Janet Yellen was sworn in as the Chair of the Board of Governors of the Federal Reserve on February 3rd and gave her first testimony before Congress the following week. As expected, the plan is to stick to the script. Yellen did not provide new insight into the Fed’s QE taper and she deemed “the current low target range for the federal funds rate to be appropriate at least as long as the unemployment rate remains above 6.5%.” The debate, of course, is how effective the Fed will be in extracting itself from the markets following the extraordinary monetary policy actions of the post-GFC era.
One point of controversy is that the unemployment rate, which fell to 6.6% in January from 7% in November, could soon hit the aforementioned 6.5% threshold and trigger the Fed to consider raising interest rates. Many suggest that the unemployment rate has declined, at least in part, to a declining labor participation rate (people currently working or looking for work) as discouraged job-seekers drop out of the work force. Why is this important? The Fed’s goals are to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates. If, in fact, the unemployment rate is overstating the improvement in the job market, a plausible case can be that the Fed has little dry powder left to promote its goals.
This line of reasoning has some market participants understandably anxious about the risk of a taper-induced economic downturn. It is our belief, however, that the direction of the global economy should not be determined by extraordinary stimulus, or a lack thereof. Instead, powerful “multiplier effects” of economics can be realized through the extension of capital to businesses pursuing sustainable economic growth and job creation. It’s widely agreed that SME’s are critical for job creation and economic growth, so the challenge is improving and accelerating the process by which markets extend these companies credit.
The first point that deserves attention is that the SME category encapsulates many different types of businesses. Recent research from the World Economic Forum (WEF) suggests that policy initiatives should be designed to differentiate between small firms and young firms. According to the WEF, “although 84.4% of total jobs in [the US non-tradable sector] are in businesses that are six years of age or older, most of the new job creation comes from start-ups.” More specifically, when looking at net job creation in the US non-tradable sector, businesses under one year of age created an average of 2.37 million net new jobs per year from 1999-2007 (in 2007 there were about 73 million workers in the non-tradable sector), while “on average firms that are more than two years old destroy jobs.” So, while it’s estimated that SMEs produce 45-50% of US GDP, start-up businesses offer the greatest benefits as it pertains exclusively to job creation.
Furthermore, new businesses in developed countries face a set of challenges that aren’t identical to those faced by firms in emerging markets. In the U.S., WEF reckons that about 85% of all commercial and industrial loans of $100k or less were made by banks with more than $1 billion in assets (see page 15 for historical C&I loan growth). Consequently, “policies like the Dodd-Frank Act that are intended to govern the behavior of large banks may have unintended consequences for SMEs.” In emerging markets, limited access to capital and/or the cost of that capital is often the primary hurdle.
In conjunction with the observations of the WEF, we believe a key impediment to the efficient flow of capital to SMEs is the damage that’s been done to the faith in capitalism itself. A concerted effort to drive greater transparency and more collaboration across all functions of the capital markets is absolutely essential. Transparency at the SME level allows lenders to be more confident in the loans they make, and this should manifest itself in lower costs of capital. Encouragingly, with the work of organizations like the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC) and at the Sustainability Accounting Standards Board (SASB) in the U.S., SMEs have more guidance in building a sustainable business and disclosing material information.
The Fed and other Central Banks have responded with extraordinary monetary policy, but we need new exciting private sector companies that can execute on the promise of capitalism. These companies are truly TheSustainableFed.Erika Karp is the Founder & Chief Executive Officer of Cornerstone Capital Inc. and the former Head of Global Sector Research at UBS Investment Bank.