Economic recessions can have major financial implications. They can cost millions of people their jobs, retirement savings and financial security. As a result, it can be hard to see a path back to a strong stock market and, in turn, positive economic growth. However, recessions are a sometimes inevitable part of a business cycle. As such, it pays to know the warning signs of a recession so you can prepare.
It’s important to minimize the impact of a recession on your investment portfolio. Find a financial advisor who can help you today.
What Is a Recession?
In broad terms, a recession is a serious downturn in an economy that lasts longer than a few months. The technical definition is a period of at least two consecutive quarters of negative economic growth. Negative economic growth in this instances is measured by gross domestic product (GDP). Often, though, the term recession is used more broadly than that technical definition.
A recession will usually last for anywhere from 6 to 18 months. The duration can vary depending on the severity of the downturn, and what measures the country’s government and central bank (the Federal Reserve, in the U.S.) take to address it, among other factors. While a one-time event (such as the financial crisis of 2008) can trigger a recession, economic downturns are part of the business cycle and have many underlying factors.
What Happens During a Recession?
During a recession, it’s common to see stock prices fall and the unemployment rate rise. Stock prices fall because investors have less income to invest and less faith in the market to increase their investment. This decreases demand for stocks, meaning stock prices (and thus portfolio values) will naturally go down.
Business revenues also decrease during a recession, which leads many to stop hiring new workers or lay off some of their existing workforce. Many companies will go out of business altogether, further increasing job losses. This causes the unemployment rate to increase. A larger unemployed population as well as general economic unease leads to more consumers saving their money instead of spending it. This decrease in spending can cause business revenues to falter even more, starting the cycle anew.
One potentially positive effect of a recession is that the inflation rate typically falls. Inflation is the economic phenomenon that causes a currency to lose value, and it can decimate an economy if it gets out of control. Periodic dips in economic growth can keep the inflation rate from rising too high.
How Do Governments Deal With Recessions?
The government can use both monetary and fiscal policy to help stimulate a lagging economy.
Monetary policy is carried out by the government’s central bank. To help kick-start economic recovery, the Federal Reserve will typically lower interest rates. This encourages individuals and businesses to borrow money from the government, which in turn can stimulate economic activity. If it’s cheaper to borrow money, it’s more likely that people will spend.
Fiscal policy refers to decisions surrounding taxing and spending. Congress can stimulate the economy by increasing spending or cutting taxes. During the aftermath of the Great Recession, the government engaged in expansionary fiscal policy. This involved the stimulus package that President Barack Obama spearheaded, as well as increased government spending and borrowing.
Some increased government spending is inevitable during a recession as a consequence of the higher unemployment rate. More people will be receiving unemployment benefits, so the government will have to spend more to supply them.
How Can You Predict a Recession?
Obviously, recessions aren’t completely predictable. If they were, we’d be able to better plan for them or even avoid them. That said, there are a few warning signs that can lead economists to predict that a recession may be on the horizon. These signs are what economists call leading indicators. There are also lagging indicators that crop up once a recession is already taking place. A high unemployment rate is the most prominent lagging indicator.
One notable leading indicator is an inverted yield curve. An inverted yield curve refers to the relationship between the yield of a short-term government bond and a long-term government bond. In normal circumstances, the long-term yield will be higher. If the yield curve is inverted and the long-term yield is lower, that can signal a lack of faith in the economy and that a recession is on the horizon. An inverted yield curve has signaled every U.S. recession since 1970.
Another sign of an impending recession is a decline in manufacturing jobs. Less demand for manufactured goods can be a sign of decreased consumer spending, so if factories cut workers or stop hiring new ones, that can mean cuts in other sectors are on the way. Other leading indicators include falling home prices, a contraction in the stock market and a lack of new small businesses.
The important thing to keep in mind during a recession is that things will turn around. The economy will rebound, consumers will start to spend again and jobs will come back. This idea may be harder to swallow in the midst of a recession, but it’s crucial to keep in mind so you don’t make any rash decisions. If, for instance, you sell all your stock because you’re afraid of the price dropping further, you won’t be able to take advantage of the recovery that tends to follow a market downturn.
If you’re looking for signs of another recession on the horizon, there are several things you can look out for. Keep tabs on the yield curve, a general stock market indicator like the Dow or the S&P 500, manufacturing jobs and the monthly house price index (HPI).
Tips for Successful Investing
- A financial advisor can help you recession-proof your portfolio, while still growing your money. Finding the right financial advisor that fits your needs is made much easier with SmartAsset’s free tool. In fact, it can match you with up to three suitable financial advisors in your area in five minutes. Get started now.
- Your investing strategy should account for the possibility of a recession, which is why your asset allocation should be more conservative as you approach retirement. By reducing your exposure to stocks, you can avoid the possibility of your retirement accounts taking a big haircut right as you need them. If you’re still in the market when a recession hits, consider these five things to invest in during a recession.
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