Context

It seems like every other day that someone is predicting an impending recession. But what exactly is a recession and what causes a recession? Perhaps more importantly, what can I do to protect my investments during a recession and the subsequent recovery (if there is one). This Article will examine the questions above and help you understand how to be a better investor during a recession.

 

What is a Recession?

Whilst the US National Bureau of Economic Research (NBER) defines a recession as ‘a significant decline in economic activity spread across the economy, lasting more than few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales’, the technical definition of a recession is more narrowly defined as two consecutive quarters of negative economic growth with GDP as metric.

In other words, a recession is simply the economy shrinking. Although recessions undoubtedly bring about undesirable financial and social consequences such as increasing unemployment rates, the risk of default, business failure, and bankruptcy, recessions are also essential for resetting the markets for subsequent economic expansions. The NBER cites that each economic expansion since 1945 has lasted an average of 58 months, compared to 11 months for each economic contraction. Accordingly, understanding that no economy can grow indefinitely and that a recession is just a healthy part of the business cycle can help you better protect your finances during times of difficulty.

 

What Causes Recessions?

Although it is difficult to identify the exact causes of recessions since each one is unique with its own causes, the simple answer is that recessions are almost always related to lower levels of spending. In other words, some triggering event or combination of triggering events incites market participants to save rather than spend.

Inflation is the rates in which prices increase. A healthy economy should grow between 2-3% per annum. But when the economy grows too fast, then we have hyper-inflation. Hyper-inflation is problematic because the economy is ‘overheated’: Everybody who can be employed is employed; the economy is producing goods at maximum output; and there is excess demand thereby causing price increases.

As prices continue to rise, consumers become increasingly reluctant to spend and will save more. When everybody starts saving instead of spending or consuming, the economy begins to suffer. Businesses will now face increased costs due hyper-inflation and decreased revenues due to consumers spending less. In attempt to maintain a profitable bottom line, businesses may be forced to reduce operating expenses and begin laying off employees. The laid-off employees will then have to reduce their spending, thereby further reducing economic activity. It therefore becomes a vicious cycle until the economy also begins to contract.

Of course, inflation may not be the sole culprit for dramatic price increases. Higher commodity prices (think oil) may also be caused by a reduction in supply, trade wars, or even political tension between large oil producers. The point is, higher prices disincentivises consumer spending.

It may be possible to tackle rampant inflation through employing monetary policy such as increasing interest rates. Higher interest rates encourage saving and discourage borrowing, and by extension, spending. The goal is to lower demand levels and alleviate continuous upward pressure on prices. Ironically, the exact same reasoning can also bring about a recession since fewer businesses will be likely to start up and established businesses will be less likely to rely on debt as a means of expansion. Accordingly, this reduction in spending caused by interest rates can contribute to lowering prices whilst also triggering a recession.

Finally, a big market shock may just be the spark needed to burst an overpriced bubble. In 2001, it was the dot-com stock bubble. In 2007, it was real estate. In each case, the sudden crash caught investors off guard and disincentivised spending which caused a recession. Regardless of whether a recession is coming in 2023 and whether interest rate policies will truly be the trigger for the recession, once it manifests, nearly everyone suffers in some way.

 

Investing during a Recession

Equities

Share prices will decline as economic growth plummets. This holds particularly true for cyclical stocks such as those operating in the airline, luxury, and hospitality industries since their values tends to mimic the business cycle. Share prices will usually also decline for companies with high levels of debt since the cost of debt is now more expensive due to the high interest rates.

However, not all stocks will decline. Defensive stocks such Procter and Gamble, Walmart, and Costco often do relatively well since much of what they sell are considered consumer staples or essentials. Other stocks within the utilities and defence industries also tend to perform strongly during a recession since their stable dividend pay-outs and well established business models present the image of being ‘recession-proof’.

 

Fixed Income

During a recession, risky corporate bonds will invariably see their value plummet as investors hold onto their cash and are generally unwilling to assume excessive risks. Government bonds of financially stable countries such as those issued by the US and UK will often see their values increase by virtue of their perception as risk-free assets. They are considered risk-free because governments of these countries can simply raise taxes or even print money to settle their outstanding obligations. In other words, they are highly unlikely to default. Accordingly, in times of volatility, risk-free assets are in high demand which ultimately drives up their prices.

 

Commodities

Most commodities prices tend to fall prior to a recession with industrial metals being hardest hit since economies need fewer materials as it slows. However, precious metals, primarily gold, tend to appreciate during a recession due to its scarcity and its established history as a stable medium of exchange.

 

Food for Thought

Interestingly, the prices of equities, fixed income products, and commodities may all begin to fall prior the actual onset of a recession. Ironically, with enough speculation, this may in and of itself, actually trigger a recession.

 

What Should I Do with My Existing Investments?

If you think a recession is coming, consider exiting your riskier positions before conditions head south. But once a recession has arrived, it may prove to be a great opportunity to accumulate assets with a strong fundamental at a hefty discount. Warren Buffet is renowned for favouring this value-investing approach. If and when the market does rebound and the bull market returns, you may be pleasantly surprised to find strong returns by running into the uncertainty while everyone else was running away.

 

Ending a Recession

In light of the economic adversities, it is often the governments and central banks that come to the rescue. To end a recession, they must stimulate spending. The first way to stimulate spending is to decrease interest rates. Lower interest rates decrease the cost of saving and makes saving less appealing. It therefore encourages business activities by incentivising market participants increase borrowing, spending, and investing for generating more productive returns.

However, slashing interest rates may not be viable if interest rates were already close to zero. In that case, governments and central banks may turn to fiscal stimulus to stimulate the economy. Examples of fiscal stimulus include borrowing to invest new infrastructure, providing government subsidies to industries and individuals, or increasing public-sector employment. Regardless of how the authorities employ fiscal stimulus, the goal is always the same: to encourage private spending. The rational is that the people involved in these initiatives will have more money to spend for circulating money through the economy.

Still, some countries may experience difficulty in introducing fiscal stimulus policies if their debt levels are already high. In such circumstances, governments and central banks may rely on the highly controversial monetary policy strategy of quantitative easing (‘QE’).

It is important to note that QE is not, contrary to public opinion, the same as printing money. In reality, the central bank employs QE by purchasing financial assets, albeit almost exclusively government bonds, from institutions such as pension funds and insurance companies. The central bank pays for these assets by creating new central bank reserves. The institutions then sell the financial assets to the central bank in consideration for the new deposits at a major bank such as HSBC. The end position for HSBC is the new deposit (a liability from it to the institution), and a new asset – central bank reserves at the central bank. Accordingly, QE simultaneously increases both the quantity of central bank money and commercial bank money. The hope is that commercial banks will then pass the money on to the public through loans to increase liquidity and stimulate the economy.

 

Profiting during Economic Recovery

Contrary to a recession, companies with high levels of debt tend to perform well during an economic recovery due largely to the lower borrowing costs which facilitates accelerated growth opportunities.

Stocks, particularly cyclical stocks, also tend to perform strongly during a recovery. You may wish to strategize and accumulate a position of stocks that perform well in times of low interest rates during the recession. When the economy recovers, demand for these high-growth stocks will lead to higher prices when the time for selling arrives.

Bonds also tend to perform well during a recovery. This is because most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond. However, bonds usually do not perform as well as stocks during this period.

Whilst the above sounds simple, it is only useful if it can be used. Fortunately (or unfortunately), you may have a chance soon as it seems all but certain that it is not a matter of if – but when a recession will arrive.