The Year Ahead

Schizophrenic Recovery

As I contemplated writing this article about how I see the next twelve months unfold for our leasing industry in general and Financial Pacific Leasing’s market segment (micro/small ticket) in particular, stressing over the editor’s submission deadline, I found myself in a perpetual state of procrastination. I was always able to rationalize my inertia by telling myself that if I waited a little longer, the economic reports and trends would provide a clearer, more consistent and timely view to share with the leasing world. But I just couldn’t seem to be able to decide which direction the economy was actually going. My schizophrenia about the state and direction of the economy is quite unsettling as I have never suffered too greatly from indecisiveness. Now that I am sitting at my computer with no more time on the shot clock, I realize that the same dynamics that are shaping my actions are also shaping the general economic recovery.

Mixed and somewhat contradictory signals from this schizophrenic economic recovery are causing commercial and consumer markets to allow procrastination to seep into their decision making process.

“The state of your life is nothing more than a reflection of your state of mind.”
Wayne Dyer

The World economy is still in a state of flux and uncertainty, vulnerable to geo-political and geo-natural events. If you lay this backdrop against the economic challenges of small businesses and the consumer, how can one get comfortable with business risks and investment decisions?

The definition of schizophrenic in Miriam-Webster’s dictionary includes “contradictory qualities and attitudes”. The average business and consumer is bombarded daily with contradictory facts and emotions about what is truly happening in our economy.

The stock market is at its highest level in three years. The S&P had its best quarter since 1998. The Institute for Supply Management manufacturing index indicates that the sector has expanded over the last 20 months. The ISM non-manufacturing or service sector index hit a 5 year high in February. CapEx was up 15% in 2010 and is projected to increase 11% in this year. Productivity was up almost 4% last year, the most since 2002. The leasing industry as a whole is experiencing growth in production and much improved portfolio performance.

On the consumer front, the unemployment rate fell to 8.8% in March. Personal spending is on the rise. Retail sales had an 8.9% year-over-year increase through February and another surprise increase in March. Auto sales are recovering at a nice clip and consumers are starting to use credit again. Interest rates are at historical lows and Federal Reserve Chairman Bernanke assures us that inflation is not a problem.

So What Is the Problem?

Home prices have dropped 3.1% since January 2010 and many are predicting a double dip is inevitable. New home sales are down 28% from a year earlier. Though trending down, unemployment is still very high and may not reflect the shadow unemployed who have given up trying or have lowered job expectations. World spot oil is at $109 and gasoline is approaching $4 per gallon on average nationwide. The Labor Dept reported that the Consumer Price Index rose 0.5% in February while the Producer Price Index climbed 1.6%. The University of Michigan’s March consumer sentiment survey had its poorest reading since November 2009. Total liquid deposits in domestic accounts in March reached a record high of $5.9 trillion, despite earning on average only 44 basis points while March’s annual inflation rate was 2.1%.

The Corporate and Small Business economic picture is equally as schizophrenic. The stock market performance speaks for itself. Corporations are flush with cash. A regional commercial banker I was talking with recently indicated that his portfolio was “self funded”. .. which is to say that his corporate borrowers had more in deposits with his bank than they had in loans outstanding. He was crying that loan demand was “soft”. Corporate earnings of the larger companies have rebounded nicely. Commercial real estate markets are weak at best.

Yet, the risk of a geo-political shock to the world economy looms in the Middle East turmoil and our dependence on oil. We have all witnessed the geo-natural risk to an economy as it has been displayed by Mother Nature.

Small Business Haves and Have Not’s

A schizophrenic economy also exists in the world of “small business”. News releases report that small business profits, liquidity and borrowing are up. The stock markets are strong. However, the Discover Small Business Watch survey indicates that small business confidence has been declining through the first quarter of this year. The survey says that 54% of small business owners say the US economy is getting worse. The results of the survey also indicate that cash flows are improving; they intend to decrease or not change spending habits; gasoline prices threaten their profitability; and the recovery for them will take at least a year.

