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Preparing for the next recession: 9 things you need to know
Jared Franz
Economist
Darrell Spence
Economist

When is the next recession?


That's one of the questions we hear most often, especially now that the coronavirus outbreak has caused unprecedented disruptions, sparking the first bear market in 11 years. Although the full extent of its economic impact will not be known for some time, it seems clear to us that the U.S. will enter a recession in 2020, if it hasn't already.


Recessions can be complicated, misunderstood and sometimes downright scary. To help you prepare for these uncertain times, we've analyzed the last 10 economic downturns to distill our top insights. This guide will help you prepare for the next recession by attempting to answer nine key questions. 


1. What is a recession?


A recession is commonly defined as at least two consecutive quarters of declining GDP after a period of growth. More formally, the National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales." In this guide, we will use NBER’s official dates.


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2. What causes recessions?


Past recessions have occurred for many reasons, but typically are the result of imbalances that build up in the economy and ultimately need to be corrected. For example, the 2008 recession was caused by excess debt in the housing market, whereas the 2001 contraction was caused by an asset bubble in technology stocks.


An unexpected shock — such as the current health crisis — that is 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 negative cycle that topples an economy. We’ve already seen the first domino fall, as a record 3.3 million people filed unemployment claims in the week ending March 21.


3. How long do recessions last?


The good news is that recessions generally haven’t been very long. Our analysis of 10 cycles since 1950 shows that recessions have lasted between eight and 18 months, with the average spanning about 11 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 are painful, but expansions have been powerful. The chart shows cumulative GDP growth of each expansion and recession since 1950. The expansions shown have a much higher magnitude and length compared to the recessions on the chart. A table shows that the average expansion lasts 69 months, has 24.7% GDP growth, and adds 12 million net jobs. The average recession lasts 11 months, has -1.8% GDP growth, and eliminates 1.9 million net jobs. Sources: Capital Group, National Bureau of Economic Research, Refinitiv Datastream. As of December 31, 2019. Since NBER announces recession start and end months rather than exact dates, we have used month-end dates as a proxy for calculations of jobs added. Nearest quarter-end values used for GDP growth rates. GDP growth shown on a logarithmic scale.

Recessions are relatively small blips in economic history. Over the last 65 years, the U.S. has been in an official recession less than 15% of all months. Moreover, the net economic impact of most recessions has been relatively small. The average expansion increased economic output by 25%, whereas the average recession reduced GDP by less than 2%. 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.


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


While the exact timing of a recession is hard to predict, it can be wise to think about how one could affect your portfolio. That’s because bear markets and recessions often overlap — with equities leading the economic cycle by six to seven months on the way down and again on the way up.


During a recession, the stock market typically continues to decline sharply for several months. It then often bottoms out about six months after the start of a recession, and usually begins to rally before the economy starts humming again. (Keep in mind, these are market averages and can vary widely between cycles.)


Chart with the headline “Equities typically peak months before a recession, but can bounce back quickly.” The chart shows two lines, comparing the average S&P 500 market cycle and the average economic cycle (using industrial production as a proxy). The S&P 500 cycle peaks several months before the economic cycle does, and it also starts accelerating from its bottom several months before the economic cycle does. Sources: Capital Group, Federal Reserve Board, Haver Analytics, National Bureau of Economic Research, Standard & Poor’s. Data reflects the average of completed cycles from 1950 to 2019, indexed to 100 at each cycle peak.

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. It’s often better to stay invested to avoid missing out on the upswing.


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.


The table explains five economic indicators that can warn of a recession, why the indicator is important, the average number of months between the signal and the start of a recession, and where that indicator is now (using the latest data available as of February 29, 2020). Indicator #1 – An inverted yield curve, which occurs when 10-year yields fall below two-year yields. It is often a signal the Fed has hiked short-term rates too high or investors are seeking long-term bonds over riskier assets. The average time between this signal and recession is 15.7 months. The yield curve briefly inverted in August 2019. Indicator #2 – Corporate profits declining from a cycle peak. When profits decline, businesses cut investment, employment and wages. The average time between this signal and recession is 26.2 months. Corporate profits as a percent of GDP may have peaked years ago. Indicator #3 – Unemployment rate rising from cycle trough. When unemployment rises, consumers cut back on spending. The average time between this signal and recession is 6.1 months. Unemployment rate was near 50-year lows. Indicator #4 – Housing starts declining at least 10% from previous year. When the economic outlook is poor, homebuilders often cut back on housing projects. The average time between this signal and a recession is 5.3 months. New housing starts have picked up after declining in mid-2019. Indicator #5 – the Leading Economic Index (LEI) declining at least 1% from previous year. LEI is an aggregation of multiple leading economic indicators, and gives a broader look at the economy. The average time between this signal and a recession is 4.1 months. LEI growth rate has flattened in recent months. Source: Capital Group. All commentary reflects latest data available as of February 29, 2020.

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, corporate profits, the unemployment rate and housing starts. Aggregated metrics, such as The Conference Board Leading Economic Index®, have also been consistently reliable over time.


