Handling recessions: a manual
June 30, 2023
5 minutes to read
Like the seasons, the economy fluctuates. Sometimes the trees scrape the sky. Sometimes the economy seems to have gone into hibernation. And sometimes the chainsaws are roaring through the forest. Just like the seasons, the economy goes through different cycles, with ups and downs, with growth and cutbacks. If the economy is sluggish, this doesn't automatically mean it's in recession. In the euro zone, a recession is defined as a contraction of the gross domestic product (GDP) for at least two consecutive quarters. GDP is a country’s total economic production measured over a given period. It includes the added value of all goods and services produced within the national borders and is a crucial indicator of a country’s economic health. In the last quarter of 2022 and in the first quarter of 2023, GDP in the euro area experienced negative growth of -0.1%. Although the contraction was very limited, we had indeed entered a recession .
In the euro area, a recession is defined as an economic contraction for at least two consecutive quarters, but this is not a universal definition. The US, for example, has a different definition. There, the National Bureau of Economic Research, a government agency, determines when the country is in recession. The agency considers GDP, but also other factors such as employment, expenditure and investment and production. If those indicators also fall over a longer period of time, they will consider the country to be in recession. The World Bank also has its own definition. A very severe recession is referred to as a depression. This is a prolonged, severe decline in economic activity. The difference lies in the duration and depth of the economic downturn. In general, an economic downturn is considered a depression if GDP falls by more than 10% in a year or if the recession lasts longer than two years.
What causes a recession?
The seasonal cycle can be easily divided into roughly four three-month periods, this is not the case at all for economic cycles. Periods of growth and contraction can follow each other quickly, or last for a long time. The timing and duration of these cycles are affected by a number of factors from within and outside the economy. Central bank policies, demographic developments, wars and other geopolitical developments, changing laws and tax rules, technological innovations, climate change and natural disasters, the property market, business and consumer confidence... They all have an impact on economic growth. There are also so-called black swan events that affect cycles. They are unexpected events with potentially major consequences. Imagine, for example, that tomorrow we manage to create an immortality pill.
There are therefore 1001 ways a recession can be triggered (or postponed). Usually it is not easy to identify one cause. There may also be several years between the actual cause and the resulting recession. For example, there is a popular theory that links the attacks of 11 September 2001 to the financial crisis and the resulting recession of 2008 and 2009. A cascade of decisions taken to boost the US economy after the attacks meant that the financial system was more and more at risk. This eventually caused the housing market to overheat and collapse, which in turn triggered the 2008 financial crisis.
A recession can also be happen after a period of inflation, as we are currently seeing in several countries. When inflation rises, central banks respond by raising interest rates. This tends to slow down the economy so that inflation falls. However, higher interest rates increase the risk of recession, as they make it more difficult to borrow money. As a result, companies and consumers reduce their spending and a downturn and eventual recession become more likely.
How quickly do recessions pass?
In recent decades, recessions were usually short-lived, unlike say, the Great Depression in the 1930s. Data from the World Bank shows that we there have been five global recessions since 1960, the length of which ranged from one quarter (2020) to about one year (1975, 1982, 1991 and 2009). Since the Second World War, recessions in the US, the world’s largest economy, have lasted on average about 10 months.
Are recessions a bad thing?
First and foremost, it is good to know that in the long term, the economy grows far more than it ever shrinks. Regardless of what country or graph you look at, the long-term trend is always clearly upwards. From Albania to Zambia, you will have to look very long and hard for a country that is in a worse economic condition today than it was a century or half a century ago. Although recessions can be very painful (job losses, company closures, stress and so on), we mustn't forget that the overall long-term picture is positive.
This may seem very cynical to people who have lost their jobs or experienced other disadvantages, but recessions are a 'normal' phenomenon. Recessions make inefficient and chronically loss-making companies disappear to allow new and innovative companies to grow and establish themselves. Recessions also help to cool overheated markets and pierce economic bubbles. In this respect, a recession can be seen as a thorough spring clean for the economy: a recession can destroy a lot, but also leaves room for new growth. Every recession is followed by a period of expansion.
What do recessions do to investments?
Every recession is unique, and so is the impact on the markets. There is therefore no reliable guide for investors. Nevertheless, it can be useful to understand how different asset classes have behaved in previous recessions. While these historical insights are not a guarantee for the future, they can help to make informed decisions.
