Capital Ideas^™

How bad will the next recession be?

That’s one of the questions we hear most often, especially now as the U.S. Federal Reserve aggressively hikes interest rates to rein in inflation at 40-year highs. It seems clear to us that the U.S. will enter a recession by early 2023, if it hasn’t already. Our expectation is that it will be less damaging than the 2008 global financial crisis, but the full extent of the economic impact won’t be known for some time.

Since 1970, Canada has experienced recessions at approximately the same time as the U.S., demonstrating the interconnectedness of the two economies. Although current signs also point to a Canadian recession on the horizon, it’s worth noting that the country has escaped some previous U.S. recessions. In 2001, there was a short-lived recession in the U.S. following the bursting of the internet bubble. The Canadian economy, in contrast, experienced only a one-quarter dip of 0.1% in real GDP (gross domestic product) despite three straight quarters of reduced exports to the U.S. Final domestic Canadian demand rose steadily, buoyed by, and lending support to, higher employment throughout the year. 

There may also be regional recessions that may bring pain to certain provinces but do not pull the entire Canadian economy into a recession. A decline in oil prices could, for instance, trigger a recession in energy-resources dependent Alberta, but have minimal impact on Ontario where manufacturing is the key driver of economic growth.  

To help you prepare for these uncertain times, we researched 70 years of data including the last 11 economic downturns to distill our top insights and answer key questions about recessions:

1. What is a recession?

A recession is commonly defined as at least two consecutive quarters of declining GDP after a period of growth, although that isn’t enough on its own. The National Bureau of Economic Research (NBER), which is responsible for business cycle dating, defines recessions as "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." In this guide, we will use NBER’s official dates.

In Canada, the government is responsible for determining when the economy has entered and exited a recession. The announcement comes from the Bank of Canada or minister of finance, based on data provided by Statistics Canada and input from economic think tanks such as the Toronto-based C.D. Howe Institute. Its Business Cycle Council plays a role similar to NBER as the council meets on an annual basis, or as warranted when economic conditions indicate the possibility of entry to or exit from a recession. The council relies on three dimensions to determine a recession — duration, amplitude and scope (how widespread the downturn is). Further, the council assigns categories of severity to Canada’s recessions, rating them like hurricanes, from Category 1 to Category 5, with the latter being the most severe. 

In a June announcement, the council acknowledged that it’s difficult to say a recession is 100% certain, but advised Canadians to prepare for one based on current economic forecasting. 

2. What causes recessions?

Past recessions have occurred for many reasons, but typically are the result of economic imbalances that, ultimately, need to be corrected. For example, the 2008 recession was caused by excess debt in the housing market, while the 2001 contraction was caused by an asset bubble in technology stocks. An unexpected shock such as the COVID-19 pandemic, widespread enough to damage corporate profits and trigger job cuts, also can be responsible.

When unemployment rises, consumers typically reduce spending, which further pressures economic growth, company earnings and stock prices. These factors can fuel a vicious cycle that topples an economy. Although they can be painful to live through, recessions are a natural and necessary means of clearing out excesses before the next economic expansion. As Capital Group vice chair Rob Lovelace recently noted, “You can’t have such a sustained period of growth without an occasional downturn to balance things out. It’s normal. It’s expected. It’s healthy.”

Go deeper:

• Rob Lovelace on all-weather investing 
• Fed's aggressive path could mean more market turmoil   
   

3. How long do recessions last?

The good news is that recessions generally haven’t lasted very long in the U.S. Our analysis of 11 cycles since 1950 shows that recessions have persisted between two and 18 months, with the average spanning about 10 months. For those directly affected by job loss or business closures, that can feel like an eternity. But investors with a long-term investment horizon would be better served looking at the full picture.

Recessions have been relatively small blips in economic history. Over the last 70 years, the U.S. has been in an official recession less than 15% of all months. Moreover, their net economic impact has been relatively small. The average expansion increased economic output by almost 25%, whereas the average recession reduced GDP by 2.5%. 

In Canada, it’s a similar story, with an additional observation from the C.D. Howe Institute Business Cycle Council: since 1926 recessions have become more exceptional events over time, evolving to become less frequent but more severe in nature.  

Equity returns south and north of the border can even be positive over the full length of a contraction since some of the strongest stock rallies have occurred during the late stages of a recession.

Go deeper:

• Braving bear markets: 5 lessons from seasoned investors   
• Is the era of easy money coming to an end?
   

4. What happens to the stock market during a recession?

The exact timing of a recession is hard to predict, but it’s still wise to think about how one could affect your portfolio. Bear markets (market declines of 20% or more) and recessions (economic declines) have often overlapped — with equities leading the economic cycle by six to seven months on the way down and again on the way up.

Still, aggressive market-timing moves, such as shifting an entire portfolio into cash, can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom. A dollar cost averaging strategy, in which investors systematically invest equal amounts at regular intervals, can be beneficial in down markets. This approach can allow investors to purchase more shares at lower prices while remaining positioned for when the market eventually rebounds.

Go deeper:

• How to handle market declines 
   

5. What economic indicators can warn of a recession?

Wouldn’t it be great to know ahead of time when a recession is coming? Despite the impossibility of pinpointing the exact start of a recession, there are some generally reliable signals worth watching closely in a late-cycle economy.

