Get ready for the next act of the crisis: a large number of European and American SMEs will fall?

Our recommendation:

  • Reduce investment in European and US SMEs, particularly those that are highly dependent on bank financing, revolving loans or ownership financing, as they are under pressure from rising interest rates, tightening credit and default risk.
  • Increase investment in larger companies, especially those that issue fixed-rate debt and are not subject to short-term interest rate fluctuations, as they are relatively more risk-resistant and stable.
  • Pay attention to developments in the US and European banking sectors, avoid investing in banks that may be affected by regional bank failures or commercial real estate crises, and look for banks with strong capital adequacy and loan quality.
  • Exercise caution in the U.K. market, as U.K. SMEs are the most vulnerable group, hit by multiple blows from weak growth, double-digit inflation and rising Bank of England interest rates, which could trigger more distress and defaults.
  • Increase allocations to safe-haven assets such as gold and the US dollar as appropriate to counter possible market turmoil and declining confidence.

Relevant information:

March 30, (Editor Xiaoxiang) – Almost all market participants have been speculating for the past few weeks about who will be the next domino to fall in this European and American banking crisis – with many focusing on other regional banks and many industry leaders worrying about commercial real estate.

But perhaps the most vulnerable, but seemingly insignificant, are the large number of small and medium-sized enterprises in Europe and the United States!

Unlike large companies that usually issue fixed-rate debt and are virtually immune to short-term interest rate fluctuations, SMEs rely heavily on banks for direct financing, so their impact on the shockwaves of the current banking crisis is felt in real time ……

While the higher interest rates and potential default risks faced by SMEs in Europe and the US may have largely escaped the attention of investors so far – especially given the fairly good performance of large corporates – some market participants have begun to look for any signs of strain emerging in this area.

Corporate financing is getting tougher

Small and medium-sized enterprises (SMEs) are vital to economies on both sides of the Atlantic. The European Commission estimates that SMEs employ around 100 million people in the EU and account for more than half of the EU’s economic output.

But right now, against the backdrop of rapid central bank interest rate hikes and tightening credit, it’s clear that Europe and the United States are having a tough time with SMEs.

Jefferies analysts estimate that the average interest rate paid by U.S. small businesses on bank loans rose from about 5 percent to 7.6 percent in 2022, and may further reach about 9.5 percent by the middle of this year.

The ECB’s latest bank lending survey shows that credit standards for loans or lines of credit to businesses reported by eurozone banks for the fourth quarter of 2022 have tightened significantly before the banking sector came under pressure this month. This is the biggest change in the survey since the eurozone debt crisis in 2011.

Elisa Belgacem, senior credit strategist at Generali Investments, said, “In the current deteriorating environment, ‘big is beautiful,’ and small businesses will instead feel the most pressure from interest and energy costs, supply chain disruptions and declining real household disposable income.”

When you think of all the small and medium-sized businesses in Europe and the U.S. that rely on bank financing, revolvers and often even ownership financing, capital is becoming a major issue,” said Guy Miller, chief market strategist at Zurich Insurance Group.

British companies most at risk?

UK SMEs are now considered particularly vulnerable due to the impact of weak growth, double-digit inflation and rising Bank of England interest rates.

An index compiled by Weil Gotshal & Manges shows that the level of distress faced by UK businesses climbed further in the quarter ending February to the highest since the early days of the epidemic in June 2020.

Another recent survey by Manx Financial Group found that 22% of UK SMEs in need of external finance have been unable to access it over the past two years due to high funding costs, long processing times and a lack of flexibility.

Douglas Grant, the agency’s chief executive, said that while many SMEs have locked in fixed-term interest rates to limit the risk of further interest rate increases, there are still many that have not done so. All that small businesses can hope for today is to bet that interest rates have now come to a peak.

In response to the Bank of England’s recent interest rate hike, Martin McTague, chairman of the Federation of Small Businesses, said, “Inflation is taking a huge toll on small businesses, which are more vulnerable to rising input costs than larger businesses. The government needs to prove that it is on the side of small business.”

Vulnerable groups begin to show up

Indeed, long before the current banking crisis festered, ratings agency S&P predicted late last year that speculative-grade corporate defaults in the U.S. and Europe could double to 3.75 percent and 3.25 percent, respectively, by September of this year.

And Biz2Credit, an online financing platform for small businesses, showed that small business loan approvals at large U.S. banks fell for the ninth consecutive month in February, with a parallel decline in business loan approvals at smaller banks. Smaller U.S. banks have seen $119 billion in outflows in recent weeks, as depositors panicked after the collapse of Silicon Valley Bank.

Biz2Credit CEO Rohit Arora said he expects small businesses to have a harder time raising money now, with the biggest challenge being that interest rates are likely to remain high for some time. Interest rates are unlikely to fall until next year.

The risk of soaring defaults is becoming more apparent as the cost of financing soars and becomes more difficult to obtain.

Brett Lewthwaite, global head of fixed income at Macquarie Asset Management, said, “As liquidity dries up, small, seemingly idiosyncratic problems will start to emerge. The vulnerable are starting to show themselves ……”

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