During a period of economic turmoil, investors often seek protection by reducing their positions in equities and going for bonds. Historically, this is a smart move: bonds tend to outperform equities during recessions. Research by Schroders shows that bonds had a return of around 10% during recessions, while equities fell by more than 10% on average (period 1970 to 2023).
However, bear in mind that the bond universe is very broad and diverse, and that not all bonds do equally well during recessions. Investment grade corporate bonds and government bonds such as US Treasuries have historically delivered higher yields during recessions than high yield corporate bonds. The big picture for shares is not black and white either. Not all shares plummet in recessions. Shares of companies providing essential goods and services (such as food, healthcare and electricity) tend to do relatively well during recessions compared to other types of shares.
Do I adjust my portfolio if there is a recession?
At first glance, the answer seems simple: it may be better to invest in bonds than in shares during recessions. Only, you may be a lot better off if you ... do nothing at all! There are a few reasons why it is better to stick to your investment strategy rather than replace your shares with bonds, recession or no recession:
- Recessions are difficult to predict: although there are numerous economic indicators and models, it is still impossible to predict with absolute certainty whether a recession is coming, when it will happen and how deep it will be. Some indicators have been a reliable predictor of recessions in the past. One example is a yield curve inversion in the US: if the 2-year rate US Treasury rate is higher than the 10-year rate for a certain period, historically a recession will follow within 8 to 19 months. However, this is not a guarantee for the future.
- Market timing is not easy: even if you believe a dip is coming, you still need to choose the right time to exit the market and enter it again. It is extremely difficult to do this well consistently. Even professional investors rarely succeed.
- Trading costs: if you expect certain economic conditions and you change your investment strategy through active trading, you are likely to incur more transaction costs. These costs can get quite high and reduce your return.
- Missing the recovery: historically, the turning point on the equity markets happens about halfway through the recession. The stock markets therefore tend to start rising again in the middle of the recession. However, no one can predict when we reach that point. If you haven't invested in shares again when this happens, you may miss some of the best days in the market. Missing these days can have a significant negative impact on your overall return.
- Bull markets last longer than bear markets. Bull markets (periods of rising stock markets) historically last longer than bear markets (periods of falling stock markets). For the S&P 500, the average duration of bull markets 6.6 years versus 1.3 years for bear markets. The average cumulative gain over the course of a bull market is +339%. The average cumulative loss over the course of a bear market is -38%. In the long term, it may therefore pay off to do nothing and simply grin and bear it.
Doing nothing doesn't mean you have to be unprepared. What can you do to make the ride more comfortable?
Diversification: a broadly diversified portfolio across different asset classes and areas of the world can help to spread risk and limit potential losses during a recession. Periodic investment: by investing a fixed amount every month or quarter. This means you invest at different points in the cycle. The idea behind periodic investment is risk diversification, as it reduces the chance that you invest all your money at the wrong time.
Invest in quality: high-quality companies with strong balance sheets and a proven track record are often more resilient to the consequences of a recession. They can also recover more quickly when the economy bounces back. If necessary, give your portfolio a safety mechanism. You can do this by investing a very small part of your assets in derivative instruments, such as put options, for instance. With put options, you buy the right to sell shares at a predetermined price, regardless of the current market price. This means that if the market falls, you can still sell your shares at the higher price, which limits your losses. However, bear in mind that these types of instruments are complex and risky. You should only consider them if you fully understand how they work and what the risks are. Put options don't avoid losses altogether, but they may help to limit your losses to a certain extent.
Stay calm: it is important not to panic and make impulsive decisions. If you already have a diversified portfolio and you are investing in the long term (more than five years), it is often just a question of patience and discipline. Investing is a marathon, not a sprint. It's important to stick to your strategy throughout the economic cycle, including recessions.
Consider buying more: recessions also come with opportunities. If you have sufficient cash reserves, it may be worth buying during a recession if your risk appetite allows this. So it may be a good idea to keep some cash on hand. If you are panicking, it may be a sign that your portfolio is not in line with your risk tolerance. How you sleep is perhaps the best gauge in this regard. If your investments are keeping you awake, it may make sense for you to adjust your investment strategy and portfolio so that you can continue to invest with peace of mind as the economy fluctuates.