The last recession began more than 12 years ago. So for many young families, you may have never experienced an economic downturn as an adult. And to be clear, we haven’t officially been declared in a recession… yet. But as recessions are typically well underway before being declared, and given current leading economic indicators, I think it’s safe to say we likely are. But instead of fearing a recession, I prefer to arm you with information and facts to prepare you instead. The fact is economic cycles happen. So let’s talk about exactly what happens during a recession.
What Happens During a Recession: The Basics
First, let’s start with the basics. To understand what we may be facing and what happens during a recession, you need to understand a few basics of economics. Key among these is that economic cycles happen. The cycles follow the same 5 phase pattern every time. And a recession is just one of these phases.
What is a Recession?
A recession is the 5th phase of the economic cycle. It is a period of declining economic activity. In the United States, the National Bureau of Economic Research officially declares the start and end of a recession. The basis for these is numerous economic factors, though unofficially, a recession has historically been declared following 2 consecutive quarters of decline in real GDP.
What Causes a Recession?
Historically, many different factors have contributed to recessions. In general, recessions are caused by a loss of business and consumer confidence, leading to reduced demand. When we don’t feel good about our future prospects – if we are worried about our jobs, where our next paycheck will come from and when it will come – it naturally follows that we start to spend less.
What triggers this loss of confidence can and has varied across economic cycles. Past triggers have included (and some recessions had multiple triggers):
- High interest rates – 1970s-1980s
- Stock market crash – 1929, 2001
- Asset (housing, stocks) bubbles – 1929, 2001, 2008
- Poor business practices – 1990 Savings and Loans crisis
- Post-War slowdowns – 1945
- Acts of war/terror – 2001
- Pandemics – 2020
The 5 Phases of the Economic Cycle
The economy follows a continuous economic cycle, around a longer-term trend of growth. The stock market, which trades on investor’s expectations of future growth, typically serves as a leading indicator of the economic cycle – slowing and selling off before we officially enter a recession. And recovering before the economy officially starts to recover.
Over the last 100 years, we have experienced 17 economic cycles, and 11 cycles since WWII. With more data, better intervention by the Federal Reserve, particularly their focus on controlling inflation, we have seen recessions be shorter in duration, and periods of expansion be longer and longer.
In the early stages of the economic cycle, the economy is in expansion mode. Economic and business activity is bouncing back from recession lows: GDP grows faster, employment improves, and incomes increase. Interest rates remain low, supporting the recovery.
The stocks that perform best during this period of the economic cycle are interest-rate sensitive (benefit from rising interest rates) and economically sensitive (benefit most from economic growth). These sectors include:
- Consumer Discretionary: luxury goods, cars, restaurants, retailers
- Financials: banks, insurance, credit cards
- Real estate
- Industrials: manufacturers, defense, airlines
- Technology: hardware, software
- Materials: energy, chemicals, steel, metals
In the mid-stage, economic and profit growth rate peaks. Interest rates rise, and credit is strong and widely available. This is typically the longest phase of the cycle.
All sectors perform well during this period, with no sector consistently outperforming in every cycle. But the best performing sectors have typically been:
- Technology: semiconductors, hardware
- Communication services: media, telecom
High prices and full employment can tend to increase inflationary pressures, leading central banks to begin to raise interest rates, tightening credit, which can contribute to further slowing growth.
Sectors who benefit from high prices (energy, raw materials) perform well, as do more defensive sectors (healthcare, consumer staples, utilities) as investors prepare for a downturn.
The recession is the contraction phase, and thankfully, it is typically the shortest. From 1945 to 2009, we experienced 11 recessions, lasting on average, 11 months.
During a recession, revenues, earnings, and GDP decline. Unemployment increases, as struggling businesses layoff employees to reduce costs in the face of declining revenue. Incomes decline. Credit can decline. Central banks begin expansionary policy – lowering interest rates – and governments use fiscal stimulus – spending and tax reductions – to try to jump-start the economic recovery.
All sectors that are sensitive to economic growth or discretionary fall out of favor. Defensive sectors – the essentials – outperform.
- Consumer staples: food and beverage, household goods, personal care, alcohol
- Health care
Related Post: Coronavirus & The Economy
What Happens During a Recession: FAQs
What happens during a recession to unemployment?
