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Sunday, April 21, 2024

What is a recession?

What is a recession?

Key takeaways

When the country’s economy is experiencing a widespread downturn, that usually results in higher unemployment rates, lower consumer spending and other investment challenges across the board.

06.29.2023

Given today’s state of inflation, there’s a lot of talk about the U.S. economy potentially heading for a recession. This can be unsettling for a number of reasons. When the country’s economy is experiencing a widespread downturn, that usually results in higher unemployment rates, lower consumer spending, and other investment challenges across the board. On a personal level, you may have concerns when it comes to your own financial moves, like buying a new house or pursuing a different job.

If a recession is in the cards, here’s what you need to know to navigate the current climate and stay on track with your money.

1. What is a recession?

Simply put, a recession is “a period of significant decline in economic activity.” Although the exact definition may vary, many experts consider a recession to be two consecutive quarters of decline in gross domestic product (GDP). The market, as a result, may experience major plunges and volatility over several months.1,2

Since the S&P 500 Index was established in 1957, the U.S. has been through 10 official recessions, with the Great Recession causing the most severe shifts and declines in the market since the Great Depression of the 1930s. The crisis itself lasted from December 2007 to June 2009 beginning with the subprime mortgage meltdown, which featured an extreme increase in defaults on high-risk housing loans. Millions of people across the world ended up losing their savings, jobs and homes during the collapse.3,4

While recessions can seem scary, it’s important to know that they are a regular part of our economic cycle.5

  • During periods of economic expansion, consumer confidence is high. This confidence leads to economic growth since consumers and businesses are more likely to spend and lenders are more likely to extend credit.
  • These periods of economic expansion are followed by contractions in economic growth. Consumer spending slows down, which can lead to a decrease in GDP growth. When this decrease is significant, prolonged and widespread, it can lead to a recession.

When a recession occurs, a number of things can happen.

First, a drop in consumer spending and economic growth typically spurs higher-than-normal unemployment rates. Not only are workers at a higher risk of losing their jobs during a recession, but they also have a more difficult time finding a new job. Even those who are able to hold onto their job may see a reduction in their wages or benefits.

As incomes begin to slide, consumers and business owners may struggle to meet their financial obligations. This factor is especially true for those who overextended their debt obligations during the expansion period. Unfortunately, this could lead to homeowners losing their homes and business owners losing their businesses. For this reason, interest rates do tend to drop during a recession, so it may be possible for some home and business owners to refinance their loans for lower rates and payments.

From an investor’s standpoint, a recession can cause a bear market. With the drop in prices for various securities, the overall value of your investment portfolio may also decrease. Selling these securities is not always a wise option for investors with a long-term approach because recessions are only temporary. However, investors should be mindful of their investing habits during a recession and consider speaking to a financial advisor about their long-term plan.

On a national level, the country is likely to see the deficit rise as tax revenues decline and the need to fund social programs and unemployment insurance increases.

2. What causes a recession?

There are many events and circumstances that can lead to a recession. Here’s a look at some common causes.

Recession shock

A recession shock may be sudden, but it can have long-lasting effects. Recessions spurred by a sudden shock to the economy can be hard to prepare for because they occur with little warning. This possibility is why it’s so important to always be prepared for financial challenges.

Bubble burst

An asset bubble occurs when the price of a specific asset, such as stocks, bonds and real estate, spikes significantly over a short period of time and for no apparent reason. When this bubble bursts, it can lead to a recession. For example, the housing bubble of 2008 played a major role in the Great Recession.6 After years of declining lending standards, consumers could no longer handle the high debt levels, and foreclosures rose significantly.  

High inflation/deflation

High levels of either inflation or deflation can also trigger a recession. With inflation, a steady increase in prices without an equal increase in earnings can impact consumer spending. Today, governments try to curb inflation by increasing interest rates. On the other hand, deflating prices can also impact the economy. When prices are too low, it can cause a reduction in wages and prompt lenders to reduce credit options.

Over-exuberant spending

When economies are expanding, consumer spending also increases. Unfortunately, this can lead to overconfidence among consumers, which can cause them to overspend. When this spending becomes exuberant, it can lead consumers to accumulate high levels of debt and minimize the importance of savings. Once this debt ratio becomes too high, it can cause high levels of loan defaults, which can then spiral into a recession.

Technological advancements

Advancements in technology can also lead to a recession if this technology disrupts the workplace. For example, the Industrial Revolution led to significant job loss, and entire professions were eliminated. Today, some economists worry about how automation in the workplace can make some jobs obsolete and lead to another spike in unemployment.

Contraction in lending

A contraction in lending may not typically start a recession, but it can serve as a catalyst that speeds up the onset of a recession. Once lenders start seeing signs of a recession, such as increasing unemployment or decreasing GDP and earnings, they often cut back on lending. When this happens and consumers can’t make the purchases they want, such as cars and homes, it can deteriorate consumer confidence and slow consumer spending.

4. Are we in a recession?

The National Bureau of Economic Research (NBER) is the entity that officially makes the call on a recession. The NBER considers a wide range of factors far beyond GDP when determining whether a particular cooling-off of economic growth qualifies as a true recession, or merely a pause in a longer period of expansion. Employment, consumption, retail sales and production are just a few of the measures it weighs.

As of now, the NBER has yet to formally declare a recession for this tough stretch.5

4. When was the last recession?

The last recession in the United States occurred during the onset of the global pandemic. This recession only lasted two months from February 2020 to April 2020, one of the shortest recessions in history. However, during this two-month period the GDP dropped by 31.5% and unemployment rates rose to 14.7%.7, 8

5. How do markets behave in a recession?

Markets are actually able to anticipate periods of weakness before they become deep enough to qualify as a recession.

