Three of their knock-on effects are more unemployment, plummeting revenues and less industrial production.
In this article, we’ll break down the definition of a recession and answer the questions, "Why does a recession happen?" and "When does a recession occur?" and how to predict one.
We’ll also look at how a recession affects monetary policy, what it means for the economy and how to invest so you can weather the storm.
What is a Recession?
First, just what does recession mean? Simply put, a recession is a downturn marked by multiple consecutive quarters of declining economic activity. The National Bureau of Economic Analysis (NBER) officially declares a recession. Although no single economic indicator is required for this declaration, a common indicator is two consecutive quarters of negative economic growth measured by gross domestic product (GDP).
"Negative growth" sounds like an oxymoron but refers to a decline in growth, so it takes two months or more to "call" a recession. For example, if the GDP were to decline from $14 trillion to $13.8 trillion, the economy would be said to have shown negative economic growth. However, if the GDP were to tick up to $13.9 trillion in the next quarter, the economy would show positive growth even though the actual number is still below the previous high.
Also, GDP numbers are frequently revised upwards or downwards for the prior month, meaning that a number that once showed negative growth could move into positive territory or vice versa.
A typical recession is a normal part of a business cycle and lasts six to 18 months. If a recession hits the U.S., the Federal Reserve may make adjustments to monetary policy in an attempt to stimulate the economy. This may take the form of lowering interest rates, thus decreasing the cost of borrowing for consumers and businesses.
Causes of a Recession
Why do recessions happen? Although they sound scary, recessions are relatively common in the business cycle. So, what causes recessions? When demand increases, businesses will aggressively increase industrial production, which can mean increased hiring and an expanding economy marked by higher business revenues and higher income for consumers.
This, in turn, fuels more demand. Eventually, the government will raise interest rates to ensure the expansion remains measured. But once these rates increase, businesses and consumers are encouraged to save more, which turns the cycle the other way. Businesses decrease production and may initiate layoffs, leading to reduced consumer demand. Economic activity can decline when this happens, pulling the economy into recession.
Bursting Bubbles
A bubble forms when the price of a product exceeds its fundamental value, often for prolonged periods. When such a bubble collapses — when prices revert to normal — it can result in damage. The recession that began in March 2001 resulted from the bursting of the dot-com bubble, which lasted from 1995 to 2000.
This bubble saw a rush to invest in technology companies, whose stocks surged. When the bubble burst in March 2001, investors pulled their money out, causing stock prices to plummet and creating a credit crunch for companies as banks refused to lend them money while the Federal Reserve raised interest rates to prevent inflation.
Later that year, September 11 further hindered economic growth by closing the New York Stock Exchange (NYSE) for four days, causing leading indices to fall to levels not seen in years. Businesses delayed expansions due to increased security measures, while consumer spending dropped due to fear. A slowing global economy caused GDP growth to slow drastically, pushing the U.S. into recession.
Loss of Consumer Confidence
Between July 1990 and March 1991, the U.S. saw a recession largely due to the Iraqi invasion of Kuwait, the subsequent rise in oil prices, and the decline in consumer and business confidence, as people spent less and saved more. Consumers can also lose confidence for other reasons, such as a stock market crash or a major corporate scandal. When consumers lose faith in the economy's stability, they tend to cut back on spending, causing companies to produce less, which leads to layoffs and a further loss of consumer confidence, creating a vicious cycle that can be hard to break. It's one element of what makes a recession.
High Interest Rates
For the Federal Reserve, setting interest rates is a key arm of monetary policy. When the Fed raises rates, it typically leads to slower or even negative economic growth in the short run. The logic goes that if borrowing money becomes more expensive for businesses, they have less incentive to invest and may choose to save their capital, causing reduced spending on infrastructure projects like construction, which links to higher demand for goods and services. All these factors together result in a decline in industrial production, leading eventually to a possible recession.
