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What is a Recession? Signs, Causes & Impact on Investors

What is a Recession? Signs, Causes & Impact on Investors

2020-01-27 16:10:00
Ben Lobel, Markets Writer
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Recessions can devastate the economy and disrupt the fortunes of individuals, businesses, and investors. But economic decline in the business cycle is inevitable, and your trading chops can be defined by how you respond to crisis. In this piece, we’ll address what a recession is, what causes it and how traders and investors can navigate turbulent times to emerge stronger for the upturn.

What is a recession?

A recession is a period of reduced economic activity in the business cycle, representing contractions that can fall across a combination of GDP, retail sales, manufacturing, employment, and more. Usually, the term is applied when GDP sees two or more consecutive quarters of decline.

Recessions are inevitable in the business cycle, which moves in peaks and troughs. This means that, as sure as there is a bull run, there will be a correspondent downturn as economies fall from their peak.

What causes a recession?

Recessions can be caused by particular patterns across a range of key indicators, from high interest rates, to low consumer confidence and stagnating wages. A single major event, such as the subprime mortgage crisis of 2007, can be enough to cause sustained periods of economic decline.

10 major recessions throughout history and their causes

Top 5 recession warning signs

There are a variety of warning signs of a recession that can predict downturns. The list below covers five of the main ones:

  1. Contracting GDP
  2. Inverted yield curve
  3. Increasing inflation
  4. Subdued manufacturing indicators
  5. Wage stagnation

1. Contracting GDP

GDP naturally fluctuates over the short term, but two consecutive quarters of contracting GDP is the generally-accepted definition of a recession.

2. Inverted Yield Curve for US Treasury Bonds

An inverted yield curve describes a situation where long-term debt shows lower yields than shorter-term debt. An inverted yield curve for US Treasury bonds, for example, means investors are flocking to longer-term bonds, increasing demand and causing the yield to fall. This occurrence has formerly been a reliable predictor for recessions, such as those of 2008, 2001, 1991 and 1981.

3. Increasing Inflation

When inflation increases too quickly as a result of a booming economy, consumers feel the pinch of the increased cost of living, and respond by decreasing their spending. As a consequence, businesses may see reduced revenues as well as struggle with higher production and energy costs. These factors, combined with debts becoming harder to service, can cause considerable economic damage and may contribute to recessionary conditions. Additionally, a rise in the price of oilhas preceded nine out of ten post-WWII recessions.

In a bid to stimulate the economy again, central banks will often cut interest rates to reduce the cost of credit to businesses and individuals – but with global interest rates at rock bottom and spending continuing to be subdued, there are widespread fears for economic growth potential in modern times.

4. Subdued Manufacturing Indicators

The wellbeing of the manufacturing industry is a notable factor in the health of a given economy. If a country’s manufacturing indicator is down, it could be a sign that purchasing managers are unsure about business conditions and/or the future growth of the industry.

5. Wage Stagnation

Naturally, when the economy is strong, companies are more willing to offer salary increases, but if wages stagnate, it could be a sign that businesses are struggling in a challenging economy.

What are the effects of a recession and how does it impact investors?

The effects of a recession can be significant and longstanding for individuals, businesses, and stock market indices. They can cause a negative cycle of further depressed consumer spending, deepened individual and commercial debt, business insolvencies, and job losses.

Here’s how recession hits businesses and the wider stock market:

How a Recession Impacts Businesses

A recession can impact businesses of all sizes, and while larger companies may be better equipped to survive an economic scare, smaller ones are often forced to take action in order to avoid decline and potential insolvency.

Lower revenues caused by less disposable income in the pockets of consumers often results in mandatory cost cutting that hits a company’s budget for marketing, R&D and hiring, limits growth plans, and necessitates a leaner, harder-working organization.

How a Recession ImpactsStock Markets/Investors

The share price of constituent stocks will often fall commensurate with falling profits in an economic downturn. This is because when profits plunge, businesses have less money to pay dividends to shareholders. And when stocks fall, naturally the wider index will fall too. This can hit some indices harder than others (see table below), depending on the extent to which certain markets are exposed to specific drivers of the downturn.

Investors and traders that have open long positions on certain types of stock may naturally see substantial losses during recessions. However, longer-term investors will expect such fluctuations over the course of what can be a period of decades in the market. Others will profit from recessions by taking short positions, while some will look to more defensive assets (see below).

What does a recession do to the stock market?

When a recession hits, major global stocks will often experience a dip accordingly, as mentioned above. For example, the S&P 500 fell from 1,527 in September 2007 to 968 in September 2008, as the Great Recession took hold, while the FTSE 100 also saw a drop from 6,466 to 4,902 over the same period.

