The Real Economy

Q3 2023 Middle Market Business Index

5 September 2023

Resurgent middle market a quandary for Bank of England as MMBI jumps to 146.5

MMBI key takeawayMiddle market activity improved significantly in Q3, highlighting its underlying strength.

MMBI key takeawayDemand for labour is holding up well, meaning firms are hiring and paying more. 

Higher pay and prices pose a problem for the Bank of England as it attempts to tackle inflation.

RSM UK Middle Market Business Index

Tom Pugh
Tom  Pugh
This quarters index is good news for the middle market, but bad for the Bank of England. The MMBI shows strong wage growth and price pass-through, implying interest rates are not yet high enough to curb inflation. Nonetheless, the strong MMBI is another reason to expect the economy to avoid a summer recession.


This year we have shifted from discussion of recession to the more positive R of resilience. Continuing our theme, it may soon be time to start talking about recovery. 

This quarter (Q3), the MMBI jumped to 146.5, indicating significant improvement in the middle market, and potentially in the wider economy, this quarter. 

We can attribute much of the rise to middle market firms passing on price increases to their customers, driving enhancement of revenue and profits. Though this doesn’t quite indicate a boom in the underlying economy – as data is adjusted for price changes – firms would be unable to raise prices without strong underlying demand. This suggests we will likely avoid a recession, at least this year. 

Nonetheless, the Q3 MMBI will make for concerning reading for the Monetary Policy Committee (MPC), as middle market firms say they’re hiring and paying more. Admittedly, fewer firms reported having to pay more for their inputs, but significantly more said they are charging more. This suggests inflation will reduce slowly, while the MPC may have to work harder to suck demand out of the economy. 

Right now, the UK economy resembles a seesaw. On one end sits the recovery in households’ real incomes, driven by falling inflation and a robust labour market. And on the other? The weight of the huge surge in interest rates over the last 18 months on households and businesses. 

Over Q3/4, the positive side will likely win out, improving economic growth after a moribund first half. But entering 2024, the negative impact of higher interest rates is likely to grow heavier. While we think the UK will avoid a recession, we’re expecting virtually no economic growth next year, meaning it wouldn’t take much to tip the balance.

Q3 MMBI video briefing
Tom Pugh and Simon Hart discuss the latest MMBI results and why they could mean a headache for the Bank of England.
  • Economic performance
  • Prices
  • Labour
  • Borrowing

Economic performance

Middle market thriving

The middle market saw a notable upswing in Q3, bolstered by rises in revenue, profits, and economic sentiment. Over half of businesses reported greater revenue (53%) and profits (54%) this quarter, with 49% noting an improved economy – the highest levels since Q4 2021.

Amid concerns over increasing mortgage rates, recent developments might seem surprising. The drop in July's inflation to around 6%, coupled with a robust labour market, led to a rise in real wages for the first time since March 2022, thereby boosting underlying demand. Notably, the private sector sustained better growth than the strike afflicted public sector, with an average growth of 1.1% (y/y) compared to the overall economy's 0.4% (y/y) in H1 2023.

While revenue and profit expansion might not directly correlate with broader economic strength, as GDP growth discounts the impact of price hikes, robust demand remains pivotal. Without strong demand, firms would simply be unable to implement price increases to bolster profits. Looking ahead, 69% of firms anticipate economic enhancement over the next six months. Elevated inflation accounts for 75% of firms expecting revenue growth and 73% anticipating profit increase.

In the immediate future, this relatively positive outlook seems justified. Projected inflation is expected to average slightly above 4% in H2, compared to roughly 9% in H1, allowing real wages to rise once more, hopefully invigorating consumer confidence and purchasing ability. However, three key factors temper the potential for a spending surge:

  1. consumer confidence remains akin to pandemic levels, hindering extravagant spending, despite increased income;
  2. many households have depleted savings due to the cost-of-living crisis, prompting income to be allocated towards rebuilding savings rather than immediate spending; and
  3. escalating interest rates mean higher mortgage and rent payments for most households, potentially offsetting additional income. The rising rates have also encouraged pre-emptive debt reduction and increased savings.

All this means that we think the economy will average zero growth in 2024. While that would mean the UK narrowly avoids a recession, it would take only a small further deterioration in the outlook to tip the scales. It will be 2025 before the economy regains any real momentum.