For example, the housing bubble burst from December 2007 to June 2009 and caused a global recession. The causes of the Great Recession were that banks made too many loans to people who couldn't afford them. This, combined with interest rates raised from their introductory levels, caused defaults and unprecedented foreclosures, contribute to plummeting home prices. Many homeowners suddenly owed more on their mortgages than the homes were worth, straining the economy.
Stock Market Crash
Recessions can come from a stock market crash, a sharp, sudden and often spectacular decline in the value of stocks or securities. Crashes usually occur after high economic growth and speculation, with investors becoming overconfident in predicting trends. One of the most famous examples of a stock market crash happened on October 29, 1929 — "Black Tuesday" — when the Dow Jones Industrial Average fell, eventually losing more than half its value. The ensuing Great Depression saw unemployment rise to 25% and poverty spread across the country.
Trade War
When countries impose tariffs and duties on goods imported from other nations, we have what's known as a trade war. The effects of such policies can have far-reaching economic consequences, including recessions.
For example, the U.S.–China trade war 2018 caused global stock markets to drop over fears that it would stifle growth in both economies. Between July 2018 and August 2019, China's exports to the U.S. plummeted by 8.5%, its exports to other countries only increased by a slight 5.5%, and its industrial production slowed significantly.
How a Recession Affects the Market and Economy
What happens in a recession? During a recession, businesses and consumers usually reduce spending, leading to layoffs and decreased consumer confidence. These events have a trickle-down effect on the stock market and other areas of the economy like real estate and retail sales.
Job losses can weaken consumer sentiment and cause higher unemployment rates, stifling demand and further plummeting the economy. The government can use fiscal policy tools such as tax cuts or increases in spending to help stimulate the economy.
Ultimately, recessions in economics are unavoidable cycles. They require patience from investors and governments as businesses try to adjust their production levels and consumers gradually rebuild their confidence.
Are Recessions Predictable?
Because no single factor causes a recession, consumers and businesses sometimes “feel” a recession long before it's declared.
However, there are several metrics that economists look at when determining if a recession is looming. These reasons for recession are divided into leading indicators and lagging indicators.
Leading indicators are economic or financial information that can forecast a recession. Examples include asset corrections, such as a significant drop in the stock market or a housing market decline and the subsequent decline in consumer confidence and spending. Another leading indicator is a yield curve inversion, which happens when the interest rates on short-term government bonds are higher than long-term ones, meaning investors are bearish on the economy's prospects.
Lagging indicators, meanwhile, are data that measure the current state of the economy. These are usually measured when a recession has been declared. Examples of lagging indicators include GDP growth and inflation. Can inflation cause a recession?
The answer is yes, especially if it leads to decreased consumer spending and a slowdown in production. Another indicator is the unemployment rate, usually tracked by an increase or decrease in unemployment claims. However, since job losses often occur months before these claims are filed, unemployment data tends to “lag” from a recovery.
Though we generally know what causes a recession in the economy, predicting a recession accurately is another matter altogether. Remember, even the most sophisticated models can be wrong.
Signs of a Recession
When economists know what causes economic recession, they can try to predict one. They look at several signs:
- Yield curve inversion: A yield curve inversion occurs when short-term interest rates exceed long-term interest rates and is usually an indicator of an impending recession.
- Declining consumer confidence: Consumers tend to be more cautious about spending their money when they fear the economy might head toward a recession.
- Decreasing manufacturing output: If businesses are producing fewer goods and services, it's typically a sign that economic activity is slowing down.
- Rising unemployment: When people lose their jobs, businesses have cut back on hiring or are reducing their workforce due to an economic downturn.
- Decreased investment: When businesses stop investing in new projects or equipment, it could signal that they're preparing for slower growth.
- Declining retail and home sales: A decrease in sales can mean consumers are becoming less confident in the economy and spending less on discretionary items like housing or cars.
- Decreasing stock prices: Unexpected falls in stock prices can indicate fears of a recession or a lack of confidence in the markets.
- Low consumer spending and saving: Lower levels of consumer spending indicate that people might be trying to save more money in anticipation of tough times. In contrast, lower savings rates mean they might not have enough extra funds for emergencies.
