Small business owners have endured a difficult four years. Before the global COVID-19 pandemic, many were benefiting from economic growth between 2017 and 2020. But when the pandemic struck, supply chains became strained and inflationary pressures intensified, even as consumer behavior shifted and work moved largely into people’s homes. Consequently, the small business optimism index by the National Federation of Independent Businesses (NFIB) plunged in early 2020 to its lowest reading in four decades. Since then, owner sentiment has remained fragile, as entrepreneurs wrestle with evolving consumer demands, shifting policies, a tight labor market, inflationary pressures, and macroeconomic uncertainty.

The NFIB reported improving small business sentiment in late 2020 and during most of 2021. But the Federal Reserve’s aggressive rate-hike campaign in 2022 renewed the pressure on small business owners: borrowing costs surged just as consumer spending cooled under the weight of rising household expenses. At the same time, small firms found themselves at a distinct disadvantage compared to national and multinational corporations, which typically benefit from integrated supply chains, dominant market share, and deeper capital reserves. Today, many of the largest firms are deploying AI to streamline operations, cut costs, and pass savings on to consumers. But for smaller companies, the resources, time, and risk tolerance required to experiment with AI are often beyond reach—especially when there’s a chance such technology could deter customers accustomed to personal service.

Below is a chart of theNFIB Small Business Optimism Indexfrom 2016 through last month, which highlights just how volatile business sentiment has become. Though September’s reading fell to 98.8, it still sits above the 52-year average of 98.0. The decline in September surprised many analysts, who had expected the index to continue climbing toward 100.5. Meanwhile, theUncertainty Indexjumped 7 points from August to 100 — its fourth-highest level in over 51 years — underscoring how much unease now accompanies shrinking optimism.

NFIB Chief Economist Bill Dunkelbergopined in this month’s report:

• “Optimism among small business owners decreased in September. While most owners evaluate their own business as currently healthy, they are having to manage rising inflationary pressures, slower sales expectations, and ongoing labor market challenges. Although uncertainty is high, small business owners remain resilient as they seek to better understand how policy changes will impact their operations.”

Other key findings in this month’s report include:

• In September, 64% of small business owners reported that supply chain disruptions were affecting their business to some degree, up 10 points from August.

• The net percentage of owners raising average selling prices rose 3 points from August to a net 24% (seasonally adjusted). A net 31% (seasonally adjusted) plan to increase prices over the next three months, up 5 points from August.

• In September, 18% of small business owners cited labor quality as their single most important problem, down 3 points from August and tying with taxes as the top single most important problem.

• A seasonally adjusted 32% of all small business owners reported job openings they could not fill in September, unchanged from August. The last time unfilled job openings fell below 32% was in July 2020. Of the 58% of owners hiring or trying to hire in September, 88% reported few or no qualified applicants for the positions they were trying to fill.

• A seasonally adjusted net 16% of owners plan to create new jobs in the next three months, up 1 point from August and the fourth consecutive monthly increase. Hiring plans are at their highest level since January.

• Fifty-six percent of small business owners reported capital outlays in the last six months, unchanged from August. Of those making expenditures, 42% reported spending on new equipment, 22% acquired vehicles, and 14% improved or expanded facilities. Eleven percent spent money on new fixtures and furniture, and 5% acquired new buildings or land for expansion. Twenty-one percent (seasonally adjusted) plan capital outlays in the next six months, unchanged from August, a historically weak reading.

We observe that only 18 percent of business owners now identify labor quality as their single most pressing issue — a sharp decline from prior years. Still, over half (51 percent) report receiving few or no qualified applicants when trying to fill open positions. Taken together, these findings suggest small business owners continue to face difficult conditions, and we believe those pressures will persist for several years — particularly for firms operating in low-demand niches or facing changing customer demographics.

What Does This Mean to Me?

The indices for the S&P 600 (small capitalized companies) and S&P 400 (mid capitalized companies) have significantly underperformed the S&P 500 (large capitalized companies). Below are the YTD returns of the major indices and the chart:

MSCI Ex US:26.50%

NASDAQ:16.57%

S&P 500:12.91%

Dow Jones Industrial Average:8.76%

S&P Bond:7.26%

S&P 400 Mid Cap:4.29%

S&P 600 Small Cap:2.50%

The marked underperformance of the S&P 400 and S&P 600 underscores just how crucial it is to watch institutional portfolio rotation. Since 2020, institutional flows have turned away from small- and mid-cap sectors—and they haven’t yet fully returned. As a result, investors who held small- or mid-cap mutual funds or ETFs saw their returns shrink relative to more favored sectors.

At some point, institutions may shift back into these segments, possibly reigniting demand and creating new investment opportunities. Until then, we’re keeping small and mid-caps off our model portfolios.

We’d love to hear your thoughts on this UPdate or answer any questions you may have regarding your financial planning. We’re always here to help you and your family reach your goals.