Overall, these factors seem to indicate that the U.S. entered 2020 in a late cycle, but in a generally strong position. Obviously, much has changed since then, and economic data will start reflecting that more clearly in the coming weeks and months.


Want insights on more warning signs of a recession?

6. How close are we to the next recession?


Even though the U.S. economy was relatively healthy a few months ago, the coronavirus outbreak has significantly altered that view.


Our base case is that a recession is a near certainty in 2020. While the full economic impact may not be known for some time, a combination of global supply chain disruptions and lower consumption will materially impact corporate earnings in 2020. Certain industries such as travel and hospitality are expected to be hit the hardest, but the effects will likely be felt across sectors.


Line chart with the headline “The likelihood of a recession rose sharply in early 2020.” The chart shows a line tracking the NY Fed’s probability of a recession within 12 months since 1962. It also shows when past recessions occurred, and a 30% threshold which has been reached before every recession. The probability has been increasing in recent months and reached 25% in February 2020. Sources: Federal Reserve Bank of New York, Refinitiv Datastream. As of February 29, 2020. Shaded bars represent U.S. recessions as defined by the National Bureau of Economic Research.

If the government and Federal Reserve continue to respond with strong fiscal and monetary stimulus, it could go a long way toward mitigating the economic impact and length of a downturn. How long it takes to contain the spread of the virus will, of course, also be a key factor.


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 can be ill-advised. So should investors do nothing? Certainly not.


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


Chart with the headline “Through eight declines, some sectors have finished above the overall market.” It shows how many times each of the sectors in the S&P 500 have outpaced the index during the last eight largest market declines between 1987 and 2019. Consumer staples and utilities outpaced eight times; health care and telecommunication services outpaced seven times; energy outpaced four times; materials outpaced three times; consumer discretionary, financials and information technology outpaced two times each; and industrials outpaced once. The chart also shows that the sectors that beat the index during declines, on average, had higher dividend yields than those that usually lagged the index during market declines. Sources: Capital Group, FactSet. As of December 31, 2019. Includes the last eight periods that the S&P 500 declined by more than 15% on a total return basis. Sector returns for 1987 are equally weighted, using index constituents from 1989, the earliest available. The telecommunication services sector dividend yield is as of September 24, 2018. After this date the sector was renamed communication services and its company composition was materially changed. During the 2018 decline, the sector would have had a higher return than the S&P 500 using either the new or old company composition.

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 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 telecommunication services and food manufacturers.


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


Fixed income is 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.


Over the last six market corrections, U.S. bond market returns — as measured by the Bloomberg Barclays U.S. Aggregate Index — were flat or positive in five out of six periods.


Chart with the headline “High-quality bonds have shown resilience when stock markets are unsettled.” It shows returns for the Bloomberg Barclays U.S. Aggregate Index and the S&P 500 Index during six recent stock market corrections. The periods include the Flash Crash in 2010, the U.S. debt downgrade in 2011, the China slowdown in 2015, the oil price shock in 2015-16, the U.S. inflation and rates scare in early 2018 and the global selloff in late 2018. In all periods the S&P 500 Index declined at least 10%, and as much as -19.4%. In these same periods, the Bloomberg Barclays U.S. Aggregate Index had returns ranging between -1% and 5.4%. Sources: Bloomberg Index Services, Ltd., RIMES, Standard & Poor’s. Dates shown for market corrections are based on price declines of 10% of more (without dividends reinvested) in the S&P 500 with at least 50% recovery persisting for more than one business day between declines. The returns are based on total returns.

Achieving the right fixed income allocation is always important. But with the U.S. economy entering a period of great uncertainty, it’s especially critical for investors to ensure that core bond holdings provide balance to their portfolios. Investors don’t necessarily need to increase their bond allocation ahead of a recession, but they should review whether their fixed income exposure is positioned to provide elements of the four roles that bonds play: diversification from equities, income, capital preservation and inflation protection.


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


Above all else, investors should stay calm and keep a long-term perspective 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 date of a recession is ultimately 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.


Key investor takeaways
 

  • Stay calm and keep a long-term perspective.
  • Maintain a balanced and broadly diversified portfolio.
  • Balance equity portfolios with a mix of dividend-paying companies and growth stocks.
  • Choose funds with a strong history of weathering market declines.
  • Use high-quality bonds to help offset equity volatility.
  • Advisors can help investors navigate periods of market volatility.

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Jared Franz is an economist covering the U.S. and Latin America. He has 14 years of investment industry experience. Prior to joining Capital in 2014, Jared was head of international macroeconomic research at Hartford Investment Management Company and an international and U.S. economist at T. Rowe Price. He holds a PhD in economics from the University of Illinois and a bachelor's from Northwestern.

Darrell Spence is an economist and research director with 27 years of investment experience, all with Capital. He earned a bachelor's degree in economics from Occidental College and is a CFA charterholder.


The Standard & Poor’s 500 Composite Index is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks. The S&P 500 is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2020 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.

The Bloomberg Barclays U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market. Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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