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What causes a recession?

Posted on Friday, March 1st, 2019 by MarketBeat Staff

Summary - A recession, in its simplest terms, is a downturn in the economy. The technical timeframe for a recession requires economic activity to be significantly depressed over a period of several months. However, this means that the economy is typically in recession before a recession is actually declared. This is one reason it is often said that a recession is “felt” long before it is declared. A recession is only declared after volumes of economic data are digested and trends are spotted. This data comes in the form of economic indicators that begin to slow economic growth.

In many cases, recessions occur naturally as a result of the business cycle. However, there are times when a recession occurs due to larger macroeconomic events. These recessions are usually due to factors that go outside the realm of predictable risk which can make predicting them difficult and it can also leave a central bank with fewer levers available to pull in order to guide an economy out of the recession.

Some of the most common indicators for a recession include two consecutive months of negative growth in the gross domestic product (GDP), an inversion in the yield curve, a rising unemployment rate, and declining asset prices such as a stock market correction or falling home prices.

Introduction

One of the most feared words for investors and economists is the “R” word … recession. Although recessions are a naturally occurring event in the private sector, they can have long-lasting effects from increasing unemployment, declining revenues, and less industrial production.

In this article, we’ll break down what a recession is, why they occur, how – and if – they can be predicted. We’ll also take a look at how a recession affects a nation’s monetary policy, what it means when the economy suffers a double-dip recession, and how to invest during a recession.

What is a recession?

A recession is a downturn in the economy marked by multiple consecutive quarters of declining economic activity. A recession is officially declared by the National Bureau of Economic Analysis (NBER). Although no single economic indicator is required for the NBER to declare that the economy is in recession, an accepted technical indicator is two consecutive quarters of negative economic growth as measured by gross domestic product (GDP).  

Negative economic growth is simply a decline in growth, which is why it usually takes two months or more for a recession to be called. For example, if the GDP of the United States were to decline from $14.0 trillion to $13.8 trillion, the economy would be said to have shown negative economic growth. However, if the next quarter, the GDP were to tick up to $13.9 trillion, the economy would be showing 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 which means that a number that was once showing negative growth could move into positive territory or vice versa.

A typical recession is a normal part of a business cycle and lasts anywhere from six to eighteen months. During a recession, a country’s central bank 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.

What causes a recession?

Although frequently carrying a bad reputation, recessions are relatively common as part of the business cycle. When demand increases, businesses will aggressively increase industrial production which can mean increased hiring. This leads to an expanding economy marked by higher revenues for businesses and higher income for consumers. This, in turn, fuels more demand. At some point, a country’s central bank will raise interest rates to ensure that the expansion remains measured. But once these rates go higher, businesses and consumers are encouraged to save more which starts to turn the cycle the other way. Businesses decrease production, they may initiate layoffs, which in turn leads to reduced consumer demand. When this happens, economic activity can decline pulling the economy into recession.

There have been 33 declared recessions in the United States. As stated above, these can last anywhere from six to eighteen months and most are part of a normal business cycle. More severe recessions, such as the global recession that started in 2009 may occur because of larger macroeconomic issues. For example, between July 1990 and March of 1991, a recession occurred largely due to the Iraqi invasion of Kuwait, the subsequent rise in oil prices and declines in both consumer and business confidence. Between March and November of 2001, the recession was a result of many technology companies whose stock had surged plunging. This created a credit crunch for companies at the same time as the Federal Reserve was raising interest rates, making credit harder to obtain. During this time, the attacks of 9/11 occurred which closed the New York Stock Exchange (NYSE) for four days and saw leading indices fall to levels not seen in years.

However, one of the worst and long-lasting recessions occurred between December 2007 and June 2009. This was when the housing bubble burst to precede the global recession of 2009. In the run-up to the financial crisis, many lenders were encouraged to make loans to individuals who might not otherwise qualify. While this helped many Americans realize the dream of home ownership, the dream turned out to be an illusion because ultimately they did not have the income to make their payments. When the economy turned down, many of these homeowners saw adjustable interest rates rise, which led to them defaulting on their payments. This, in turn, led to a record number of foreclosures which further depressed housing prices. Other homeowners saw the equity in their home disappear completely or be reduced significantly seemingly overnight. This meant that homeowners who were current on their mortgage found themselves "upside down" on their mortgage, meaning they owed more on their home than the home was worth.  This put enormous stress on the economy as the ability for consumers to refinance their homes, even if they had good credit, was squelched until home prices could recover. 