Stocks typically peak and begin dropping roughly three to seven months prior to the onset of recession. In a similar way, stocks also seem to anticipate the end of a recession by beginning to recover roughly six months before economic activity bottoms out. By the time a recession begins, markets may have already done a fair job of “pricing in” much of the damage.

The implication is that the market may have already suffered a majority of its declines by the time the NBER officially declares a recession. In fact, during the modern era (1945 to present), both the average and median equity market return during an actual recession may have actually produced slightly positive results.

6. How long does a recession last?

Every recession is unique.

But U.S. downturns have become somewhat shorter and less frequent as the American economy has matured. The COVID-19 recession in 2020, which saw roughly 22 million jobs erased, lasted just two months and is the shortest recession on record.9 In general, though, the average recession in the modern era (1945 to present) lasts about 11 months. That’s because the U.S. economy has become more sophisticated, flexible and adaptive over time.

One possible reason for this phenomenon is the rapid implementation of policy measures that are designed to combat recession that has become so commonplace in the modern era.

7. What is the difference between a recession and a depression?

While recessions and depressions are similar in that they’re both spurred by an economic downturn, depressions have a more significant impact in scope and length. In U.S. history, there has only been one depression, referred to as the Great Depression.

While there are no set guidelines for defining a depression vs. a recession, there are several distinct differences. The best way to see just how vast the difference between a depression and recession is may be to compare the impact of the Great Depression with the Great Recession, the largest recession in modern times.

 

Great Depression

Great Recession

Length

1929-1939 (120 months)

2007-2009 (18 months)

Unemployment Rates

25%

10%

Drop in GDP

30%

4.3%

Decline in Home Prices

67%

30%

As you can see, the impact of the Great Depression far extended the effects of the biggest recession in the country's history. While it took many years for the country to recover from the Great Recession, it took decades for the United States to fully recover after the conclusion of the Great Depression.

8. How long do recessions last?

Since the inception of the United States, the country has incurred 48 recognized recessions lasting anywhere from 6 years to 2 months. However, the nation has become better at minimizing the impact of these recessions. For example, since 1980, the U.S. has only experienced six recessions, as shown in the table below.

Dates

Duration

January 1980 – July 1980

6 months

July 1981 – November 1982

16 months

July 1990 – March 1991

8 months

March 2001 – November 2001

8 months

December 2007 – June 2009

18 months

February 2020 – April 2020

2 months

While the longest of these recessions was the Great Recession (2007 – 2009), which lasted 18 months, the average length of these recessions is just 10 months.

9. What should you do in a recession?

When economists are seeing signs of a potential recession on the horizon, it’s time to take action. There are a few steps you can take to prepare for a recession.

Create an emergency fund

If you have not done so yet, it’s crucial to set up an emergency fund. This type of savings can provide a safety net in the event you lose your job, experience a reduction in pay or see higher interest rates that make it harder to meet your monthly financial obligations.

Cut unnecessary spending

If you think a recession is on the way, it’s time to cut unnecessary spending. Redo your household budget to include only necessities. This step can help you save money to prepare for a recession or pay down debt in expectation of higher interest rates.

Pay down debt

The last thing you want to deal with during a recession is excessive debt. Take the time to examine your debt payments and make a plan to pay down as much debt as possible. Focus on high-interest debts or those with variable rates that could change significantly if lenders start raising rates.

Don’t sell investments

The most important thing to remember is not to panic. Financial decisions based on fear or panic can be quite costly. Remember that recessions are only temporary. Unless it’s necessary, you should consider not selling investments during a recession. If you do so, you lock in your losses.

Keep investing

While cutting unnecessary spending is important,  it’s also important to continue investing in your 401(k) or other retirement funds. It’s likely that these funds will rebound once the impact of the recession ends. Additionally, any change to these investments may impact your overall retirement savings plan.

Talk with a financial professional

There are no set parameters when it comes to dealing with a recession. Each recession comes with its own causes and repercussions. It's helpful to meet with an experienced financial professional who can work with you to develop an investment strategy for weathering the challenges of a recession.  

The bottom line

Nobody knows for sure what lies ahead for the economy or for their investments, because each recession is fundamentally different from the last. The good news? If history is any guide, it might not be as bad as people think.

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1 The Economist, “What is a recession,” August 2022.

2 Bankrate, “What is a recession,” August 2022.

3 Federal Reserve History, “The Great Recession and Its Aftermath,” September 2022.

4 Investopedia, “What Was the Subprime Meltdown?,” April 2022.

5 Forbes Advisor, “Are We In A Recession Yet?,” April 2023.

6 University of Wisconsin - Parkside, “The Crash of 2008: Causes and Lessons to Be Learned.”

7 CNBC, “It’s official: The Covid recession lasted just two months, the shortest in U.S. history,” July 2021.

8 U.S. Bureau of Labor Statistics, “Unemployment rate rises to record high 14.7 percent in April 2020,” May 2020.

9 Reuters, “U.S. recession ended in April 2020, making it shortest on record,” July 2021.

The S&P 500 Index is a registered trademark of Standard & Poor’s Financial Services LLC. It is an unmanaged index considered indicative of the domestic large-cap equity market and is used as a proxy for the stock market in general.

Todd Burnaford

Contributor

Todd Burnaford is a Senior Financial Professional at Empower. A CERTIFIED FINANCIAL PLANNER™ professional, he provides a wide range of financial planning services for clients who are enrolled in the Personal Strategy managed asset program.

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