Why everyone's talking about… recession

The technical definition of ‘recession’ is when Gross Domestic Product (GDP) – a measure of the size and health of a country’s economy, over a period of time – shrinks for two consecutive quarters.

However, recession is more generally regarded as a significant decline in economic activity that lasts for more than a few months, according to the US National Bureau of Economic Research.

Recessions can be accompanied by many factors, including an increase in unemployment, a decrease in consumer spending, and a decline in stock prices. Additionally, there might be an increase in bankruptcies and defaults on loans.

They might be caused by external factors such as war, natural disasters, or changes in government policies. A war, for instance, can disrupt trade and reduce demand for goods and services.

Additionally, some sectors of the economy may be more affected than others. For example, during the 2008-2009 recession, the financial sector¹ and the housing market were particularly hard-hit: In the US, $19.2 trillion in household wealth evaporated², while house prices declined 40% on average³.

The severity of a recession can vary too. Deeper and longer recessions are often called ‘depressions’ – or as former US president Harry S Truman once explained it: “It's a recession when your neighbour loses his job; it's a depression when you lose yours.”

They can also cause the market to crash: In October 1929, for example, shares on Wall Street fell sharply following a speculative boom during the ‘Roaring Twenties’. Over two days, the Dow Jones industrial average fell by 25%. When it finally reached its record low in July 1932, the Dow Jones had fallen 89%, and it did not recover to 1929 levels until 1954⁴.

But not every recession leads to a disaster in the markets. There have been a number of times in history where the US went into a recession but not a debilitating market crash.

One reason is that when we’ve experienced a big spike in inflation historically, we’ve needed a recession and a rise in the unemployment rate to bring inflation back down.

To explain, inflation refers to the rate at which prices rise – prices of everyday goods and services we purchase, like groceries, petrol, and consumer items. Central banks can raise interest rates to try to cool the economy and bring elevated inflation back under control.

The theory being that, by raising rates, a central bank can influence borrowing costs for everything from credit cards to mortgage payments. Higher interest rates limit the amount of money available to borrow, and as the flow of cheaper debt to both consumers and companies is cut off, prices will fall because people will be spending less on discretionary goods and other non-essential purchases, while corporations cut costs via layoffs.

The Bank of England, which recently announced a 0.75 percentage point hike to 4% (its biggest such move since 1989)⁵, started raising rates in 2022. But the US Federal Reserve (the Fed), the central banking system of the US, had already started hiking before this – and far higher.

That’s because the US was the first major economy where higher inflation began to surface. It started in 2021, following the US economy’s injection from the government’s pandemic relief money and the spending activity it spurred.

Inflation then began to take root in other countries: with strong US demand pushing up the cost of oil, while Russia’s war on Ukraine in early 2022 disrupted energy and food markets – especially across Europe. The Fed’s response to its own inflation was to increase interest rates to the highest level in 15 years, triggering many countries around the world to follow suit.

In this way, the actions of the Fed can greatly influence the decisions made by central banks across other major economies. The crucial thing therefore is its timing: how far and fast should the Fed raise rates? And when should it pivot and roll back those higher rates – to potentially avoid causing a recession?

In the summer of 2022, economists, market strategists and business leaders were all weighing in on what they felt were a series of policy mistakes by the Fed. It largely boiled down to three things⁶.

1. that the Fed didn’t act quickly enough to tame inflation
2. that it wasn’t aggressive enough (even with a series of rate increases)
3. that it should have been better at seeing the crisis coming.

There are many warning signs that experts and everyday economists keep an eye on to anticipate a potential recession – such as a decrease in banks’ willingness to give out loans (credit availability), a spike in unemployment, or a slowdown in house building.

Some refer to the Leading Economic Index (LEI), which The Conference Board has been publishing for decades. It aggregates a number of indicators of the way the economy is going. They include the change in the S&P 500, jobless claims, new manufacturing orders, and new housing permits.

Other notable indicators include:

• The yield curve inverts

In early 2022, yields for 2-year Treasuries moved higher than those of 10-year Treasuries – or what economists call a ‘2s10s’ curve inversion – which has, historically, signalled a recession.

