Furthermore, I have frequently suggested that inflation-linked swaps give a better picture of inflation expectations amid the substantial and very volatile liquidity premia incorporated into nominal US Treasuries. The chart below shows the development of the 10y break-even rate implied in TIIs and 10y inflation swap rates. Additionally, it shows also the difference between these two time series which I consider as a proxy for the liquidity premia inherent in nominal US Treasuries. As can be seen, this liquidity premia has dropped as of late (amid TII break-evens rising more than inflation swap rates) and has moved back to pre-crisis levels.

Liquidity premia inherent in US Treasuries back towards pre-crisis levels

Source: Bloomberg, Research Ahead

While 10y TII implied break-even inflation rates have increased by 45bp since early October, 10y inflation swap rates have risen by 33bp. More importantly, at currently 2.63% they remain well within the established 2.30-2.80% range of the past six months. In turn, I do not yet regard this as a very significant market development.