Will soaring prices cause small-business credit quality to plummet?

A mix of soaring inflation and rapidly rising interest rates could create new complications for banks’ small-business borrowers, potentially opening the first cracks in credit quality since the early days of the pandemic.

While many banks have passed along inflation-induced price increases to clientele, small-business owners may struggle to absorb these rising costs if their customers pull back on spending in the second half of 2022. This, in turn, will make it harder for businesses to repay existing loans.

The combination of prices reaching a 40-year high in May and Federal Reserve policymakers ratcheting up interest rates to tame inflation — making borrowing expensive — is weighing on consumer confidence and, by extension, spending.

“For a time here, we are going to have both high prices and higher borrowing costs,” said Mike Matousek, head trader at U.S. Global Investors. “That’s got to have an impact on the ordinary person’s spending and typical small business’s income.”

Surging food and fuel costs, caused in large part by pent-up demand and pandemic-era supply-chain challenges, sent overall consumer inflation to 8.6% in May.

The Fed this spring raised interest rates by 75 basis points — from near zero — over the course of two hikes. Policymakers this month jacked up rates by another 75 basis points, the largest one-time increase since 1994. Markets expect another hike when the Fed meets in July.

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Piper Sandler analysts met with chief credit officers from banks spanning the East, Midwest and West this month and found a generally “cautious” tone.

“While all credit metrics are still holding up well to date,” the credit officers believe small business loans and leases are “where we'll likely see early indications of economic weakness,” the Piper Sandler analysts said in a report. This could affect banks’ conventional commercial credits, Small Business Administration loans and commercial real estate loans.

Credit officers “are trying to stay ahead of the potential problem by getting updated financials” from borrowers and assessing business owners’ ability to maintain revenue streams, the Piper Sandler analysts said.

Analysts at Raymond James similarly expect credit quality to deteriorate in the second half of the year, albeit gradually.

Prior to the pandemic, aggregate net charge-offs for the entire banking industry were running at what the Raymond James team viewed as normalized levels, with charge-offs as a percentage of total loans in the range of mid-40 basis points to low-50 basis points throughout 2018 and 2019. However, they said, net charge-offs declined consistently over the last two years, falling to a quarterly low of 19 basis points in the third quarter of 2021 and were at 21 basis points at the end of the first quarter of this year.

The analysts cited pandemic-related government stimulus programs that supported small-business owners and consumers as keys to the strong credit conditions of the past several quarters. But such support has largely wound down this year.

Now, “with the economic environment becoming increasingly uncertain due to the impact of stimulus fading away, persistent elevated inflation, and the sudden and rapid increase in interest rates, we believe it is entirely possible credit metrics begin to normalize, at least back to pre-pandemic levels,” the Raymond James analysts said.

Against the backdrop of rising rates and prices, consumer confidence is indeed waning.

The Conference Board, a nonpartisan think tank, said Tuesday that its consumer confidence index fell to 98.7 in June from 103.2 in May, the second straight monthly decline and the lowest reading since February 2021.

“Consumers’ grimmer outlook was driven by increasing concerns about inflation,” said Lynn Franco, the Conference Board’s senior director of economic indicators. Expectations now suggest “weaker growth in the second half of 2022 as well as growing risk of recession by year end.”

The University of Michigan's closely watched consumer sentiment index landed at a reading of 50.0 in the final June survey. That was down 14% from the prior month and down 42% from a year earlier.

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"Consumers across income, age, education, geographic region, political affiliation, stockholding and homeownership status all posted large declines," said Joanne Hsu, director of the Michigan survey.

"Inflation continued to be of paramount concern to consumers; 47% of consumers blamed inflation for eroding their living standards, just one point shy of the all-time high last reached during the Great Recession,” Hsu added.

Consumers also are worried about future conditions. Nearly 80% of consumers expect “bad times in the year ahead for business conditions, the highest since 2009," Hsu said.

Consumer spending, the lifeblood of the economic recovery following the 2020 pandemic-induced recession, has started to taper off.

Retail sales fell a seasonally adjusted 0.3% in May from the previous month, the U.S. Commerce Department said. It marked the first monthly decline this year and indicated the economy may be losing momentum.

Provident Bank in Iselin, New Jersey, surveyed 600 Americans during the spring and found that a majority are cutting back on nonessential spending because of high food and fuel costs. More than 53% said they now spend between $101 and $500 more per month on groceries than prior to the recent spike in inflation. That leaves less discretionary money for savings and entertainment. For example, 72% said they have made at least some changes to personal travel habits.

“As bankers, it’s important that we uncover these financial pain points for consumers as it relates to inflation,” Anthony Labozzetta, president and CEO of the $13.6 billion-asset Provident Bank, said Tuesday. “Similar to the pandemic, it’s a time for financial institutions to step up and work with their customers on how best to help them navigate through these challenging times.”