When will the next economic downturn happen, if ever?
That is one of the most frequently asked questions we receive after more than a year of ferocious interest rate hikes intended to control rogue inflation. A recession has been looming for some time, but the economic picture is murky since different sectors have been hit harder and recovered at different times. We anticipate a less severe contraction than the 2008 global financial crisis and other more typical recessions, followed by a robust recovery if a widespread contraction does occur during the following year.
It’s common for people to feel anxious or confused when facing a recession. However, they are notoriously difficult to foresee. Therefore, this blog will not attempt to pinpoint when the next recession will begin but rather provide insight into the following issues:
- Answering the question, “What caused recessions in the past?”
- How have stocks responded to recessions in the past?
- How do you know which economic indicators you can count on being the most reliable?
- Is the next economic downturn imminent?
- What should financial backers do to get ready?
First, the obvious question: what triggers economic downturns?
Why do economies sometimes experience downturns?
It takes more than just two consecutive quarters of falling GDP (gross domestic product) following an extended period of growth to qualify as a recession. When it comes to determining when a business cycle began and ended, the following definition of recession can be used: “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
While there have been many potential causes of recessions in the past, economic imbalances are usually to blame. Excess debt in the housing sector led to the recession of 2008, whereas a technology stock asset bubble precipitated the economic downturn in 2001. The COVID-19 pandemic is just one example of a sudden, large-scale event that can have a significant impact on business and result in layoffs.
Consumers tend to cut back on spending when unemployment rates rise, putting additional downward pressure on economic growth, corporate profitability, and stock prices. A domino effect of these elements might bring down an entire economy. Recessions are a difficult part of life, but they are required to clean up the economy and make room for growth.
Just how long do they typically last?
Historically, recessions haven’t lasted too long, which is excellent news. Based on an examination of 11 cycles since 1950, recessions have, on average, lasted roughly 10 months. That may seem like an age to individuals who have lost their jobs or seen their businesses close. However, those with a longer time horizon for their investments would do well to consider the big picture.
In the grand scheme of things, recessions barely register as a hiccup. In the past seventy years, we have experienced an official recession in fewer than fifteen percent of all months. Furthermore, their overall economic effect has been modest. As GDP rose by an average of 25% during expansions, it fell by an average of 2.5% during recessions. Some of the strongest market rallies have happened in the late stages of a recession, suggesting that equity returns can even be positive during the full duration of a contraction.
When the economy is in a downturn, what happens to the stock market?
Recessions are notoriously difficult to anticipate, but it’s still smart to plan for their potential impact on your investments. Equities typically lead the economic cycle by six to seven months when going down and again when going up; therefore, bear markets (market drops of 20% or more) and recessions tend to occur simultaneously.
However, extreme market-timing strategies, including liquidating all holdings and reinvesting the proceeds, might backfire. Late in a business cycle, particularly right after a market bottom, is when you could get the highest gains.
Investing the same amount of money at regular intervals regardless of market fluctuations is called dollar cost averaging, and it can be helpful in down markets. With this strategy, investors can buy more shares at lower prices and stand to gain when the market recovers. Even consistent investing can’t guarantee a return or prevent a loss. When stock prices go down, an investor must decide if they still want to buy shares.
What signs in the economy can point to an impending downturn?
Having forewarning of an impending economic downturn would be fantastic. There are still important signs to keep an eye on in a late-cycle economy.
There are numerous reasons for economic downturns, and the primary ones frequently shift. To better determine where excesses and imbalances may be accumulating, it is helpful to look at multiple parts of the economy. Remember that a sign is more of a mile marker than a distance to the objective.
The yield curve, the unemployment rate, consumer confidence, and new home construction are four economic indicators that might foretell a recession.
In addition to individual indicators’ long-term reliability, we find that aggregate metrics are exceptionally good at predicting future peaks and troughs.
There is uncertainty here due to several considerations. While the yield curve and LEI suggest a deeper recession may yet be on the horizon, the healthy labor market and fortitude of consumers tell a different tale. The housing market has effectively entered a recession, but it may soon begin to rebound, which would be good news for the economy. However, the story can rapidly shift in response to fresh economic data.
The definition of an inverted yield curve
Although an inverted yield curve may sound like a complicated gymnastics routine, it has proven to be a reliable and frequently referenced warning of an impending economic downturn.