These recessions tend to last longer and have more long-lasting implications. For example, when the economy first started to pull out of the global recession, it was referred to as a “jobless recovery” because while GDP growth was showing signs of improvement, the unemployment rate remained higher than analysts typically expect to see during a recovery.

How do recessions impact monetary policy?

When a recession occurs, the central banks of a country have many tools at their disposal to help stimulate the economy. These tools take the form of interest rates, access to credit and tax policy. In an ideal situation, central banks will try to use each of these levers in moderation thus creating a “Goldilocks” recovery – one that is neither too hot nor too cold. However, if one of these levers is compromised it can either cause the recession to linger, or even move into depression. Or, it can lead to a central bank taking more drastic steps to steer the economy out of the recession. In the recession that was precipitated by the burst of the housing bubble, many banks were in danger of becoming insolvent. This led to an unprecedented program of quantitative easing in which the federal government pumped money into the economy, primarily to allow these banks to continue to make loans.

Can a recession be predicted?

Because no single factor causes a recession, it is often said that consumers and businesses “feel” a recession long before one is actually declared. However, there are several metrics that economists look at when determining if an economy is headed towards recession. These metrics are divided into leading indicators and lagging indicators.

A leading indicator is something that occurs before a recession is declared. A leading indicator can be a decline in asset value. For example, the stock market might undergo a correction, housing prices may decline. These start to occur several months before a recession and are said to “lead into” a recession. Another leading indicator that is a form of technical analysis for investors is a yield curve inversion. This is a state in which yields on long-term debt falls below short term yields (e.g. 10-month Treasury bonds have a higher yield than 3-month Treasury bonds).  Instead of a gentle, upward sloping graph where long-term investors are rewarded with higher yields, the presence of an inverted curve shows a growth in inflation which makes short-term debt more attractive.

Lagging indicators on the other hand usually do not begin to be measured until the economy is already declared to be in a recession. An example of this would be the unemployment rate. When a recession is declared, the unemployment rate may indicate a healthy economy. That’s because the unemployment rate is usually tracked by an increase or decrease in unemployment claims. However, in some cases, job losses occur months before claims are filed for unemployment. Plus, after an economy begins to pull out of a recession, unemployment is one of the last things to come back (i.e. it “lags behind” a recovery).

What is a double-dip recession?

As the name suggests, a double-dip recession is two periods of recession that fall quickly after each other. If you were to view the traditional indicators of a recession: GDP, unemployment numbers and retail sales on a graph, a double-dip recession would present a very defined "W" shape indicating a first dip, a slight recovery, then a second dip. Double dip recessions can occur if the economy has overheated in an effort to climb out of the first recession. For example, if the government increases economic stimulus to provide extra liquidity to the financial markets, the removal of that stimulus could jolt the economy back into a recession. Likewise, a tax policy that is too punitive after an initial recession can choke off a recovery.

When does a recession become a depression?

There is no single metric that defines when a recession turns into a depression. The only officially declared depression remains the Great Depression that defined the early 1930s. This was marked by a decline in the gross domestic product (GDP) in excess of 10%. The depression also saw the unemployment rate climb, briefly, to 25%. With these criteria as a baseline, the Great Depression remains the only declared depression in the United States. In contrast, the United States has declared 33 recessions since 1854.

How to invest during a recession?

For some investors, a recession means a withdrawal from equities and a flight to safety in an investment such as bonds or cash. However, recessions can be a great time to find quality stocks that are “on sale” due to the recession. One of the first rules of thumb is to continue to invest even if you have a low-risk tolerance. That's because, history shows that equities recover, and frequently move to higher points than where they were at the start of the recession. Investors who pull their money out of stocks may miss out on gains by trying to time the market. 

While no stock is completely immune from the effects of a recession, there are some stocks that are more "recession-proof" than others. These may include defensive stocks such as those of consumer staples products that are needed regardless of the economic conditions. Even "sin stocks" for alcohol and tobacco companies tend to hold up during a recession.

The bottom line on a recession

A recession, while frequently seen as a negative for consumers and businesses, is a naturally occurring event in a normal business cycle. A recession can have lingering effects. Consumers may find it difficult to set aside money for saving and may defer big-ticket purchases and decrease discretionary spending. Businesses may cut jobs and look for other ways to reduce spending thus pulling money out of the economy.

No one single event can be used to definitively predict a recession. However, there are both leading indicators and lagging indicators that are historical indicators of a recession. These include a correction in asset prices, an inverted yield curve and a rise in the unemployment rate.

However, most recessions are marked by periods of strong recovery. This can mean that recessions can provide opportunities for both institutional and retail investors who can invest in companies while their stock price is undergoing a correction.

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