Understanding Recessions

There’s been talk in recent months about the possibility of entering a recession. With such concern often comes uncertainty, so we took this opportunity to provide a look into what constitutes a recession, and what entering a recessionary period can mean for investors.

A basic definition of a recession is a period of a prolonged downturn in economic activity, usually characterized by two consecutive quarters of negative GDP. The impacts of recession can be far-reaching, including on payroll, industrial production, retail sales, and employment. Recessions in the U.S. are declared by the National Bureau of Economic Research (NBER), a think-tank that conducts non-partisan economic research and monitors data on economic cycles.

Let’s first look at what causes a recession.

There is no singular cause for recession. There are multiple reasons for an economic downturn, and multiple ways a normal business cycle may be thrown off its course. They are most often caused by an accumulation of economic events with unintended negative consequences. In recent years, events like the Covid pandemic, the banking crisis, and an excessive housing market have been contributing factors. The rapid advent and investment in technology and the internet also had a big influence in the 2000 recession, as the swift market acceleration was followed by contrition.

Implications on Wealth

A slowdown in economic activity is usually anticipated by the stock market. As warning signs emerge, the value of stocks, fixed income, and hard assets, like real estate begin to fall – and investor returns begin to drop. Market activity, the anticipation of recession, and the unknown severity of the recession can often influence the spending habits of consumers and corporations. From the corporate side, as companies observe these signals of a changing market and customer spending habits, they may need to make adjustments to their growth strategy by slowing hiring plans or even beginning layoffs, tightening their budgets, and stabilizing spending. Their forecast for revenue and future earnings may reduce due to this expectation of a slowing economy.

How Do You Protect Your Investments?

It can be hard to anticipate recessions, so building a balanced portfolio that can withstand normal market and economic cycles is key to protecting your investments through a recession. An investment portfolio strategy should not be reactionary; it should be constructed to withstand volatility from the onset. In addition to this strong baseline, one tactic your wealth manager may deploy in advance of an economic downturn is a shift away from economic-sensitive companies to those that can be more "recession-proof." A recession-proof company is one whose business is relatively more stable when there’s economic turmoil, for example, those operating in food staples and pharma will experience less volatility in the demand for their product as compared to manufacturing, retail, and travel

Managing Risk

Recessions, like all market cycles, are not scheduled. This means that even the most skilled economist cannot predict exactly when growth or contraction will occur. With uncertainty comes volatility, and to manage volatility it’s important to build a wealth strategy that compensates for both asset value growth and contraction. Balancing your investment portfolio with varying levels of risk, and risk buffers, is important to smooth out volatility during a recessionary cycle and prevent your lifestyle from being impacted.

A good wealth manager will make strategic moves both before and during the cycle, as well as shifts back when the economy rebounds. For example, leading into a recession you may have a higher allocation to "quality" investments (companies with strong balance sheets) to help mitigate the downside risk. This can be applied to either a business plan or personal finances; it’s important to have limited debt service requirements and good positive cash flows going into a recession. This reduces the chances you’ll need to liquidate assets, like stocks, at a low point in their valuation to fund your cash flow needs. At Richard P. Slaughter Associates, we work closely with our clients on these long-term, goal-oriented plans.

Finding Opportunities in a Recession

When the economy cycles to a recession, the shift is usually caused by an imbalance in the economic ecosystem. Businesses that are overly speculative or not using capital efficiently have likely created pockets of inflated pricing that "need" to be corrected. So, as an individual investor or business owner, recessionary cycles can provide opportunities. Oftentimes business and hard asset valuations will over-correct during challenging economic times, which can offer a chance to make initial investments or re-allocate current investments. Your wealth manager may direct a shift in assets to market segments that were hit hard or over-corrected, and thus may offer the best opportunities for future gains.

In the right circumstances, it’s possible to find other hidden benefits amid a recession – such as interest rates. When the economy experiences growth rates well above the norm, a common action to cool off economic growth is for the Federal Reserve to raise interest. However, if rates go up too high or stay elevated too long, a recession can result. These higher interest rates can create benefits for some investors, including conservative investors and those whose portfolios generate needed cash flow for living expenses (for example, seniors). Regardless of the recession, cash flow needs usually don’t change, but if interest rates go up it’s possible to generate that cash flow with less risk because low-risk (fixed income) rates are higher.

Perhaps the most important thing to keep in mind is that every recession is unique and includes elements that haven’t happened before. What we’re seeing this year, as reflected in the news, is a confluence of events: the highest inflation in several decades, a bull market, very-low interest rates coming to an end, and a reversal of massive liquidity for the past 15 years. From this standpoint, it’s looking like a traditional recession – a shock to the system with a downturn.