What is Recession & How to Identify It? | CFI
What does recession mean?

What is recession and how to identify it?

What is a recession?

There is not a specific definition for recessions; however, according to the National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee, an economy is said to be in a recession if there is a trough in the business cycle that is characterized by a negative Gross domestic product (GDP) and is accompanied by a general decline in the country’s economic activity and output such as high unemployment rates, contracting income, decreasing retail sales and declining industrial production for two consecutive quarters. Recessions are inevitable as they are part of the business cycle where economies undergo into different stages throughout time, starting with expansion, reaching a peak, then declining (recession) till reaching a bottom, and then recovering and the cycle goes on. Throughout history, a recession occurs almost every decade after a strong period of economic growth. A recession is sometimes considered healthy for the economy as it clears the road back to prosperity by ending an era of misallocation of investments.

 

Several factors determine whether a recession turns into a serious and protracted depression, including the volume and quality of credit provided during the preceding era of prosperity, the level of speculation authorized, fiscal and monetary policy potential to halt the downward trend, and the quantity of unutilized productive capacity. A depression in economics is a prolonged severe form of a recession that can persist for years. An example of depression is the 1929 Great Depression when GDP declined by 30%, industrial production fell by around 50%, and unemployment surpassed 20% during 1929-1933.

 

The bond market plays a role in identifying a recession. To be precise, the inversion of the yield curve is a key harbinger of recessions. It has accurately predicted the last 10 recessions; downturns are not brought on by the yield curve. Instead, it shows the course that investors believe the economy will take. If investors see an imminent slump in the economy, they will turn to buy long-term treasuries. Investors will hurry to purchase long-term bonds if they think a downturn is soon to come to lock their returns instead of risking to lose their money in the short term and as demand increases suddenly for long-term treasuries in a short time, their yield decreases, and vice versa with short-term treasuries. Therefore, during a recession, as the maturity increases, the yield decreases. When the short-term bonds have higher yields than those of the long-term bonds, the yield curve inverts and slides downward depicting speculations of a weakening economy.

What are the factors that cause recessions?

Recessions have different causes. However, common root causes are oversupply, speculation, and uncertainty.

 

The oversupply happens during an economic boom when businesses typically boost output to keep up with demand from customers. The surplus of goods and services that aren't used when demand peaks can cause a recession, in which businesses reduce production and lay off workers as consumers' purchasing power declines and consumption declines further. Another main factor is a sharp increase in inflation figures causing a sharp decline in aggregate demand, and to counter the inflationary pressure, a central bank would adopt a tightening policy and if done excessively, a recession might occur.

 

With a sharp sudden rise in a specific asset due to consumer speculations, investors start selling their assets hoping to earn a return from the increase in prices; thus, supply exceeds demand as fewer buyers are available and hence driving prices down causing the bubble to burst. Many of the recessions that have occurred in the past were due to problems within the financial markets such as the credit bubbles leading to even more prolonged recessions. Such as that of the 2008 Financial Crisis which occurred because consumers were borrowing excessively during an uncontrolled financial sector collapse.

Financial shocks during the years

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Uncertainty is another factor that happens due to external shocks such as political turbulence, or pandemics where people halt their investment and consumption such as that of 2020 during the COVID-19 pandemic when economic activities all over the world were halted as tight restrictions were imposed to halt the spread of the pandemic. Oil shocks are the most common with financial crises shocks becoming more common recently, while monetary and fiscal policy shocks are the least common of all affecting smaller and more open economies, as seen in the below graph that shows the type of shock that probably caused the recession.

What are the effects of a recession on the financial markets?

According to the NBER, there have been 34 recessions in the United States since 1857, ranging in duration from two months (February to April 2020) to more than five years (October 1873 to March 1879). The six recessions since 1980 have averaged fewer than 10 months in length compared to the average recession duration of 17 months. The stock market falls during a recession and they experience high volatility. Table 1 and Figure 1 below show the change in real GDP from peak to trough and the percentage change in the S&P500 peak to trough showing an average of –3% and –30%, respectively. The S&P 500 surprisingly increased by an average of 1% during all recession periods since 1945 as markets usually top out, meaning that they are at the end of a flourishing period and now can be expected to stay on a plateau before the start of recessions and bottom out before ending.