How Governments Encourage Growth
When a recession occurs in the U.S., the government has many tools to help stimulate the economy. These tools include interest rates, access to credit and tax policy. In an ideal situation, the government will try to use these levers in moderation and create a “Goldilocks” recovery — neither too hot nor too cold.
However, if one of the levers fails, it can lead to the causes of recession lingering or even become a depression. Or it can lead to more drastic steps. In the Great Recession that began in 2009, many banks were in danger of becoming insolvent, which led to a never-before-seen program of quantitative easing, which meant the government pumped money into the economy, primarily to allow these banks to continue to make loans. However, in the long run, too much quantitative easing can lead to hyperinflation and devaluation of the U.S. dollar, ultimately compounding the problem.
The government can also encourage growth by investing in infrastructure projects, such as building or repairing roads, bridges and other public facilities, which creates jobs and stimulates economic activity. The government can also provide tax incentives for businesses to invest in research and development, hire more employees or offer financial assistance to struggling industries, such as bailouts for banks or airlines, as in the aftermath of the 9/11 attacks.
For instance, during the Great Recession of 2008 and 2009, the U.S. government implemented numerous initiatives to help reignite economic growth and prevent further job losses. It increased spending on infrastructure projects, extended unemployment benefits and initiated tax breaks for small businesses.
How Investors Can Handle a Recession
Investing during a recession can be daunting, but there are strategies to help weather the storm. While no stock is entirely immune from the effects of a recession, one way to invest in a downturn is to focus on defensive stocks or stocks that tend to hold up well in down markets. Think of companies that produce staples or necessity items, like food and healthcare products.
Even "sin stocks" for alcohol and tobacco companies tend to hold up during a recession. You can also invest in high-quality bonds or bond funds, as interest rates typically fall during a recession, which means bond prices rise. You can also diversify investments across different asset classes, such as stocks, bonds and real estate. This can help reduce risk and potentially protect against significant losses in any area.
Above all, remain patient. Markets often experience short-term volatility, but historically, they've always recovered. Some of the best investment opportunities can pop up during a downturn, as quality companies may be trading at discounts. This approach, known as value investing, involves searching for undervalued companies compared to their intrinsic value, as opposed to simply buying popular stocks or following market trends.
Keep a level head and don't react impulsively to short-term market swings. By pulling your money out of stocks, you may miss out on gains by trying to time the market. Instead, sticking to a well-thought-out investment strategy and periodically rebalancing your portfolio can help you stay on track. Ensure an emergency fund is in place to cover unexpected expenses or income loss during a recession.
How Traders Can Handle a Recession
If you're a trader, you likely tend to focus more on short-term strategies, so you may have different approaches for handling a recession than a long-term investor. During a recession, you may want to capitalize on market volatility by taking advantage of price discrepancies between different markets or sectors. For example, during the Great Recession, some traders made profits by taking long positions in undervalued stocks and short-selling overvalued stocks. You may also look to buy options or futures contracts if you expect a particular stock or asset class to move significantly in either direction quickly.
You can also use technical analysis to find trading opportunities during a recession. Such analysis involves looking at historical charts to identify previous support and resistance levels and then using these levels as guideposts for entering and exiting trades.
Ultimately, remain flexible and be willing to adjust your strategies to fit changing market conditions during recessions. While no trading strategy is foolproof, identifying potential opportunities quickly and seizing them can help generate profits even during economic downturns.
Recessions: Not as Scary as They Sound?
Recessions are a common part of the business cycle. They can be hard for consumers and businesses alike. People may struggle to save money, buy big-ticket items or keep their jobs. Companies often try to lower their spending, too.
Why does recession happen? Many signs point to one, some of which can be identified early and make it easier to identify. Recessions offer opportunities to savvy investors at all levels, who can snap up discounted stocks during this period.
Stay focused, and don't give in to rash decisions when stormy economic weather hits. Instead, opt for a planned approach with regular portfolio reviews and recalibrations.
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