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What is an economic recession?
The United States National Bureau of Economic Research defines an economic recession as “a significant decline in the economic activity spread across the country, lasting more than a few months, normally visible in real gross domestic product (GDP) growth, real personal income, employment (non-farm payrolls), industrial production, and wholesale-retail sales”.
A technical (rule of thumb) perspective to an economic recession sees it as a period when a country’s GDP declines consecutively for at least two (2) quarters on a quarter-on-quarter comparison. Economic recessions are generally characterised by a persistent decline in economic activities and output, which results in the worsening of key macroeconomic indicators such as employment, consumption, industrial production, stock market capitalisation, wholesale and retail sales, amongst others.
Consequently, as income and employment weakens, the economy begins to experience increased poverty, hunger, crime and inequality. An example of an economic recession in recent history is the global economic recession of 2007/2008.
A “recession” represents one (1) of the four (4) phases of a business cycle, with the other phases being “boom”, “trough”, and “recovery”. Recessions have been observed to succeed a period of sustained economic progress known as a ‘boom’; and when not promptly addressed, could result in a ‘depression’, which is characterised by a significant decline in income and employment. This in turn pushes the economy to its ‘trough’, a state which marks the end of output, representing a period of decline in employment, and the likely beginning of economic recovery. A ‘recovery’ can be said to be underway when the GDP, employment and welfare parameters begin to improve.
Possible Causes of an Economic Recession
Several factors can trigger an economic recession. Key amongst these are: A sharp and unexpected increase in the price of the factors of production, which often leads to a decline in output, employment and consumer spending; persistent monetary policy tightening, seeking to reduce inflation through increase(s) in interest rate, which incidentally cascades to a shrink in credit, investment, and output; financial market crisis where credit expansion triggers a debt crisis as was experienced in the 2007/2008 global economic recession; and persistent decline in the prices and/or demand for commodities, for countries with a dominant export sector
Irrespective of the cause(s) of an economic recession, it often depresses economic activities and creates an atmosphere of business uncertainty, with implications for investments across virtually all sectors of the economy, including the financial markets.
Impact of economic recession on key economic indicators
Interest Rate: Interest rates are generally expected to decline during an economic recession. Monetary authorities often pursue low interest rates during a recession to stimulate the economy and encourage spending. This has implications for yields across various asset classes, particularly fixed income securities. This decline in interest rates may drive out investors (who are typically after higher interest rates) to other markets where they can obtain a higher return on their investments
Exchange Rate: An economic recession often triggers the exit of foreign portfolio investments to “safer” markets, thereby mounting a downward pressure on the local currency. Broadly speaking, the impact of a recession on exchange rate depends on the current account position of the economy.
When an economy with a large current account deficit (the value of imports of goods/services/investment income is greater than the value of exports) experiences a recession, a trade deficit will mount a downward pressure on the currency.
The reverse is true for an economy with a current account surplus (the value of imports of goods/services/investment income is less than the value of exports).
This partly explains the scenario in the 2007/2008 global recession, where the United Kingdom experienced a significant depreciation of the British Pound, compared to the United States where the US Dollar remained largely stable.
Inflation Rate: Intuitively, an economic recession should trigger a decline in the inflation rate, however, experience across various countries shows that the root cause of the recession will determine how the inflation rate is impacted. Where a decline in aggregate supply occasions a recession, an inflationary trend is triggered as a knock-on effect of the high prices of factors of production. On the other hand, a recession induced by a slump in aggregate demand often triggers a deflation as disposable income and consumer spending shrink.
Impact of economic recession on securities portfolios
Fixed Income Portfolios: During an economic recession, fixed income portfolios often exert more resilience; given that the instruments characteristically have guaranteed returns, and could be ‘risk-free’ (for instance government securities).
Consequently, sovereign bonds often witness increased demand pressure during an economic recession, which pushes up the bond prices and portfolio valuations. Nevertheless, should the monetary authorities increase the purchase of fixed income instruments in the secondary market, yields are bound to crash as systemic liquidity expands. It is worth noting that if the government expands domestic borrowing (through the bond market), as a way out of the recession, an upward pressure on interest rates will mount and reduce the value of bond portfolios
Equity Portfolios: An economic recession is bound to have the most immediate impact on equity portfolios, given the correlation between economic indicators, earnings performance of companies and stock market indices.
The expectations of a recession or an actual recession often trigger a crash in the stock prices, as investors exit equity holdings for safer asset classes such as cash and government securities. In addition, investors often adjust dividend expectations and risk premiums in stock valuations, hence making the intrinsic prices less attractive. Consequently, equity portfolios are severely impacted as stock market prices and indices shrink
How can Portfolios be made Recession-Proof?
An important strategy for investing before, during and after an economic recession is to keep an eye on the big picture, with limited attention to the historical evidence of the cyclicality of certain investments. Ordinarily, when confronted with a recession, risk-averse portfolio managers may adopt a strategy that is favourably disposed to safer securities such as treasury bills and government bonds, as opposed to corporate bonds (especially high-yield bonds) and mortgage-backed securities, since these instruments are riskier than government securities.
Similarly, in the equities market, blue chip stocks across consumer goods, industrial goods and pharmaceuticals are often perceived to be recession-proof. Some strategies that can be adopted to combat the negative effects of a recession on portfolios include:
Diversify investments: This is referred to as the golden rule. However, it is important to note that different asset classes perform well or poorly at different times. The key strategy is to always ensure that a portfolio is diversified across asset classes and geography, such that, if one is doing badly, another may be doing better, helping to hedge against concentration risk
Look beyond economic data: Usually, economic data releases are backward-looking. At the onset of an economic slowdown, economic data might suggest otherwise, contradicting everyday experiences. Similarly, economic recovery takes time to fully reflect in published data
Reconsider ‘cash’ as a safe haven: Inflation impacts the purchasing power of cash over time. Although the nominal value of money when invested as cash is secure, it should not be considered a “risk-free” option. Furthermore, rushing out of a perceived volatile market might deprive one of the opportunity to make quick returns when the market rebounds
Check for over-exposure: Different sectors and asset classes are known to respond differently at different stages of the business cycle. Pharmaceuticals, consumer goods and industrial goods are relatively more resilient in a recession, compared to banking, insurance and construction sectors. The norm is to always hold sizable resilient asset classes during recessionary periods
Think long-term: Since a recession is technically defined as two (2) consecutive quarters of negative growth in GDP, it might be valid to consider six (6) months in the average lifetime of a portfolio as not long. The most important consideration, however, is to ensure that the portfolio meets the stipulated investment policy, and is well diversified at any time
In summary, it is important to note that all investments are subject to risk. Even the ‘safer’ bond portfolios have interest rate, issuer default and inflation risks. Diversification does not guarantee an impressive return or protection against a loss in a declining market.
Market concerns in a recession naturally raise anxiety about the prospect of portfolio declines and prompt risk-averse investors to run to ‘safety’. Nevertheless, irrespective of the phase of the business cycle an economy is in, the most important consideration is for portfolio managers to have an asset allocation strategy that matches their risk tolerance and long-run portfolio objective.
