Unemployment in the U.S. has at long last fallen below 6 percent. Gross domestic product growth has recovered following a stumble early in the year. The economy seems to have settled into a decent growth rate — better than desultory but worse than ideal.
Things are different in the middle market, which continues to outperform the economy as a whole. According to the latest Middle Market Indicator (MMI), a quarterly survey of 1,000 C-Suite executives, America’s mid-sized companies have completed a remarkable run in which revenue growth has accelerated for four quarters in a row: 5.0 percent in the fourth quarter of 2013, then 6.5 percent, 6.6 percent, and most recently 7.5 percent in the third quarter of 2014. For the last year, employment growth in the middle market has averaged about three and a half percent — a full percentage point higher than the average in the eight previous quarters. The middle market has found a higher gear.
But like a car that develops a shimmy above a certain speed, the middle market shows some unevenness in its growth. Three months ago, executives from companies in the core of the middle market expressed less confidence in their future growth than the rest of middle market, and they were right. In the quarter just ended, these firms enjoyed notably lower growth (5.3 percent) than smaller (8.9 percent) and larger (6.4 percent) companies. Now, only one of eight executives within this group say business is getting worse, and that number has not increased. But the number saying business is better has fallen from two-thirds to half. It’s not clear where the problem is, or whether it’s temporary. But core middle market executives are, again, conspicuously more cautious in their future revenue projections than the other groups.
Balancing that out is ebullient growth in the lower end of the middle market and steady progress among firms in the upper middle market — those with revenue of between $100 million to $1 billion. The smaller firms are now projecting 6.5 percent revenue growth, a forecast that is 67 percent higher than their prediction a year ago.
It’s also encouraging that almost every industry shows growth that’s at least as high as its second-quarter growth. The exception is financial services, where, it should be noted, second quarter numbers were anomalously high.
The Productivity Play
One possible explanation for somewhat slower going in the middle of the middle market: These companies may be pushing against the limits of the strategy of trying to grow without increasing investments in people or capital equipment. Sooner or later, executives will have to open one or both purse strings.
There’s some evidence that core middle market companies are facing the choice now, especially in the talent market. According to the latest MMI, they are more likely than either smaller or larger firms to say that it is becoming more difficult to attract and retain entry-level and science, technology, engineering, and mathematics (STEM) workers. They are also the most likely to say that they’d rather hold onto an additional dollar of revenue as cash than invest it. And they are more concerned than the other groups about their ability to maintain margins, which might indicate they feel pressure to increase wages, capital spending, R&D and marketing budgets — or all of these.
The Case of the Missing CapEx
What are we to make of the middle market’s apparent reluctance to make capital investments? Consistently — one might say stubbornly — nearly 40 percent of middle-market executives tell us every quarter in the MMI that they would hold additional revenue as cash rather than invest it, even as their revenue and confidence have increased.
Partly the middle market is reflecting broader realities; in the economy as a whole, net business investment is where it was in 2007, which means it is lower as a share of GDP — though corporate profits are the highest they’ve been in decades in relation to GDP.
But there exist more optimistic explanations for the middle market’s low appetite for capital investment. First, rising revenue means that CapEx is increasing in dollars terms, even if not as a percentage of sales. Second, a number of trends are lowering the capital intensity of business. There’s the long-term move toward a services economy. More intriguing is the rapid rise of cloud-based information technology (IT) services. No longer do middle-market companies (and others) have to invest billions in servers, switches and software; instead, they can rent what they need as they need it. Economists may have underestimated the speed with which the cloud is affecting IT capital spending, though it’s evident in the flat sales of enterprise computing companies such as IBM and Hewlett Packard. If companies can acquire capabilities without CapEx, that’s a good thing for everyone except equipment sellers.
The second explanation has to do with discipline. Author, researcher and management expert Jim Collins has documented the fact that the most successful middle market companies manage their finances conservatively to provide stability against crosswinds. We see that discipline in the middle market’s focus on investing to strengthen the core business. They want to put money to work to introduce a new product or service (44 percent) or expand into new domestic markets (41 percent) more than to expand abroad or add a new facility (25 percent) or make acquisitions (24 percent). They are most likely to tap close-to-home sources of funds like local banks or their own profits.
The seemingly low rate of capital expenditure results from a combination of cyclical, structural and self-imposed factors. Judging from the growth of the middle market, executives have so far done an admirable job of sorting through their choices.