When the difference between the short- and long-term rates widens, this is known as an inverted yield curve. This same market signal has predicted every recession over the past 50 years. During central banks tightening cycles, short-term rates tend to increase. When there is a lot of demand for bonds, the interest rate on them tends to go down. When the yield curve inverts, it means that investors are fleeing to the safety of long-term government bonds in favor of buying riskier assets, which is a negative development.
Since central banks began raising short-term rates in the middle of 2022, the yield curve between two-year and 10-year bonds has inverted and fallen sharply. Yields on longer-term bonds, such as those with a duration of between two and five years, have also gone negative. This is the most severe inversion in decades, but you shouldn’t freak out just yet. Recessions have historically not begun until as late as 24 months after an inversion occurs.
Is the next economic downturn imminent?
Although it might have felt like we were already in one, we don’t think a recession has happened yet. While we still expect a brief, mild recession, the likelihood of no recession at all has increased. High inflation and interest rates have dampened consumer confidence and company profits, but the labour market has proven unexpectedly robust and has helped keep the economy afloat.
A rolling recession, in which different areas of the economy decline and recover at different times, may continue even if a formal recession does not.
The semiconductor industry has made a remarkable comeback after a precipitous decline last year. The likelihood of avoiding a full-scale recession increases if some industries keep growing while others contract.
Of course, there could be other problems that hinder the short-term picture. The timing of a recession may be hastened by a worsening labor market or a geopolitical shock, like an intensification of the war in Ukraine.
How should you adjust your stock holdings in preparation for a downturn?
While it is true that stocks tend to perform poorly during recessions, attempting to sell stocks at the right time is not recommended. Should stockholders then do nothing? No way, no how.
Investors can get ready by checking their asset allocation to make sure their portfolio is well-rounded. Since these choices can be very emotional for many investors, seeking the advice of an expert can be extremely helpful.
When the economy is in a downturn, not all equities react the same. Some industries, typically those with greater dividends like consumer staples and utilities, fared better than others in the 10 greatest equity drops between 1987 and 2022. When stock prices are falling, dividends can still be a reliable source of income.
Investors can still benefit from holding growth firms, but they should prioritise those with solid financial profiles, reliable cash flows, and extended growth potential over those that are more vulnerable to short-term fluctuations.
Many businesses may still be successful even in a down economy. Invest in companies that produce food, utilities, and telecommunications products and services because they have pricing power and a large customer base.
How should a bond portfolio be positioned for a downturn?
During a market downturn or bear market, fixed-income investments can be especially helpful. This is because, especially in times of high volatility in the equity markets, bonds can offer a much-needed cushion of safety and capital protection.
Many bonds did not perform their customary duty as a haven during the market selloff of 2022. Bonds fell by less than one percent four times in the seven prior market corrections.
The proper allocation of fixed income is crucial. Investors should always prioritize diversifying their assets, but it is more important to do so now since the economy is entering a period of uncertainty and bond holdings can help provide some stability. We do not believe that investors need to increase their bond allocation in anticipation of a recession; however, they should consult with a financial consultant to ensure that their fixed income exposure is optimized to provide diversification away from equities, income, capital preservation, and inflation protection.
How can I best brace myself for a possible economic downturn?
- Keep your cool and think long-term!
- Invest in a diverse and well-balanced portfolio.
- Invest in funds with a proven track record of withstanding market downturns.
- Use high-quality bonds to cushion the effects of equity volatility.
- Consult with us before making major changes to your portfolio.
Lessons Learned from Past Recessions
For every business cycle, there must be a recession. They manifest themselves whenever economic output falls following an upswing.
• Few economic downturns have occurred. Since 1950, the world has had fewer than 15 percent of its months in an official recession.
• Short durations of economic downturns are typical. The duration of recessions has varied from two months to eighteen months, with a median of ten months.
• The effects of recessions have been milder than those of economic expansions. Since 1950, expansions have boosted the economy by around 25% on average, while recessions have shrunk GDP by an average of 2.5%.
• Each of the last eight recessions had an inverted yield curve that occurred 14.5 months before the economic downturn. It’s one of the most reliable indicators that the economy has hit rock bottom.
• Historically speaking, peaks in stock prices have occurred seven months before economic cycles. They can also recover before the official end of a recession.
• During significant stock market losses, some industries have fared better than others. The S&P 500 Index has been led down throughout each of the last 10 big market falls by consumer staples.
• In times of economic uncertainty, a dependable bond portfolio can be a lifeline. High-quality bonds have proven resilient in the face of stock market declines.