That's one of the questions we hear most often, especially following more than a year of aggressive interest rate hikes aimed at reining in inflation. Although a recession has seemed imminent for a while, the economic picture has become muddied as industries have weakened and recovered at different times. If we do see a broad contraction, our expectation is that it will be less severe than the 2008 global financial crisis and other more typical recessions, followed by a strong recovery.
To help you prepare for these uncertain times, we researched more than 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?
2. What causes recessions?
3. How long do recessions last?
4. What happens to the stock market during a recession?
5. What economic indicators can warn of a recession?
6. Are we in a recession?
7. How can you position a stock portfolio for a recession?
8. How can you position a bond portfolio for a recession?
9. What are ways to prepare for a recession?
A recession is commonly defined as at least two consecutive quarters of declining GDP (gross domestic product) 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.
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 equity portfolio manager Rob Lovelace has 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.”
The good news is that recessions generally haven’t lasted very long. 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%. Equity returns 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.
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 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 may 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, may be beneficial in down markets. This approach allows investors to purchase more shares at lower prices while remaining positioned for when the market eventually rebounds.
Wouldn’t it be great to know ahead of time when a recession is coming? Despite the impossibility of pinpointing the exact start, 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 different aspects of the economy to assess where 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 confidence 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 paint a mixed picture. Whereas the yield curve and LEI indicate that a broader recession could still be looming, a resilient consumer and robust labor market tell the opposite story. The housing industry has essentially already fallen into recession and may be on the verge of recovery, which could lift the entire economy. New economic data can quickly change the narrative though.
While at times it may have felt like we were already in one, we believe an official recession has yet to begin. Our base case remains that we will have a relatively short and mild recession, but the odds have increased that we won’t get one at all. Despite the impact that high inflation and rates have had on consumer sentiment and corporate earnings, the labor market has been surprisingly resilient and continues to support the economy.
Instead of an official recession, what we may see is a continuation of a rolling recession, where parts of the economy contract and recover at different times. Housing had a slowdown deeper than many past recessions and has started to bounce back. Likewise, the semiconductor industry has recovered strongly from a sharp contraction in 2022. If certain sectors continue to go up while others go down, it increases the possibility of avoiding a broad recession.
Of course, other factors could potentially darken the near-term outlook. A weakening labor market or geopolitical shock — such as an escalation of the war in Ukraine — could quicken the timeline for a U.S. 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 allocations, which may have changed significantly during the bull market, to ensure their portfolios are balanced and diversified. Consulting a financial advisor can help immensely since these are often emotional decisions for investors.
Not all stocks respond the same during periods of economic stress. In the eight largest equity declines between 1987 and 2022, 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 better 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.
Fixed income is often key to successful investing during a recession or bear market. That’s because bonds can provide a measure of stability and capital preservation, especially when equity markets are volatile.
The market selloff in 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%.
Achieving the right fixed income allocation is always important. But with the U.S. economy entering a period of uncertainty, it’s especially critical for investors to focus on core bond holdings that can help provide balance to their portfolios. Investors don’t necessarily need to increase their bond allocation ahead of a recession, but they should review their fixed income exposure with a financial professional to ensure 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.
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 difficult, but also not that critical. What is more important is to maintain a long-term perspective and make sure portfolios are appropriately balanced to benefit from periods of potential growth, while being resilient enough to minimize losses during periods of volatility.
Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.
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