 

Table 1: Source: Romer, D (2019), RBC Capital Markets (2022)

Quarter and Peak in Real GDP Change in real GDP Peak to Trough S&P500 Peak to trough decline (% change)
Q4 1948 -1.75% -21%
Q2 1953 -2.5% -15%
Q3 1957 -3.6% -21%
Q1 1960 -1.3% -14%
Q3 1970 -1% -36%
Q4 1973 -3.1% -48%
Q1 1980 -2.2% -17%
Q3 1981 -2.8% -27%
Q3 1990 -1.3% -19.9%
Q4 2000 -0.3% -49%
Q4 2007 -4.2% -56.8%
Q2 2020 -10.1% -33.8%
Average -3% -30%

 

Businesses that collapse during a recession might permanently lose their ability to produce goods and services and destroy their productive potential. This is particularly expensive when companies already possess specialized expertise or are an integral element of a supply chain. Recessions have both social and economic costs. As companies’ earnings are adversely affected, they tend to lay off some of their employees to decrease the high costs accompanied by the recession. For example, in 2022 as widespread fears of recession chatter, many giant companies decided to lay off their workers; such as Wells Fargo laying off more than 400 employees since April 2022 to date, Nordstrom plans to lay off employees starting October 2022, Snap, Snapchat app developer, announced a plan to lay off around 20% of its staff in August 2022, Apple laid off 100 contracted recruiters amid the economic slowdown in August 2022, and the list continues. Looking back at historical figures, companies’ earnings declined heavily with an average EPS decline of –18.75% excluding outliers.

Daily S&P500 Index since 1928 with recession

Figure 2, Daily S&P500 Index since 1928 with recession based on Bloomberg Finance LP, NBER, Deutsche Bank

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 Recession details during the years

Figure 3, Recession Details, based on FactSet, National Bureau of Economic Research (NBER), D.A. Davidson

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Peak month: the last month of economic growth before contraction. Trough month: the bottom of the contraction (as per the NBER), and EPS Change uses S&P500 reported EPS, trailing four quarters updated quarterly

What are the different types recoveries?

Various shocks are connected to various patterns of macroeconomic and financial variables. Recovery shapes determine the different types, the length and complexity of the recession, and they are named in different letter such as V, U, W, L and K. Each recovery type is charted on a graph looking like those letters gauging the overall health of the economy. These letters are not formal terms but rather they are common ones within the market. A V-shaped recovery signifies that the economy went through a sharp brief decline then bounced back to normal levels such as the 1953 recession. A U-shaped recovery signifies a steady slower recovery of the economy such as that of the 1973-1975 recession. The W-shaped recovery, aka double-dip recession, signifies a double whammy where the economy recovers and then dips into another second recession before it fully recovers back to pre-recession levels such as that of the 1980s recession. An L-shaped recovery signifies a depression such as that of the 2007-09 crisis. Finally, in a K-shaped recovery, the newest of all, the economy experiences two contradictory trends.

 

Although the other forms are uncommon, the V-shaped and U-shaped recoveries are the most typical. The best-case scenario is a V-shaped recovery due to the brief time spent in the recession's trough, whereas the worst-case scenario is an L-shaped recovery due to the lengthiest recovery.

What are recession-proof investments?

There is no recession-proof recipe; however, there are some investments that could guard one’s portfolio at times of economic uncertainty but still the market is unpredictable. Gold is commonly known as a safe haven asset. Defensive stocks are also considered safe havens as they sectors have a highly inelastic demand as consumers will still have to consume them regardless of the economic situation or prices such as consumer staples, utilities, healthcare, food services, discount stores, and transportation etc.

 

A wise investor during economic downturns will diversify his portfolio by including different types of assets whether stocks or fixed-income instruments with both short and long termed ones. Also, investors could choose dividend-paying stocks in mature industries. For example during the 2008-2009 Financial crisis, the S&P500 index fell by more than 40%, but stocks such as Walmart (WMT) declined by only 3.7%, McDonald’s (MCD) declined by only 2.8%, 10-year treasury securities (1999-2009) started at 5.65% and fell to 3.26% in 2009 only. Increasing the amount of inflation-protected assets, short-term bonds, and cash to further cushion against market volatility. Also, an investor needs to understand that an emotional roller coaster is inevitable. However, with a well-diversified portfolio, an investor can ride out the decline.

 

The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice.  Any view expressed does not constitute a personal recommendation or solicitation to buy or sell.  The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI.  Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.

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