3/14/2019
TOM STEWART: One thing that's certain about 2019-- uncertainty. We're going to talk to a leading economist about what middle market companies can expect on the next episode of The Market That Moves America.
NARRATOR: Welcome to The Market That Moves America. A podcast from the National Center for the Middle Market, which will educate you about the challenges facing mid-sized companies, and help you take advantage of new opportunities.
TOM STEWART: The US economy has grown for 116 straight months. That's the second longest expansion on record. And in the last seven years, revenue with the average middle market company has grown at a 6.9% annual rate. Can it keep going?
I'm Tom Stewart. I'm the executive director of the National Center for the Middle Market at the Ohio State University Fisher College of Business where the nation's leading research group studying mid-sized companies, which account for a third of private sector employment and GDP and the lion's share of economic growth. It is indeed the market that moves America. The National Center for the Middle Market is a partnership between Ohio State and Grant Thornton, LLP Chubb, and Cisco Systems.
Today, I'm happy to welcome back Dan North. Dan is the chief economist of Euler Hermes. The insurance company that specializes in trade finance. Dan was with us in March of 2018 to talk about the economy. A year ago. And we're delighted, Dan, to have you back with us.
DAN NORTH: Tom, thank you very much. Pleasure to be here.
TOM STEWART: But Dan, maybe we should start with describing the vantage point from which you are looking at the economy. I mentioned that Euler Hermes focuses on trade finance as an insurance company. But tell me a little more about the catbird seat that you're in.
DAN NORTH: Right. So we do insure our clients against non-payment basically. And what that means is if you're a business that sells to other businesses, typically, you might ship your goods or even your services on open terms like 30, or 60, or 90 days. And you run the risk in that time period that the business you sold to might go bankrupt, and might not be able to pay you back. So we insure our clients against that. And we also insure them against late payment or slow payment.
So we have actually a pretty good view on the ground of what's happening in the economy because payment is actually one of the leading-- it's a leading indicator. So for instance, if you're a company, you'll pay back your bank first. You'll pay your rent first. You'll pay your employees. The last person you'll pay is your trade credit partner if it comes down to it. So when we see that happening, it's a pretty good indicator of what's happening in the economy. And it's a leading indicator.
And more than that is our past due-- our slow payment. Every month all our clients report us and tell them who's paying him late, how late they are, for how much. It's a couple thousand data points every month. And it gives a really good leading insight into the economy.
TOM STEWART: So how's business?
DAN NORTH: Business last year was great. Both for us and for our clients. It was very strong. There's very strong demand. And I think business conditions are really good. In fact, the big constraint from most of our clients was trying to find labor. That has been an universal refrain. Demand is terrific. It's a pro-growth agenda. It's the best it's been in years. I sure would love to grow faster if I could just find people to work for me.
TOM STEWART: And so the constraint on that is talent not capital. Not other things. It's basically I just cannot find people at all levels of the house in order to drive my growth.
DAN NORTH: Yeah. That has been the big constraint. And I think continues to be for a while. And it's not only just people. It's people with the right skills. There is that really significant skills gap. And in fact, I guess it was just today the labor department came out with their JOLTS report. And showed a record high level of job openings in this country. Not just a high, but a record high. There is more than one job available for every person that's unemployed in this country. More than one job available.
So you know hirers-- employees are going begging for people to come work for them. But the trouble is they can't find people with the right skills.
TOM STEWART: Every quarter, we surveyed 1,000 middle market companies. And we asked them their biggest challenges short term and long term. And then group those challenges into three categories. One is costs. One is sort of competitive challenges. And the third is talent. And for the last 2 and 1/2 years, the talent group has been the number one set of challenges. And we also have a data point that says I think 37% of middle market company leaders say that a lack of talent is constraining their growth, which goes directly to that number. So there is room to grow. I'm just lacking basically the human capital to grow. And not the other resources. I've got demand. Other things seem to be in line. But that's my biggest problem.
DAN NORTH: Absolutely. And sitting here at Ohio State brings to mind one of the things that I pound the table on all the time is skilled legal immigration. I'm not talking about the illegal immigration debate, or the wall, or DACA, or anything like that. Skilled legal immigration because we have this aging workforce, and we can't replace the baby boomers fast enough.
TOM STEWART: As a baby boomer, I know I'm irreplaceable.
DAN NORTH: Yeah. Yeah. Well, we're losing 10,000 of you guys every single day. And it's very hard to replace them. So if we could bring in more skilled legal immigrants, we could do that quickly and plug that skills gap. And sitting here at OSU, one of the big problems I see is we have a million foreign students in this country. And the vast majority are studying STEM. And virtually the day that they graduate, we kick them out of this country and say go back home and compete against us now with the education you got right here. That's a crazy system.