Many factors can contribute to a recession, and the main causes often change. Therefore, it’s helpful to look at several different aspects of the economy to better assess where excesses and imbalances may be building. Keep in mind that any indicator should be viewed more as a mile marker than a distance-to-destination sign.

Four examples of economic indicators that can warn of a recession include the yield curve, unemployment rate, consumer sentiment and housing starts. Aggregated metrics, such as The Conference Board Leading Economic Index (LEI), which combines 10 different economic and financial signals into a single analytic system to predict peaks and troughs, have also been consistently reliable over time.

These factors suggest the U.S. is in a late part of the economic cycle and moving closer to a recession, even as the labour market remains relatively resilient. New economic data can quickly change the story though.

Go deeper:

• 4 charts that explain U.S. labour dynamics 
   

6. Are we in a recession?

While it may feel like we’re already in one, we believe an official recession is still unlikely until later this year or early 2023. Despite the impact that high inflation has had on consumer sentiment and corporate earnings, a strong labour market continues to support the economy in the near term.

The exact timing will likely depend on the pace and magnitude of the Fed’s moves. It is hard to see a clear path to bring inflation back to the Fed’s 2% target without pushing the economy into recession. In our view, the only way to break the spiral of escalating wages and prices is to create a lot of slack in the labour market. The unemployment rate may need to rise to at least 5% or 6% before wage growth starts to moderate. We believe this will make a recession very difficult to avoid by 2023.

The above equally applies to Canada where the central bank is most concerned about inflation remaining high and broadening, as this may lead to a de-anchoring of inflation expectations. De-anchored inflation expectations lead firms to set prices even higher. Similarly, in response to higher expected inflation, workers may bargain for persistently higher wage growth to protect against anticipated losses in purchasing power. The resulting stronger wage growth feeds into production costs and prompts firms to raise prices further. This process boosts inflation expectations, perpetuating the spiral. In its Monetary Policy Report released in July, the Bank of Canada detailed the risks of de-anchored inflation expectations stating it may require interest rates to rise higher and longer than currently projected, which significantly elevates the risk of recession in 2023. 

Geopolitical shocks — such as an escalation in the war in Ukraine — or the consequences of a recession overseas are even harder to predict but could quicken the timeline for U.S. and Canadian recessions.

Go deeper:

• Is the U.S. already in a recession? 
• U.S. outlook: Time to pursue all-weather investing 
   

7. How should you position your stock portfolio for a recession?

We’ve already established that equities often do poorly during recessions but trying to time the market by selling stocks is not suggested. So should investors do nothing? Certainly not.

To prepare, investors should take the opportunity to review their overall asset allocation, which may have changed significantly during the bull market, to ensure their portfolio is balanced and diversified. Consulting a financial advisor can help immensely since these can be emotional decisions for many investors.

Not all stocks respond the same during periods of economic stress. In the eight largest equity declines between 1987 and 2019, some sectors held up more consistently than others — usually those with higher dividends such as consumer staples and utilities. Dividends can offer steady return potential when stock prices are broadly declining.

Growth-oriented stocks can still have a place in portfolios, but investors may want to consider companies with strong balance sheets, consistent cash flows and long growth runways that can withstand short-term volatility.

Even in a recession, many companies may remain profitable. Focus on companies with products and services that people will continue to use every day such as telecom, utilities and food manufacturers with pricing power.  

Go deeper:

• When volatility is rising, boring is beautiful 
• Rotating into dividends in an inflationary world 
   

8. How should you position your bond portfolio for a recession?

Fixed income is often key to successful investing during a recession or bear market. That’s because bonds can provide an essential measure of stability and capital preservation, especially when equity markets are volatile.

The market selloff in the first half of 2022 was unique in that many bonds did not play their typical safe-haven role. But in the seven previous market corrections, bonds — as measured by the Bloomberg U.S. Aggregate Index — rose four times and never declined more than 1% in U.S. dollars. 

Achieving the right fixed income allocation is always important. But with the U.S. and Canadian economies entering a period of uncertainty, it’s especially critical for investors to focus on core bond holdings that can provide balance to portfolios. Investors don’t necessarily need to increase their bond allocation ahead of a recession, but they should review their fixed income exposure with their financial professionals to be sure it is positioned to provide diversification from equities, income, capital preservation and inflation protection — what we consider the four key roles fixed income can play in a well-diversified portfolio.

Go deeper:

• Rising yields put bond markets back on a road to normal 
• Bond outlook: What to know as Fed fears hit markets 
• Investing for income as rates rise 
   

9. What should you do to prepare for a recession?

Above all else, investors should stay calm when investing ahead of and during a recession. Emotions can be one of the biggest roadblocks to strong investment returns, and this is particularly true during periods of economic and market stress.

If you’ve picked up anything from reading this guide, it’s probably that determining the exact start or end date of a recession is not only impossible, but also not that critical. What is more important is to maintain a long-term perspective and make sure your portfolio is designed to be balanced enough to benefit from periods of potential growth before it happens, while being resilient during those inevitable periods of volatility.