Pricing power poses an issue for the fight tackling inflation

One key reason for the improvement in middle market businesses revenue and profits is that the proportion of firms saying they have increased prices jumped from 46% in Q2 to 55% in Q3, the highest level in the survey’s history. At the same time, the proportion of firms saying they had to pay more for the goods and services they buy dropped from 72% to 65%. 

This will provide a bit of a headache for the Bank of England (BoE). While it will be glad to see input price inflation starting to fall, evidence that a larger proportion of firms are feeling able to raise prices will cause concerns that inflation may be falling too slowly for its liking. 

That said, inflation is still likely to fall sharply this year. This is mainly due to base effects, as the previous very sharp rises in energy, shipping and commodity prices start to fall out of the annual comparison. But the most recent falls in inflation have been broad based and near-term inflation momentum has fallen sharply. Indeed, monthly annualised inflation fell to just 1.3% in June, a clear sign that price pressures are easing. 

Headline inflation is set to fall to between 4% and 5% by the end of the year. However, it will probably take until late 2024 for headline inflation to drop to 2% and, given that 69% of firms expect to increase prices over the next six months, inflation may prove even stickier than we expect.


Strong demand for labour adds to the Bank of England’s problems

Recent signals indicate that the UK labour market is slowly easing. The workforce on the supply side is recovering, with a 0.5% (180K) increase in the three months leading to May. We can attribute this rise to a higher participation rate, pushing the unemployment rate from 3.8% in April to 4% in May. Conversely, demand for employees faces a setback, as vacancies dropped by 20% compared to the prior year. Redundancies in 2023 surged by 23% compared to 2021 and an even more noticeable 58% compared to 2022.

And yet, demand for middle-market labour remains robust. Firms increasing their workforce rose from 43% in Q2 to 54% in Q3. A striking 73% of companies plan to expand their workforce in the next six months, a record high. This strong demand has led to increased compensation, with 55% of firms raising pay during Q3. Moreover, 71% of businesses expect to raise pay in the coming six months, another record high.

This poses a challenge for the Bank of England, as wage growth heavily influences service sector inflation. The Monetary Policy Committee (MPC) emphasises the need for tangible evidence of decreasing wage growth to confirm inflation control. At 7.8% in June, wage growth remains high for the MPC to halt interest rate hikes. In context, the Bank sees around 3% wage growth as conducive to 2% inflation.

Predicting a gradual rise, the unemployment rate might reach 4.5% by the end of 2024, curbing pay growth. Presently at 6.7%, it's forecasted to decrease to 4% by next year's end. Yet, the latest MMBI results highlight the potential for a sustained tight labour market.

As long as wage growth remains significantly above 3.5%, interest rate hikes remain likely. Peak interest rates of 5.5% or 5.75% are expected later this year. Afterward, interest rate cuts aren't anticipated until late 2024, and any reductions are likely to be gradual.


Investment to boost productivity

Despite the sharp increase in interest rates over the last year, 36% of firms said it was easier to access credit in Q3 and 56% of firms said they were planning on borrowing more over the next six months. This could be evidence of firms turning to debt facilities to manage the continuing economic weakness. But given the jump in the proportion of firms saying they invested more in Q3 (44% to 56%) and of firms planning to invest more over the next six months, which rose to 72%, this could be evidence that middle market firms are increasingly making the productivity enhancing investments so desperately needed across the UK economy. 

Admittedly, economic growth is likely to remain depressed until late 2024. This means the rise in the proportion of firms currently holding more stock (41% to 52%) and planning to increase stock levels over the next six months (61% to 70%) raises a red flag and remains one area of risk. 

However, the firms that continue to invest will be in the best position to take advantage of the upturn in the economy when it arrives in late 2024. What’s more, labour will remain at a premium, both in the short term, where the labour supply is being held back by elevated levels of sickness, and in the longer-term, where demographic challenges will lead to a sharp slowdown in labour force growth. As a result, businesses wishing to expand their output will need to focus on upskilling their existing workforce and automating what processes and functions can be, rather than hiring more employees.


The report

The Q3 2023 MMBI provides a guide – not just to the current state of the middle market, but to what tactics firms in this key part of the wider economy might use to forge ahead.

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