The Thomson Reuters/PayNet Small Business Lending Index which measures small business financing activity had been on the rise for most of 2010. It has declined so far this year. “These numbers are a little disheartening and disappointing.” William Phelan, PayNet’s president and founder, said in an interview with Reuters. “There’s not a lot of positive data here to support the view that small businesses are in a sustainable rebound. It looks like they’re kind of running in place at best. What we’re definitely not seeing is the kind of explosive growth coming out of a recession that we might hope for.”

The dichotomy in the small business economic recovery is explained in the definition of “small business”. Government statistics tracked by the Small Business Administration, public company results, and regional, national, even community bank customers are small businesses with 20+ employees and annual sales of in excess of $10 – $500 million. Many of these small businesses operate in the world economy.

Yet, the vast majority of “small businesses” in the US are actually “micro-businesses”. They have 1-20 employees and less than $10 million in annual revenue. These so-called small businesses are typically closely held in ownership. These small businesses do not have annual capital expenditure budgets. The owners wake up in the morning and make investment decisions based on their “state of mind”.

I contend that their state of mind is presently schizophrenic and they are procrastinating in their business decisions to expand for valid reasons. While world events and macro-economic indicators might be contributing factors to their mood, considerations much closer to home are causing the wait and see attitude that is predominant in the mood of the recovery.

Many of us have seen our home equity values shrink and know of a friend or relative who has been out of work for an extended period of time. We all fill up our gas tank about once per week. These real and psychological factors are what has caused the real small business market to lag behind in the economic recovery where they were leaders in past recession recoveries. Home equity has been the capital account for most closely held, small business balance sheets. Gasoline expense is cutting into already squeezed margins. While small business owners are not personally affected by unemployment, unless their business fails, the employment fears they witness in those friends and family around them create a natural aversion to risk.

From Financial Pacific’s Vantage Point

Because FinPac operates in the micro business economy as described above, we are experiencing soft and uneven demand for equipment leasing and financing. Application volumes have trended lower for the past two years as borrowers continue to deleverage. We have been fortunate to benefit from a consolidation in the funding market which has allowed us to increase market share and maintain outstanding receivables. We have also used the recession to strengthen the predictiveness and efficiency of our credit process. This has allowed us to actually grow our production over the same two year period despite lower application flow. Our 35 years of operating experience and seasoned employees have allowed us to prosper in the downturn.

While the macro and micro-economic environment continues to be muted, we are just now starting to see the really small business economy pick up. It is fragile for certain and there are many risks to still overcome, both financial and political. We believe that the next twelve months are poised to produce cautious but sustained growth for the very small business segment based on the fundamental changes in the credit markets.

The fallout from the Great Recession will affect the micro business market more severely than the general commercial markets. Capital and liquidity have returned to their pre-recession levels for performing middle and large ticket borrowers. The bank leasing sector has a great deal of capital to deploy. As a result, margins and credit requirements will continue to come under pressure as lenders of all types compete for that business. The “Haves” are being courted aggressively.

However, the “Have Nots” in the small and micro-ticket segments have lost access to capital through credit card, mortgage and small business bank lenders. Credit cards are more regulated now than ever. Home equity loans have lost their influence as real equity has been bled out of the market. Banks are either afraid of micro businesses or do not know how to underwrite that type of risk. Regulators are NOT encouraging banks in this segment.

Therefore, I believe that independent leasing companies and third-party originators (brokers) who serve this segment will enjoy growing attention from borrowers. As the recovery is led by larger businesses, top line revenue for the small and micro businesses that support them will encourage capital investment in equipment. Schizophrenic procrastination is slowly turning into optimistic investment. Our leasing industry is poised to prosper from this renewed state of mind. Financial Pacific stands ready to serve the higher risk tranche of the market as it cautiously achieves full bloom.