We should embrace the students that come here-- foreign students. And say, if you want to come here that's great. Love to have you. But then we want you to stay. We want you to be a citizen. We want you to pay in social security, and Medicare, and plug the skills gap. This is what Canada does. In fact, Canada takes in about 20 times as many skilled legal immigrants.
TOM STEWART: That's 20 times in raw numbers. Not in percentage terms.
DAN NORTH: Compared to the labor force. Compared to our labor force. But still, it's 20 times. And that's a model we should emulate. And that's how we could plug that skills gap, and that aging workforce gap.
TOM STEWART: You know, if you go back, I think it's Gary Becker who won his Nobel Prize among other things, for looking at some of those issues about the value of immigrant highly skilled human capital. And capturing it. I mean, it's an acquisition. Right? It's an acquisition of highly skilled. As you look forward, Dan, as you're looking at the data that you see, do you see growth continuing at the same level? Do you think it's slowing down? Do you see-- just sort of put on your crystal ball. Or look into your crystal ball give us what that was a one handed or a two handed economist would say the future is going to hold.
DAN NORTH: I'm going to try to keep it one hand. But look, last year 2018, was really pretty good. 2.9%, 3% GDP growth. Again, giving our aging workforce and skills mismatch, that's probably as good as it's going to get. We do think this year is going to be a bit slower. Something like 2 and 1/2 percent. And there are two principal fundamental reasons. One is the Federal Reserve has been tightening monetary policy for three years now. And it's possible they might have already gone too far.
So we've got tightened monetary policy. And by the end of this year, all that wonderful fiscal stimulus that we had with tax cuts, and corporate tax cuts, and spending, and the budget, that's going to tail off by the end of this year. So there are two fundamental drivers there that are going to put a weight on the economy. And then there are a host of other risks on top of that that could contribute.
TOM STEWART: So right now as we speak in February 2019, Britain is heading toward some form of exit from the EU or a new referendum. There are European economic growth is slowed way down I think from-- well, it wasn't really all that robust. But it's more anemic than it was. China's growth seems to be slowing, and there's some questions of a big debt overhang in China.
So when you look at the global demand picture-- I want to get to tariffs in a second. But when you look at the global demand picture, is that also sort of another contributor to slowdown? Or is it just a collection of risks? Or what are you seeing?
DAN NORTH: I think it's definitely a contributor. And it could turn into a bigger risk. Did you know that in the third quarter of last year, which is the latest for which many countries have reported, the third quarter last year there were six economies that recorded negative GDP growth? Including Germany, Japan, Sweden, Switzerland, Italy, Turkey. Relatively major economies.
TOM STEWART: Those are not insubstantial economies.
DAN NORTH: That's right. And each one has a story. OK, you can explain away each one of them. Right? So in Germany there were troubles in the auto industry for instance. And each one. But when you get six fairly big ones all at once, and they're not surviving a bump in the road, that tells you you've got some fairly serious global slowdown. Global headwinds.
Now we're seeing Italy really is in a recession. We're going to be seeing slower growth in Germany and France. And, as you mentioned, China. And China is really kind of the big piece of the puzzle there. Now Chinese growth forecasts, by most forecasters, as you know 6-ish percent. But there are a lot of other indicators there showing a lot more weakness in the Chinese economy. Like the measures of production and manufacturing are all really weak.
And there's always the question about the official numbers versus what the what the real economy sees. What private estimates there are. And private estimates we see are things are really, really taking a dip. So those are big risks. Global growth. Global slowdown in Europe and China.
TOM STEWART: And what about trade policy? I mean, a year ago when we talked these issues weren't on the radar at all. And just to give you one of our data points, I mentioned we have this bucket of challenges and within that cost bucket is costs of trade including tariffs and so on and so forth. And that went from a number where 2% of middle market executives said it was a concern. That was in the second quarter. And it went up to 10% like a quarter later. Jumped up to 10%. So we see a big increase in concern about it obviously.
Do you see this as a drag? As a risk? As some combination of each?
DAN NORTH: Definitely see it as a drag already.
TOM STEWART: How is it showing up?
DAN NORTH: Well, I'm going to backtrack for a second and talk about what is already in place in terms of tariffs because there's a little bit of confusion about what we have out there already. So in the end of 2017, we put 20% tariffs on Canadian softwood, which raised housing prices. Then we put tariffs on washing machines. And the price of washing machines went up 15%. So tariffs get passed through to consumers.