Unemployment increases rapidly during a recession, as businesses facing declining revenue and demand, look to reduce costs.
Some industries are far more cyclical than others, and employees in these sectors will experience much higher levels of unemployment during recessions. The chart below shows the year over year change in employment levels by industry. During the 2008 recession, construction jobs declined for nearly 4 years.
Note that the hardest-hit industry is not always the same. Through the 2008 recession, leisure and hospitality suffered fewer employment declines than the total private sector. Given what is happening currently, with restrictions on travel, I foresee that being the hardest hit sector this time.
Government employment tends to fall on a lag to the rest of the sectors. This is due to tax revenues which are collected somewhat on a lagging basis, as well as the need to tighten government spending following periods of major government stimulus.
What happens during a recession to personal income?
Income declines during a recession. Those who remain employed, often see reductions in hours. Many will settle for underemployment, earning less than what they are capable of just to earn something.
Others will have no income and will rely on unemployment insurance, which is typically equivalent to only a portion of your prior earnings level for up to 26 weeks, in normal economic periods. During the 2008 recession, the time frame was extended.
What happens during a recession to housing prices?
Many of you are concerned about the housing market and what will happen to housing prices. Everyone hears the word recession and thinks back to 2008 – when we had a recession that was caused by an asset bubble, specifically housing.
What happened to the housing market in 2008 is not the norm for recessions. Historically, housing prices have not always fallen, and certainly haven’t collapsed like they did in 2008, during recessions.
Recessions triggered by a financial crisis – like 2008 or in the early 1990s during the Savings & Loan Crisis – are more likely to see an impact in the housing market due to limited credit and bank balance sheets being in trouble.
That is not the situation today. While this Spring, housing sales may be impacted since we can’t go out to look at houses to buy them, once the virus spread is contained, I am optimistic, that the housing market will resume normal activity.
What happens to the stock market during a recession?
If you caught my previous post about leading, major economic indicators, I talked about how the stock market trades on investor’s expectations of the future growth. It therefore, is a LEADING economic indicator, and performance leads the overall performance of the economy. It falls before GDP falls, and recovers before GDP recovers.
What happens during a recession to bring us out of it?
For many who may be living through their first economic downturn, it can feel like the world is coming to an end all around you. For those of us who are either students of history or who have been through this a time or two already, know that this is a normal part of the business cycle.
Every recession is a little bit different in terms of what sets it off, and how strong our economy is going into it. Those two factors also help determine how we get out of it. But historically, economic stimulus – actions taken by the government or government agencies – have been necessary to help the economy recover.
These can take different forms:
- Fiscal stimulus: efforts to boost economic activity by reducing taxes, regulations, or increasing government spending. This would include policies currently being considered, like issuing every American a $1,000 check. These are intended to get more money into the economy to stimulate demand
- Monetary stimulus: refers to actions by central banks, the Federal Reserve here in the United States. This includes lowering interest rates (expansionary monetary policy) or purchasing securities in the open market (quantitative easing), both of which are intended to make it easier or cheaper to borrow and invest
Getting money back in people’s hands and making credit cheaper and more available are both intended to improve confidence, which then increases demand and begins the recovery and expansion cycle again.
However, government intervention is a double-edged sword. Too much can lead to inflation, an overabundance of credit, asset bubbles and future economic volatility.
What Happens During a Recession Sets Up Future Expansion
What sets it off may not always be normal – but economic downturns do have benefits as well. Companies learn to operate more leanly, which when things get better, fuels higher earnings, higher salaries, and greater investment returns. Balance sheets that need cleaning up, get cleaned up – either through bankruptcy or consolidation.
That doesn’t mean it is easy for those who experience unemployment, who face bankruptcy, and lose income during these times. But they are a reminder of the importance of living within your means, saving and having an emergency fund, and investing for the long-term.
Have more questions about recessions or what’s happening in the markets? During this time, I’m taking your questions LIVE daily on Instagram – you can find all the replays uploaded to IGTV, and just like all you other moms working from home, they sometimes feature a guest appearance from my new quarantined co-workers 🙂
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