Market Volatility
Recessions are scary but surmountable

There’s no getting around the fact that recessions can be disconcerting and occasionally even vertigo-inducing. That can be doubly true when a recession is accompanied by an abrupt bear market, which is almost certainly the case today. The coronavirus has already shoved U.S. stocks into bear territory. A recession has yet to be officially declared, but that’s likely only because such designations come in hindsight.

Certainly, much remains unknown about the eventual fallout from COVID-19. The outbreak pounded the stock market with lightning speed and prompted Federal Reserve policymakers to take unprecedented steps to contain the damage.

“The next 12 months are going to be difficult — in particular, the next few months as the virus eats away at activity,” says Capital Group economist Jared Franz.

As uncomfortable as recessionary periods are, it’s important to put them in perspective. In truth, economic contractions generally haven’t lasted long. Most downturns have had fairly small net impacts, and they amounted to relatively small blips in economic history. In other words, their long-term impact has been modest.

Recessions are part of economic life.

On a fundamental level, economic contractions provide a path for future growth by clearing away the financial excesses of the past. Thus, they’re a natural and even necessary part of the business cycle. They’re generally defined as two or more consecutive quarters of declining GDP. In that sense, the current downturn hasn’t yet had time to qualify. But a recession is likely underway, Franz says.

Downturns occur for many reasons, typically when imbalances that have accumulated over time become top-heavy. Excess debt in the housing market caused the 2008 recession, whereas an asset bubble in technology stocks lay behind the 2001 contraction.

However, they can also spring from hard-to-forecast exogenous shocks, such as the current pandemic. The initial emergence of the virus in China unsettled global markets, but the spread of the contagion to Europe and the U.S. raised the stakes considerably as investors realized it would be a deeper and longer-lasting phenomenon than expected.

The economy has grown most of the time.

While recessions can be painful, they’ve historically been far shorter than periods of growth. And the impacts of downturns have often been dwarfed by those of growth periods. Over the past 65 years, the U.S. has been in a recession in less than 15% of all months. Most recessions have a relatively small economic impact. During the average expansion, economic output jumped 24%, but in the average recession GDP dipped less than 2%. Additionally, equities are often positive over the full period of a recession because some of the strongest stock rallies come at the end of a contraction.

Most recessions aren’t 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. That can feel like an eternity for those directly affected by job losses or business closures. But investors with a long-term investment horizon are better served by looking at the full picture.

Bear markets and recessions often overlap, with equities tending to peak about seven months before the economic cycle does. By the time a recession has been officially declared, equities already may have been declining for months. But just as stocks often lead on the way down, they also have led on the way up. The S&P 500 has typically bottomed about six months after the start of a recession and has usually rallied before the economy started humming again. This means that aggressive market timing, such as shifting an entire portfolio to cash, often can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom.

The downturn could give way to good news in some industries.

As for the immediate future, there’s little doubt that the bad news may outweigh the good as governments release glum economic data and companies uncork a stream of profit warnings.

“We should be prepared to see some negative numbers through the second quarter,” Franz says. “That’s not just GDP contraction but everything that goes along with that: jobless claims, lower business activity.”

However, sectors that were directly affected by the virus or efforts to contain it could see a sharp recovery once the outbreak fades. The federal stimulus program could help businesses bridge the gap until that point, but investors must be cautious, as the virus spreads exponentially while policy response moves linearly. Investors must be prepared for policymaking to potentially lag the virus, at least at first.

Capital Group analysts are working to assess the effects on industries of all kinds. For example, one of the more notable changes since the outbreak has been the number of people working from home. That could have all kinds of impacts: The demand for rented office space could dip while consumer demand for office furniture for spare bedrooms could grow.

“Capital Group is thinking about those impacts on our behavior,” Franz says.

Although it may feel painful in the short term, investors with a long-term horizon may be best served by staying the course. Regardless of economic conditions, it’s wise to regularly review your asset allocation with your Private Wealth Advisor to ensure your portfolio is broadly diversified and tailored to your personal needs.

                        The above article originally appeared in the Spring 2020 issue of Quarterly Insights magazine.

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