Small Business Survey ticks up again in July, important for REITs

The National Federation of Independent Business Optimism Survey is a finger on the pulse of small business

The National Federation of Independent Business is a monthly report that contains a wealth of information regarding trends for small businesses. It examines labor markets, plans for capital expenditures, credit availability, inventory and sales data, inflation, earnings, and the economic outlook. The survey goes back to 1986, so it’s useful to compare current conditions versus prior peaks and valleys.

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Small business accounts for roughly half of U.S. GDP and jobs. While the financial press tends to focus on the large-cap stock market indices as a barometer of the economy, small business tends to not get as much focus. Large capitalization stocks tend to have a large international focus, which means that their earnings and sentiment don’t necessarily represent the economy as a whole. When forecasting the Fed’s next move, it pays to focus on small business earnings as much or more than the earnings of, say, Apple.

The Optimism Index ticks up again towards its 12-month high

The Optimism Index ticked up to 94.1 from 93.5 last month. “Normalcy” is an index reading of around 100, so we’re well below the trend. Actual employment fell, but the planned employment index ticked up two points.

What’s holding back hiring plans? Lower sales. More firms are reporting sales declines than sales increases, and 18% of all small business owners cited poor sales as their greatest problem. Taxes came in first, with 21% of all respondents citing taxes as their biggest concern. Tied with taxes was government regulations and red tape, which was cited by 21% of the surveyed firms as their biggest concern. The lowest concern? Credit availability—although half of the respondents said they weren’t interested in borrowing. This dovetails with the low capital expenditures level, where only 23% of all respondents intend to make capital outlays in the next three to six months. This is a recessionary reading, but it has been par for the course since the recession began.

Implications for mortgage REITs

The biggest driver for mortgage REITs, like Annaly (NLY), Capstead (CMO), American Capital (AGNC), Hatteras (HTS), or MFA Financial (MFA), is the level of interest rates. Reports like this tell the Fed that they should continue holding interest rates at close to zero and continue purchasing long-term Treasuries and mortgage-backed securities. That said, the Fed intends to exit quantitative easing. Ben Bernanke has said that even if QE ends, interest rates will remain at extremely low levels for the foreseeable future.

The financial press will continue to focus on asset prices, record levels in the Dow Jones Industrial Average, and increasing house prices in places like Phoenix. While those are important data points, the economy doesn’t feel as if the stock market were at record levels. As long as there’s a disconnect between large caps and small business, the Fed should take its cues from small business—in other words, Main Street, not Wall Street. Regardless, the bond market is forecasting the end of QE and REITs must adjust their portfolios accordingly.

This means that mortgage REITs will have reduced leverage in order to take risk off the table. As long as there’s stability in the financial markets, their borrowing rates will remain low. Pre-payments become a non-issue, while delinquencies can become a problem if rising rates trigger an economic slowdown.