Then we put tariffs on solar panels. And guess what? Billions of projects get canceled. And then we put the steel and aluminum tariffs on, which are, by the way, are still on for every country. And we're starting to see losses in manufacturing jobs. Steel prices go up 35%. That's great if you're a steel producer. It's really not good if you are a steel user.
TOM STEWART: And there are a lot users than steel producers.
DAN NORTH: Exactly. Exactly. So this is a protectionist measure to protect and create steel and aluminum jobs. As you say, there are a lot more jobs and people that use those products. And for instance, you go back to the third quarter earnings. I think it was Alcoa-- an aluminum producer. They boosted their earnings by 27 million dollars and a quarter. Go back to Caterpillar. They lost 40 million dollars. GM says we've lost a billion dollars in the last year due to tariffs.
You've also got a big loser in agriculture. The soybeans is the number one export from US to China. And that has taken an enormous hit. Both in volume and price. So the trouble with tariffs is it creates winners and losers. And overall, it creates more losers and now it's creating that really significant risk of a significant trade war. I guess you'd say where we are now is what? A trade feud? Trying to negotiate out of it.
If we go to a trade war or can't resolve our differences and remove tariffs with China, that could be a really significant drag on the US and on global GDP. And in a world where we're growing at 2 and a 1/2 percent, that is that is pretty risky. So tariffs are something I want to see go away. All that said, from an economist point of view, tariffs being something that destroys prosperity for everybody, they do seem to have been used pretty effectively as negotiating tools. As leverage in negotiations.
For instance, the new NAFTA 2.0 with Canada and Mexico. We were able to bring them to the table and renegotiate a better deal. Look, it wasn't a tremendous improvement. But it was an improvement. And we were able to do that by using tariffs as leverage. Now we have brought the Chinese to the table to negotiate. And that's not happened before. And it's most important I think as a result of these negotiations to get the protection against and for intellectual property. That has been a folly for US corporations over the past several decades to basically give away intellectual property. And that's got to stop.
And so, if we can have a short term cost by having tariffs, if we can negotiate the IP protections it might be worth it.
TOM STEWART: So the risk here is that things could-- what might be leverage could turn a feud into a war. The benefit might be if it works, we end up with a better international trade system. A short term cost and a long term gain. So looks to me like we have a couple of things here. We have like the trade in human capital, if we can say, or the flow of human capital is interrupted in ways that are slowing growth. For the moment, there's a slowing or there's some barriers to the trade in goods and services that are slowing growth but might be removed.
And we've got some sort of geopolitical risks in terms of the overall picture with the EU, China, and so on and so forth. All of which could-- but these are layered upon. As you said, basically, business is good. And I want to ask you a question economists never get to answer because your job to forecast. Economists are usually asked as to forecast what could go wrong. What could be the upside surprises that we could see? And how would you know if they were coming?
DAN NORTH: I'm going to tell you what the upside surprises would be after I spend another minute or two on what we see as potential downsides. Now we do see the rest of this year, most of the rest this year, as pretty good. Business conditions really are pretty good right now. We've got high consumer confidence. We've got wages growing. We have a still positive yield curve, which is a good indicator of continued growth. We have some fiscal stimulus in the pipeline. So conditions right now are pretty good.
Manufacturing lead the indicators. Good corporate profits and so forth. There are some other things that are leading out there several quarters that can tell us more about the end of this year into early 2020. For instance, you go into the details of the consumer confidence survey. You know this is a phone survey. And ask people how do you feel about that things now? How do you feel about things six months from now?
Well, the response about things six months from now has plummeted in the past few months. And when you get a huge difference between the expectations and the current situation, that is often associated with a recession. And we're at levels that where spread is very, very large right now. CEO confidence has been very positive up until the last quarter or so. Why? Well, one reason is S&P earnings for the first quarter are probably going to be negative year over year. And part of that's due to that comparable from the tax cuts.
TOM STEWART: So an artificially high number makes a bad comparison.
DAN NORTH: Right. Right. But you know you can explain it away. But it's still a negative number. And growth is still slowing. And then you've got debt and asset levels that are high. And are indicative towards something you'd have at the end of a cycle. And the biggest one of all is as I said before is maybe the Fed has already tightened too much. And that leading indicator, that treasury yield curve, that difference in interest rates on the treasury curve, when that gets very, very small, when it gets actually goes down to negative, that's a really strong indicator of a recession. It didn't go negative. But it got really, really close. It got within 15 basis points.
