Guess the year: E.T. was released in cinemas, Prince William was born, and the Mary Rose was raised from the Solent. These notable events occurred in 1982 – the year another headline was made amid economic turmoil: UK inflation reached a whopping 10.4%. The magnitude of this reading is underscored by the time it took to register another double-digit annual increase: 40 years and five months to be precise.

In July 2022, inflation jumped above 10% for the first time in more than four decades. According to the Bank of England’s governor Andrew Bailey “the Russia shock is now the largest contributor to UK inflation”. It’s a similar story in the US where price pressures remain elevated amid these conditions. In June, inflation in the world’s largest economy also hit its highest level in four decades, at 9.1%.

Inflation is intrinsically linked with another economic phenomena: recession. As prices heat up, central banks typically hike interest rates to cool them – a move that can contribute to the economy sliding into recession. The Bank of England (BoE) and the US Federal Reserve have embarked on policy tightening cycles this year, both hiking interest rates to their highest levels since 2008.

For small and medium-sized enterprises (SMEs) price pressures and a looming recession pose an existential threat at a time when many are still recovering from the pandemic. Let’s explore the associated factors that are impacting SMEs in the current economic climate.

Energy crisis

The energy crisis has largely been triggered by a combination of last year’s long cold winter and Russia’s invasion of Ukraine.

Higher demand means higher prices. In 2021, European and Asian countries – notably China – burned through a significant amount of their gas reserves during a relentless winter. Around the same time, the reopening of economies following successive lockdowns also led to higher energy usage as businesses tried to make up for lost time.

Since Russia – one of the world’s largest producers of gas – invaded Ukraine in February 2022 the cost of its gas has soared, causing energy bills to spiral. Sanctions imposed on Russia have forced European nations – which purchase around 40% of natural gas from Russia – to look elsewhere for their supply, pushing up the price from other sources. While the UK does not import as much Russian gas as its neighbours, the interconnected nature of the European market exposes it to price pressures across the continent.

According to the Federation of Small Businesses, UK firms have experienced a 424% rise in gas costs and a 349% rise in electricity costs since February 2021, causing rising energy bills for the average small business to reach over £28,000 – quadruple their level early last year. This forced the UK government to step in with an emergency support package for businesses, including a six-month cap on the price paid for energy from 1 October 2022.

SMEs in the US aren’t immune from this crisis. Despite the nation’s vast domestic resources, a rise in heating bills is expected this winter in the face of tight natural gas markets. According to the National Energy Assistance Directors Association, the average US household bill is expected to increase by 17.2% this winter compared to last year – a trend that could play out in the commercial market as well.

Fuel prices

Fuel is a major expense for many SMEs, which typically lack the finances to absorb a sudden surge in prices. So, as the cost soars against a backdrop of war in Ukraine, the brakes are being applied to SMEs’ spending power at the petrol pump.

Soaring crude oil prices – which is used in manufacturing petrol and diesel – are the root of the problem. Geopolitical forces – notably sanctions against Russia, which is the second-largest exporter of crude oil worldwide – have pushed the price of a barrel higher this year, dragging the price of fuel up with it in the UK and the US:

• UK: By July 2022, pump prices had set records of £1.91 a litre for petrol and £1.99 for diesel. Just two years ago petrol was at a low of around £1 a litre.
• US: In February 2021, the national average petrol price was $2.65 a gallon. Fast-forward to October 2022 and it had jumped to $3.89, with experts predicting it could exceed $4.

SMEs across industries are being forced to grapple with several challenges that stem from rising fuel prices: supply and overhead expenses, service territories, staffing, and the pricing of products and services. Those that operate internationally, relying on the global supply chain to import and export goods, will be hit hardest, with haulage firms passing on increased operational costs.

Cost of living crisis

SMEs are the backbone of the UK and US economies, but a rise in costs is threatening their future. The full extent of the cost-of-living crisis became apparent in early 2022 when COVID-19 restrictions were lifted, compounding the blow dealt to SMEs by the pandemic.

As decades-high inflation continues to push the cost of living higher, consumers are feeling the pinch. The subsequent fall in demand for goods and services is hitting SMEs where it hurts the most: their bottom line. And with wages failing to keep pace with rising costs, they’re also finding it harder to attract and retain staff.

Unable to compete with economies of scale, many SMEs are struggling to survive. PayPal’s Business of Change: Wellness & Empowerment Report 2022 found that more than three-quarters (78%) of SMEs in the UK cite the rising cost of living as the biggest threat to their operations. In the US, inflation has forced over 80% of SMEs to hike their prices, increasing the strain on consumer spending.

Higher interest rates

SMEs in the UK and the US have sounded the alarm over surging interest rates – the BoE and Fed’s main weapon in the fight against inflation. September was the tipping point as borrowing costs were lifted to multi-year highs on both sides of the Atlantic: The BoE’s seventh consecutive hike took UK rates to a level not seen since 2008; and the Fed’s fifth consecutive hike lifted its rate to 3% for the first time since early 2008 – from near zero at the start of the year.

The knock-on effect is potentially crippling for SMEs: the cost of repaying loans taken out to weather the pandemic has spiralled; their ability to secure affordable funding has been stymied; and the cost of mortgage repayments has risen, potentially resulting in defaulted payments and even eviction.

Risk of recession

With a recession – usually defined by two consecutive quarters of negative economic growth – looming, swathes of British SMEs are in the process of battening down the hatches. According to iwoca’s quarterly SME Expert Index, over three-quarters of brokers surveyed (77%) say SMEs are worried about the possibility of a recession – and they have good reason to be. An economic downturn can impact them in several ways, including:

• Reduced profits as consumers tighten their belts.
• Less likely to invest in new products.
• Employees made redundant.
• Lenders are spooked by higher rates, strangling lines of credit.
• Vendors and customers find it difficult to make timely payments, reducing cash flow.

The UK economy unexpectedly shrank in August, strengthening forecasts that it will slide into a recession before the end of the year. Consequently, SMEs are scrambling to swell their cash reserves to insulate themselves from inflation and an economic downturn. Nearly half of business loan brokers have filed more applications for credit for their SME clients, the research found.

A survey by Goldman Sachs this summer showed 93% of small business owners are worried about the US economy experiencing a recession in the next 12 months. Like their British counterparts, they are taking steps to protect themselves from a severe economic downturn. But there is a steely confidence that they can see it out, with the pandemic cited as the main reason for this sanguine mindset. In the latest Small Business Recovery Report by Kabbage from American Express, over 31% of respondents said the pandemic has helped them find a greater sense of resilience and preparedness to be successful during future economic turbulence.

What next for SMEs?

SMEs have two choices in the face of red-hot inflation and recession risks: stay small or grow. Staying small by regulating cash flow requires them to cut back on nonessentials and acquire a basic form of financing to maintain inventory and operational costs. Whereas capacity building with sizable financing can help them generate enough revenue to weather inflation and stay ahead of the competition.

However, access to financing is difficult enough at the best of times for SMEs – especially innovative ones. This challenge has been exacerbated by inflation and high interest rates, which are severely impacting their cash flows. This brings the need to secure the right type of financing into sharp focus for SMEs as they fight to survive. For example, revenue-based financing allows SMEs to access funds based on their overall business revenue. This alternative funding option does away with set monthly repayment dates and personal guarantees for a more SME-friendly experience.