5 Things To Know About Recessions

Is a recession coming? A question that is top of mind for investors, businesses, and everyone in between. In our Annual Outlook, we shared our view that growth will continue to slow, and a recession is the most likely outcome. If a recession does materialize, we expect downward pressure on corporate earnings, and a challenging environment for investors.

No one has a crystal ball to know for certain if, or when, a recession will occur, but with an elevated likelihood of it happening, here are five things to know about recessions and their effect on the market.

What is a recession?

First and foremost, let’s understand what a recession is. A recession is a prolonged period and pattern of decline resulting in a shrinking economy. The most common definition of a recession is two or more consecutive quarters of negative growth in a nation’s Gross Domestic Product (GDP) on an inflation adjusted basis (real GDP). GDP measures the value of goods and services produced by an economy. In the case of a recession, it reflects a decrease in a country’s economic output. The National Bureau of Economic Research (NBER), an organization dedicated to monitoring and analyzing major economic issues, broadens the definition by not placing time constraints on economic activity. According the NBER, a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months”

What are the warning signs of a recession?

Beyond GDP, there are other indicators that provide insight into the strength of the economy.

• Consumers: The health of consumer spending and savings can provide insight into consumer confidence. When individuals become concerned about the future of the economy, their confidence drops, and they look to prioritize saving instead of spending – reducing demand for goods and services.
• Employment: If there is a decrease in buying and selling goods, then in return employers will begin spending less on raw materials and labor to mitigate the impact of decreasing sales. During recessions, we will see falling wages and higher unemployment as businesses become more conservative. Indicators such as overtime hours worked, job openings and initial claims for unemployment can provide an early warning of building weakness in the jobs market.
• Production: Companies will begin reducing output near the beginning of a recession to mitigate the effects of reduced demand.

Are recessions the same as a bear market?

While bear markets can often be found around recessions, they are not the same. Recessions reflect economic conditions, not stock markets. Markets are forward looking; they operate off future expectations. As such, it is common for bear markets to begin before recessions officially start as investors anticipate tougher economic conditions and lower earnings ahead. Similarly, bear markets tend to end while the economy is still in contraction, but investors start to anticipate better days ahead.

What should you do during a recession?

Recessions and market volatility are uncomfortable to experience as an investor. As financial advisors and active managers, we cannot emphasize enough the importance of talking with your advisor to discuss your concerns and potential impacts to your plan.

Together you can review your risk tolerance, portfolio, cash savings, and all the other components of your plan. Overall, the sentiments of ‘Stay the Course’ and ‘It’s not about timing the market, but about time in the market’ still hold true during recessions and economic downturns – and your advisor can help you remain committed to the long term and address short term concerns.

What comes after a recession?

Just like no one can predict when a recession will occur, no one can say how long one will last. But since it’s one part of the economic cycle, it will pass. Recessions ultimately end when excesses of the prior expansion cycle have been cleared and central bankers (e.g., the Fed) loosen monetary policy to stimulate growth and encourage risk-taking again. While recessions are never pleasant, they often create an opportunistic landscape longer term. As these factors of slow growth compress, they set the stage, or springboard, to catapult growth into the next phase of expansion. As that happens and optimism begins to return, earnings grow, and investors gain confidence and become opportunistic for what’s to come, which is illustrated in the exhibit below.

A Look at Past Recessions and Equity Market Returns

Click to enlarge

Source: Morningstar.

Looking back to 1949, there’s a clear trend of stock market rebounds in the years following a recession that often meaningfully eclipses the losses from the prior drawdown.

It’s unsettling to go through recessionary periods of declining growth. However, by working with an active manager it is possible to proactively position for the opportunities that recessions frequently create.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.