Services Kept Economy Humming, but Can It Last?

Americans resumed eating out, traveling for business, going to movies, booking cruises, and attending sporting events over the last year. If you've paid for any of those things lately, you're probably quite aware of the impact on menu and ticket prices (not to mention your wallet).

All the above and more are part of what economists call the "services" sector of the economy. This goes far beyond restaurant dinners and sports tickets, and includes product deliveries, financial services, home repair, health care, and corporate real estate. Growth in the services sector over the last year far outpaced declining demand for goods, helping drive economic growth, according to the U.S. Bureau of Economic Analysis. 

But now, services-driven growth faces a threat as the small and mid-sized banks that play an outsized role in this part of the economy come under pressure. Smaller banks provide credit to many start-ups, farms, and commercial real estate companies, among others. Tightening in credit from these banks could potentially slow or stall services growth, possibly increasing the odds of recession. And banks are already getting choosier about who they're lending to. 

In the chart below, the net percentage of small lenders tightening standards rose to an average of around 44% as of January. "We expect this to continue to increase when we get the next release in about a month," says Kevin Gordon, senior investment strategist at Schwab. 

"Small and mid-sized banks have been through many interest-rate cycles, but nothing as dramatic as this one since the Savings & Loan crisis of the 1980s," says Kathy Jones, chief fixed income strategist at Schwab. "They've had to curtail lending because they have less capital to lend out and they don't want to get caught with bad loans. If the Fed raises rates even as credit is already tightening, there's a compounding effect. You have to prepare for the rising likelihood of a recession or a downturn."

"For the last year, core services outside of housing stayed relatively strong," Kevin says. "Now stress could be developing for small businesses, and they're such a significant part of the economy that a large hit to them makes it hard to escape recession."

Could this already be happening and showing up in the data? Possibly. The Institute for Supply Management's March Non-Manufacturing Index, released April 5, ended up well below Wall Street analysts' expectations. The index, which measures economic activity, is based on data compiled from purchasing and supply executives across various non-manufacturing industries.

Other numbers deeper in the report showed less exuberance, as well. New orders, which give helpful insight into current demand, fell sharply. So did employment. Prices paid fell to its lowest level since all the way back in July 2020. 

The report's key takeaway, research firm Briefing.com noted, is that the services sector "is slowing noticeably, with a cooling off in the new orders rate." While one data snapshot doesn't show a trend, it's worth watching this report in coming months to see if the softness continues.

For a few years now, smaller banks have faced a major challenge from commercial real estate, a services sector that suffered as remote working took off during the pandemic.

"Commercial real estate has to refinance relatively often, and a lot of loans come due in the next year or two," Kathy says. "It's harder to refinance if landlords can't fill up office space and shopping malls, so that can lead to losses and writing down assets."

Small- and mid-sized banks account for more than 40% of lending in the commercial real estate sector, as these firms tend to have local relationships with banks, Kathy says.

As worries build for commercial real estate in coming months, small and mid-sized banks may find themselves under double-barrel pressure that ultimately could extend to other parts of the services sector. First, they're dealing with commercial real estate customers that may default rather than refinance at higher rates. Second, the government is likely to scrutinize small banks much more closely following recent bank failures.

In anticipation of tighter credit, we could see services-related companies start pulling back. No part of the economy operates in a vacuum. "Ripple effects are a concern," Kevin says.

Earlier this month, for instance, the Wall Street Journal reported that sales of rental apartment buildings in the first quarter of 2023 fell 74% year over year—the fastest drop since the subprime mortgage crisis. This is partly due to higher interest rates and slowing rent growth, the newspaper reported, but lending institutions are also pulling back from these loans or offering them only at high rates—a reflection of the recent banking turmoil.

If services start pulling back, a hit to wages could follow. Wage growth in leisure/hospitality—the largest single part of the services sector—is currently running well above the median wage growth for all workers. 

"The good news is that a hit to services helps the Fed's mission of driving down inflation, but I always say that when it comes to disinflation, there can be too much of a good thing," Kevin says. "If there's enough downward momentum for wages, that will be a decisive recessionary development."

While the picture may be getting gloomier, the current situation is very different from, say, the financial crisis of 2008. "At that time, residential housing represented a huge proportion of the market," Kevin says. "This time the problem is rising interest rates, not risky mortgages that nobody understands."

Kathy says investors should consider longer-term U.S. Treasuries and high-quality investment-grade corporate bonds rather than lower-quality fixed income offerings that may pose the danger of potential defaults. 

Shorter-term Treasuries do pay higher yields than long-term ones at this point, but anyone investing in short-term fixed income now faces what Kathy calls "reinvestment risk." If the economy slows and yields fall, investors in short-term securities will face lower yields relatively soon when they mature.

"If you can control cash flows for the next five years and get in at 4% or 5%, that's not a bad option given all the uncertainty out there," Kathy says.

Like Kathy, Kevin suggests that investors focus on asset quality, emphasizing "factor-based" investing that zeroes in on company health, rather than any specific sector. "Screen for companies with strong profitability over the long term and strong margins," he says. "If you have a shrinking supply of companies with strong earnings and a low cost basis, the market will put a premium on those. 

"Make sure you're not exposed to names with high costs or a negative earnings profile," Kevin adds. "High labor costs have been a sticking point for companies over the last year. The cost of money has gone up significantly, and it's a pretty toxic brew for companies that didn't adjust costs in advance of slower growth."