To explain, the US Treasury Department issues short- and long-term securities. The yield curve compares the yields of short-term Treasury bills with long-term Treasury notes and bonds. The Treasury issues bills for terms of less than a year and notes for terms of two, three, five, and 10 years; it also issues bonds in terms of 20 and 30 years.

Typically, the longer one’s money is locked up for, the higher the yield should be – as compensation for that time risk. So, a normal yield curve slopes up with yields rising as the length of the bond grows. But, when investors are more worried about the present than they are the future, that curve can invert.

An inverted yield curve predicted all of the last seven recessions: 1970, 1973, 1980, 1990, 2001, 2008 and 2020⁷. It is often a sign that the Fed has hiked short-term rates too high, or that investors are seeking long-term bonds over riskier assets.

• Corporate profits decline

In January 2023, the FTSE 100 – the UK's blue-chip index – fell 0.4%, with healthcare and commodity stocks leading losses after data showed British private-sector economic activity fell at its fastest rate in two years8. Share prices reflect predictions of a company’s future profits, and when profits decline, businesses cut investment, employment, and wages. A downward market trajectory can therefore be an indicator the economy is headed towards recession.

• Consumer confidence drops

When people and businesses are uncertain about the future, they tend to cut back on spending and investment. This can lead to a decrease in demand for goods and services, which in turn can lead to a decline in production and employment.

According to the World Economic Forum’s Chief Economists Outlook, almost 20% of the respondents now see an extremely likely chance of a global recession – double the number as in the previous survey in September 2022⁹.

Likewise, the World Bank slashed its 2023 growth forecasts as the impact of central bank rate hikes intensifies, Russia's war in Ukraine continues, and the world's major economic engines sputter. The development lender said it expected global GDP growth of 1.7% in 2023, the slowest pace outside the 2009 and 2020 recessions since 1993¹⁰.

However, not everyone agrees. Economists at Goldman Sachs no longer predict a euro-zone recession – they cite an economy that proved more resilient at the end of 2022, the fact that natural gas prices fell sharply, and China abandoned Covid-19 restrictions earlier than anticipated¹¹.

Likewise, Jack Janasiewicz, Portfolio Manager and Lead Portfolio Strategist at Natixis Investment Managers Solutions, thinks a ‘soft landing’ is still possible in the US. Among the 12 data points he lists, Jack says that “the labour market remains robust and job gains and wage gains are moderating while not crushing the labour market”¹².

Ultimately, recessions are notoriously difficult to predict. As veteran investor Peter Lynch once put it: “The stock market has a 100% record, in the last 50 years, of predicting upturns in the economy. It's never been wrong. It's less than 50-50 on a downturn.”¹³

In December 2022, the Fed’s chair Jerome Powell said: “I don’t think anyone knows whether we’re going to have a recession or not … It’s just not knowable.”¹⁴

Even ChatGPT – the all-knowing chatbot launched by OpenAI in November 2022 – won’t be drawn into predicting whether or not a recession will occur in 2023.

It said: “I am a language model and do not have the ability to predict future events such as whether or not there will be a recession in 2023… Additionally, the current state of the global economy is constantly changing and can be affected by a wide range of unpredictable events, making it even more difficult to predict the future.”

Naturally, recessions pose risks for investors and can have a big impact on investment performance. Reducing exposure to certain sectors and industries can therefore be a smart strategy.

For example, defensive sectors – healthcare, utilities, and consumer staples – tend to perform well during a recession because they provide essential goods and services that are in demand regardless of economic conditions.

Likewise, bonds are considered a safer asset class because they provide a steady stream of income and can protect against stock market volatility. During a recession, investing in US government bonds or high-quality corporates could therefore be a sensible move.

Indeed, if central banks stop hiking rates by the end of the first quarter of 2023, it could create several opportunities in fixed income, such as an increase in duration exposure (which measures a bond’s sensitivity to changes in interest rates).

On the equities side, value companies typically have strong fundamentals, such as high cash reserves and low debt levels, which can help them weather economic downturns.

Just remember that a recession is a short-term economic slowdown, and markets eventually recover. So stay invested and, as ever, make sure you have a well-diversified investment portfolio that can weather market volatility.