If We Enter a Recession, What Are the Implications?
These days, “recession” is by far the most frequently uttered word on financial news networks. It’s a term that evokes fear and loathing. But what defines an economic recession and what lay in its wake can cover a broad spectrum.
It’s Not the Stock Market
A recession refers to the economy, not the stock market.
Historically speaking, virtually all recessions have included at least two consecutive quarters of negative GDP (gross domestic product). Consequently, it’s a common misconception that the technical definition of a recession is just this: two consecutive quarters of shrinking economic activity.
In actuality, there’s no specified definition. There’s just a judge, and that judge is the National Bureau of Economic Research. The NBER is an independent, non-partisan organization founded in 1920, and they’ve been defining economic recessions for over a century.
According to the NBER’s website, their traditional definition of a recession is: a significant decline in economic activity that is spread across the economy and that lasts more than a few months.1
There are three criteria that must be met: depth, diffusion, and duration. In other words, the decline in activity must be significant, it must be experienced broadly, and it must linger for a time.
In extreme cases, one criterium with weak significance could be offset by another with extreme significance. For instance, the last official recession was also the shortest on record, lasting from February 2020 until April 2020. According to the NBER, economic activity peaked in February and troughed in April, an unusually short period, but the extreme depth was enough to qualify in their view.
Are We in a Recession Now?
The NBER’s recession calls are always retrospective. It wasn’t until the summer of 2021 that the NBER made the official announcement regarding the 2020 recession.
Whether we wind up being in a technically-defined recession now or next year is probably not the most important question to answer.
It’s hotly debated and good to know for trivia night, but recessions impact all of us differently depending on our jobs, our expenses, and the part of the country we live in. In 2020, restaurant owners were certainly under the impression that a recession was afoot, while homebuilders might have been blissfully unaware since they had more work than they could handle.
Tropical Storm or Hurricane?
As far as hurricanes are concerned, most Americans recall Andrew, Sandy, and Katrina. Most don’t remember Hurricane Gloria, a Category 1 storm. I do. I was in the second grade and couldn’t believe it when I heard a hurricane was going to hit my home state of New Jersey. It was the most intense storm my 6-year-old eyes had ever seen, and I’ve been interested in meteorology ever since.
Hurricane Gloria left a huge impression on me personally, but not on most Americans. Hurricane Katrina more intensely impacted more people. Both were hurricanes, but their impacts were felt very differently.
Likewise, it’s important to remember that there are varying degrees of recession intensity. For example, “The Great Recession” or “The Great Financial Crisis” of 2008-2009 was an extremely intense recession that cost 16% of American workers their jobs.2 But if you were born after 1970, then you’ve also lived through seven other recessions.
On average, recessions happen every six years or so and last about 11 months. Economists sometimes refer to them by name, but unlike meteorologists, they haven’t established a standard format. Evidently, some were only noteworthy enough to be referred to by year3:
Why Is Everyone So Concerned That a Recession Is Imminent?
Think of the U.S. economy as a fireplace. You want the logs to be on fire, but you don’t want the fire to burn out of control.
If the fire started to burn outside the confines of your hearth, and you had a firehose, how easy would it be to get the fire back under control without putting it out altogether? Imagine how difficult it would be to get things back to the way they were before things got overheated. Would the carpet be ruined? Would you be left with soggy logs and ash but no fire? How long would it take to dry out and get the fire going again?
In this context, one can see the challenge that the Federal Reserve is faced with. After the COVID-19 pandemic shutdowns slammed the brakes on the economy in both the U.S. and abroad, the response by central banks was to pump out stimulus in the form of money. The combination of too much money (think lighter fluid in the example above) and too few goods due to a supply chain in chaos led to higher prices.
The Fed was slow to respond at first but has now arrived with their fire hose in hand. The hose represents interest rate increases meant to cool the economy, their only real weapon against rising prices. In the chart above, notice that similar interest rate increases have often (but not always) led to a recession (indicated by the gray bars). Consequently, the market has become conditioned to worry when rates rise.
Will this time be different? Each situation is different somehow. This one is unique to any previous business cycle because of COVID-19 and the fact that jobs are still relatively plentiful and workers are in short supply. There doesn’t seem to be much precedent for the current situation.
If We Do Enter a Recession, What Will Happen to the Stock Market?
The stock market is a “leading indicator,” meaning that once an event such as a recession takes place, the market has likely already experienced a drop in value. You may already be seeing it now.
The market tries to predict the future, though it’s not always right. In the fourth quarter of 2018, an economic recession was widely expected but never materialized. Stocks fell around 20% and quickly recovered in early 2019 when it became apparent a recession wasn’t in the cards.
It’s possible that a recession of some degree has already been priced into stocks. It’s also possible that the “degree” of the predicted recession is mild and that if evidence indicated a more severe economic slump, the market could fall even further before recovering.
Are we “due” for a recession based on history? If you don’t count the shortest recession on record that occurred in early 2020, then yes. If you do, then we aren’t. Can we have a recession when jobs are so plentiful? Probably not. Will they remain plentiful? Maybe not. You can clearly see why diverging opinions abound.
As a long-term investor, the important lesson is that recessions are a natural part of the business cycle. Some argue they’re even necessary as a “reset button” from time to time. While they aren’t pleasant, trying to time the market responses to such an event is a dangerous endeavor that often leads to missing the “rip” higher in prices that often results once the market senses the “all clear.”
Inconveniently, that doesn’t usually occur after the recession but sometime before the recession officially ends (see chart above). So, while you may fear for your job, your business prospects, or your family’s well-being, try not to “over-manage” your portfolio by jumping in and out when you hear talk of storm clouds brewing. That’s the fastest way to jeopardize your long-term rate of return.