So that was that is still something to keep an eye on. So there are a number of indicators that make us uneasy about the end of this year, early 2020. But just be to reiterate, we think most of this year is going to be pretty good. Now the positive sides? All those things I talked about could in fact change. Consumer confidence could back could come back up. Maybe we'll see that the Fed didn't raise too fast. Maybe they'll be able to pull off that soft landing. It's been done once before. Maybe they might even cut interest rates this year.
Maybe the US and China settle that trade dispute. Entirely a possible trade tariffs get removed. That would boost the consumer confidence and consumption. Wage growth is already growing. That could accelerate. Could see earnings growth return. Housing market could start to pick up again if rates start to fall. So there are lots of things. Nothing's set in stone. These things could change. These could be the positive surprises. But Tom, we ought to be prepared for the less happy picture.
TOM STEWART: You know, it's interesting. Our last fourth quarter 2018 middle market indicator showed a dip in confidence. Still from a very at a high level. Confidence was at a very high level. But confidence in the global, national, and local economies dipped a little bit. People's projections of the short term business climate and demand dipped a bit. But at the same time, their plans-- executives plans-- hadn't changed. The same number of people were saying we're planning to open a new plant. The same number of people were saying we're planning to enter a new domestic or international market. Launch new products.
So we saw sort of a little anxiety. But what they told us about their budget was we're budgeting for what we see is what we get. But we're a little bit anxious. Does that sound like the right approach?
DAN NORTH: Well, I'm not sure I could tell how middle market businesses how to plan out for the next couple of years. How to plan their capital budgeting. But typically, that's common. When times are good, you think they're going to be good for some time. And that's where you start running up into things like what we have now. Very high corporate debt levels because corporations are saying things are good. Let's borrow some money, keep expanding, and so forth.
And it gets into behavioral economics. You get plans in place where you want to grow. You think things are going to be OK. And maybe you don't look so carefully at what some of the negative indicators could be.
TOM STEWART: So build some-- when Cain's talked about uncertainty, he said that basically in the face of uncertainty, you want to build a bit of a war chest. You want to build liquidity. I think it was [? Kansas ?] response to uncertainty. And so that would mean you could sort of extend the definition of liquidity to be not just money in the bank or the ability to get money right away. But liquidity and agility in some of your planning. Don't over commit yourself to things because business is good right now. But there's some negative signs, and you don't want to be caught out over your skis.
DAN NORTH: Yeah. And it's a tough call, of course. That's why I say I couldn't really advise companies how to manage their capital budgeting. But I would say if you do anticipate that there may be a slowdown, there are other things you can do. For instance, and none of these are easy things, but there are things to contemplate. And it gets back to the world view that 95% of the world lives outside of the US. So if you're looking to expand a market, boy, there is a huge opportunity.
And if you're thinking that things are going to get a little bit tighter, well, if you're managing your business, maybe tighten your credit terms a little bit. Maybe go really harsh on expenses. And I know in our industry, that is very much the case with very tight expenses. Maybe you can raise prices a little bit. And in fact, some of the big consumer product companies are doing that now. Fatten up the margin a little bit. Get that cheap financing I suppose. And maybe limit exposure to equities because I think there is a pretty big risk in the equity markets.
And I'm not giving investment advice. But valuations are overextended I think. And it's been a very, very long and nice run. But we maybe need to be careful there.
TOM STEWART: And so that allows us to sort of wrap up where we began, which it has been an extraordinarily long and nice run with economic conditions that you might described as sort of being like Bermuda. And there is the possibility that Bermuda will continue. Or the possibility that various things might come in and disrupt that and basically tighten your ship. Prepare for that. But in the meantime, don't neglect to take advantage of the fact that conditions are pretty good right now.
DAN NORTH: You got it. And I just would reiterate that. I want to make sure that it's clear we think this year things are going to be pretty good for most of the year. We really do. But there are some clouds on the horizon that we really have to keep an eye on.
TOM STEWART: And that's the view from Dan North who is the chief economist of Euler Hermes. And as he said at the beginning of this conversation, Euler Hermes sits in a position where it sees the way in which companies are paying each other for the goods and services that they trade among each other along with the larger macroeconomic picture that he was able to discuss. So where we're seeing sort of a granular and a big picture view of the economy simultaneously from what Dan has to tell us.
So let me extend my thanks to Dan North for joining us. As I said, Dan is the chief economist of Euler Hermes-- the insurance company. And you can learn more about him and learn more about the company at their website, which is eulerhermes.com/us. And you can learn more about us at our website middlemarketcenter.org. Thank you all for listening to The Market That Moves America. Never miss a new episode. You can subscribe to the podcast on iTunes, Stitcher, Google Play, or wherever fine podcasts are found. And as I said, you can subscribe and learn more about us at middlemarketcenter.org.