The National Federation of Independent Businesses conducts a monthly survey of small business members, and a closely watched measure from this is the Small Business Optimism Index.
Most of the job creation in the economy emanates from small business. So, the optimism of small business owners could be viewed as an early signal of future business conditions. The most recent Optimism Index showed the largest monthly increase in the Index, at least going back to 1995. There was a similar surge after the 2016 election, but not as large as the most recent. Small business owners are optimistic that the new administration will introduce policies that are supportive of small business formation and growth, such as a deregulatory environment, and tax policies favorable to small business.
During the first Trump administration, the optimism trend of small business owners was largely positive until the first set of tariffs implemented in early 2018. Tariffs were first implemented in early 2018, but the second round of tariffs on $16 billion of Chinese goods came in late August.
Small business optimism peaked around August of 2018, and then plummeted. There was a collapse of optimism during the Covid pandemic, and then the trend was largely negative during the Biden administration, attributed to the 40-year high inflation that followed supply shocks and government stimulated demand. In fact, in response to the question of “the single most important problem” of small business owners, inflation received the highest recorded response since 1995, in mid-2022, the height of inflation. The most recent surge in the optimism index is the highest level since 2018, and its sustainability depends on fulfillment of high expectations of a more favorable climate for small business, including deregulation, tax cuts, and curtailing inflation.
After a volatile December and the absence of any Santa Claus rally, the equity markets showed some recovery with the recent release of two inflation indicators, the Producer Price Index (PPI) and the Consumer Price Index (CPI). Both measures came in a bit softer than expected, and equity markets liked what they saw. Since the release of the PPI, the market has added almost 1,000 points to the Dow. The softer inflation shows up in the retrenchment of the 10-year Treasury yield. After this latest round of softer inflation reports, the 10-year yield did retreat off the recent high of 4.77%. This is important because of the link between the 10-year yield and what customers ultimately pay to finance assets, such as consumer loans and home mortgages. If disinflation continues, the 30-year mortgage rate will resume the downward trend that we saw in the 3rd and 4th quarter of 2024.
The 10-year yield is a function of growth and inflation expectations in the economy. If market participants are optimistic about economic projections, this will typically lead to higher interest rates, due to higher expected growth and inflation expectations. With strong optimism, and a robust economy, what will it take to put the inflation genie back in the bottle?
The key is on the supply side of the economy. Policies of the new administration will need to stimulate both labor and capital. Policies that encourage investment and capital formation will increase the nation’s productive capacity, providing additional headwinds to inflation. Policies that result in an expanding labor force, by increasing the labor force participation rate, will place downward pressure on the growth of average hourly earnings, providing additional headwinds to price hikes.
Reducing the taxation on capital will increase the return on capital and thereby motivate and attract capital investment. Jobs are created when entrepreneurs and investors are rewarded for capital they place at risk. There is a reason why shareholders are referred to as residual claimants of the firm. They are compensated for the investment of capital only after employees, suppliers, interest, and taxes, are paid. Shareholders are last in line, and their residual claim is often pennies on the dollar.
Rewarding capital through higher returns will motivate the investment of additional capital, going a long way to expand the supply side of the economy. Optimism is riding on it.
This post was originally published on here