2007-2008 Stock Market Indices Decrease (%)

Index

Year on Year Percentage decrease

S&P 500

-36.6

Nasdaq

-36.3

FTSE 100

-32.3

DAX

-36.5

Shanghai

-56.4

Nikkei

-31.8

Hang Seng

-23.7

However, while prominent ‘growth’ stocks such as Apple, Microsoft, and Alphabet all experienced significant share price falls during the Great Recession, there are a range of more defensive choices that fared better. These included pharma stocks like Johnson & Johnson whose share price drop was limited to just 6.5%, and McDonald’s, which saw its share price actually rise by 5.8% during the period from September 2007 to September 2008.

The table below shows a selection of the performances of a variety of stocks over this timeframe.

Major stock performance during 2008 recession

How to trade during a recession

When it comes to trading during a recession, the downward direction of the market need not be a deterrent; indeed, a slump in one market may pave the way for opportunity in another. Whether that means benefiting from defensive stocks or capitalizing on gold, read on for more on how to approach the major asset classes.

Trading Stocks in a Recession

When trading stocks in a recession it pays to understand the sectors that can thrive even in the most unfavorable economic conditions. While certain tech stocks, for example, will invariable fall, businesses in industries such as pharma and food and beverage can retain custom due to the enduring necessity of the products they offer – and may consequently be a viable buy.

Look for companies with a strong cash position and low debt. While the likes of tech stocks may fall heavily, it’s worth keeping an eye on them too in order to capitalize when they move into oversold territory and a recovery begins.

As mentioned above, McDonald’s is an example of a stock that has historically shown resilience against market turmoil. The below chart shows three instances where it maintained or increased its share price in uncertain economic times.

Share price of McDonald's during recession and instability

Trading Forex in a Recession

Trading forex in a recession successfully depends on a thorough understanding of the drivers of currency pair fluctuations. For example, as the world’s default funding currency, the rest of the world must buy USD when banks and companies deleverage, making greenback potentially worth considering as a recessionary hedge.

Elsewhere, consider the effect of the reliance of certain economies on others. For example, China is a key market for Australia’s rich commodity resources, meaning economic problems in China would potentially curb this demand and have a considerable impact on AUD.

Additionally, pairs involving the traditional safe haven currencies JPY and CHF may be worth considering, as these tend to strengthen during economic instability. The below chart shows three instances where JPY did just that.

Performance of Japanese Yen during recession and instability
  • Read up on safe haven currencies for a more comprehensive picture of how to trade forex intough market conditions.

Trading Commodities in a Recession

The most obvious commodity to trade in a recession is gold, which has historically shown a tendency to thrive in risk-off conditions (see the chart below). However, while commodities essential for infrastructure development such as copper may see declines, there may be an opportunity to trade other commodities such as corn and livestock – although these markets may have the downside of being less liquid than those traded at higher volume.

Gold performance during recession and instability

Are we headed for a recession?

There has been remarkable global stock market bull run, among the longest in history, leading some to speculate that a downturn is likely at some point in the year. Additional fundamental drivers representing recessionary risk include:

  • The US-China trade war
  • Tensions between the US and Iran
  • The potential for sovereign debt crises in Europe
  • Unrest in the Far East, such as a slowing Chinese economy and tensions between Japan and South Korea

Will the stock market crash in 2020? It’s certainly possible, but trade data has also contradicted these concerns. For example, Q4 2019 data showed US GDP on pace to rise more than 2% for the period, suggesting a strong chance that expansion will continue into 2020.

Recession FAQs

What is the difference between a recession and a depression?

A recession describes a period of economic decline that lasts at least six months, while a depression refers to a more sustained period. For example, the Great Depression of the 1930s was in effect for most of the decade, while the Great Recession of 2007-2009 lasted merely 18 months.

During a recession, how do governments encourage economic growth?

When recession hits, governments encourage economic growth through monetary and fiscal policy. Through monetary policy, lowering interest rates makes debt cheaper for individuals and companies, and theoretically encourages consumer spending and business investment. Through fiscal policy a government may reduce taxes, increase spending, or both, to put more money in the hands of consumers and businesses in an attempt to reinvigorate the economy.

What is the opposite of a recession?

The opposite of a recession is a recovery or bull market. This was observed in the bull run beginning in 2009, marking the end of the financial crisis and leading to growth which saw the S&P 500 move from a value of 1,000 in June 2009 to 3,000 and rising in October 2019.

Read more: How to determine a bull or bear market

Are there any positive effects of a recession?

One positive effect of a recession is that it keeps inflation down. While inflation rises in the period preceding a recession, when economic unrest kicks in, a lower demand for certain goods and services pushes prices down again.

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