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Market Volatility
Guide to recessions: 7 key things you need to know
Jared Franz
Economist
Darrell Spence
Economist

How bad will the next recession be?


That's one of the questions we hear most often, especially now as the 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.


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

1. What is 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.
 

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.”


3. How long do recessions last?


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.
 

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.
 

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.


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. A table shows that the average expansion lasts 69 months, has 24.6% GDP growth and adds 12 million net jobs. The average recession lasts 10 months, has –2.5% GDP growth and eliminates 3.9 million net jobs.
Sources: Capital Group, National Bureau of Economic Research, Refinitiv Datastream. Chart data is latest available as of 8/31/22 and shown on a logarithmic scale. The expansion that began in 2020 is still considered current as of 8/31/22 and is not included in the average expansion summary statistics. 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.

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 labor market remains relatively resilient. New economic data can quickly change the story though.
 

6. Are we in a recession?


Equities have typically peaked months before a recession, but can bounce back quickly

The chart shows two lines comparing the average S&P 500 Index market cycle and the average economic cycle (using industrial production as a proxy). The S&P 500 market cycle has peaked several months before the economic cycle, and it also started accelerating from its bottom several months before the economic cycle.
Sources: Capital Group, Federal Reserve Board, Haver Analytics, National Bureau of Economic Research, Standard & Poor's. Data reflects the average change in the S&P 500 Index and economic activity (using industrial production as a proxy) of all completed economic cycles from 1950 to 2021. The "cycle peak" refers to the highest level of economic activity in each cycle before the economy begins to contract. Both lines are indexed to 100 at each economic cycle peak and also indexed to 0 "months before/after cycle peak" on the x-axis. A negative number (left of the cycle peak) reflects the average change in each line in the months leading up to the cycle peak. The positive numbers (right of the cycle peak) indicate the average changes after the cycle peak.

Although 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 labor 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 labor 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.


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 a U.S. recession.
 

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


The table shows five economic indicators that can warn of a recession, the average number of months between the signal and the start of a recession, and the current status of the indicator. Indicator #1 — An inverted yield curve, which occurs when 10-year yields fall below two-year yields. The average time between this signal and recession is 14.5 months. The threshold has been met. Indicator #2 — Unemployment rate rising from cycle trough. The average time between this signal and recession is 5.6 months. The threshold has not been met. Indicator #3 — Consumer confidence declining from the previous year. The average time between this signal and recession is 2.9 months. The threshold has been met. Indicator #4 — Housing starts declining at least 10% from the previous year. The average time between this signal and a recession is 5.3 months. The threshold has not been met. Indicator #5 — The Leading Economic Index (LEI) declining at least 1% from the previous year. The average time between this signal and a recession is 3.6 months. The threshold has not been met.
Source: Capital Group. Reflects latest data available as of 8/31/22.

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.



Jared Franz is an economist with 16 years of industry experience (as of 12/31/2021). He holds a PhD in economics from the University of Illinois at Chicago and a bachelor’s degree in mathematics from Northwestern University.

Darrell R. Spence covers the United States as an economist and has 29 years of industry experience (as of 12/31/2021). He holds a bachelor’s degree in economics from Occidental College. He also holds the Chartered Financial Analyst® designation and is a member of the National Association for Business Economics.


Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.

 

The S&P 500 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 © 2022 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.

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