Understanding the Economic Cycle and Recessions
The jobs report has come out and looks very healthy, inflation is still below 2%, yet many strategists still believe that a recession is on the way within the next year. This quarter, we take a look at what the actual cycles are, what a recession is defined as and what to expect should we enter into one.
Economic Cycles and Identifying the Four Stages of the Cycle
All countries have moments of growth and decline with their output, employment, income and spending. Through their long-term growth, there are four primary labelled stages:
Growth, Expansion, Recovery; The economy is recovering and/ or growing. The gross domestic output, a key measurement for economic output, is increasing. During this phase, one would expect the Growth Domestic Product ‘GDP’ (the value of goods and services produced in a country) rate to be between 2% and 3%, unemployment to be around 4.5% to 5% and inflation to be close to 2%.
Peak; The economy has reached levels that are too high on all the aforementioned factors and has overheated. GDP is between 4% and 5%, inflation will be much higher than 2% and investors have enjoyed a long bull run and pushed the prices in the market too high, creating ‘bubbles’.
Contraction/ Recession; The economy is correcting and is described as being in a recession or bear market. Here you would expect the GDP to fall below 2% and when it turns negative it is labeled as a ‘recession’ by economists. Investors sell and hold back for better prices in the market, companies lay people off to cut their costs and wait until confirmation that the recession is over, causing unemployment rates to rise (typically one of the last things to occur).
Trough; The economy has hit the bottom of its point in the cycle and the expansion phase is about to commence.
The economic cycle and the stock market cycles do not move in the same time frame. The stock market cycle will always precede the economic cycle yet both have a natural effect on one another as the indicators can help investors and companies time their moves more accurately.
What is a Recession and What to Expect
When there is a significant drop in GDP, income, sales, manufacturing and employment for a period of at least six months (two quarters), it is usually believed to be the start of a recession. A recession only actually lasts for a period of approximately nine to 18 months, with the average being 11 months albeit the effects can last longer. The 2008 recession had negative GDP growth for four consecutive quarters.
There are a number of leading indicators and factors that can ignite a recession and turn the markets. The most common one being a reduction in consumer demand and/ or spending.
With less spending, there is less income being brought in by businesses. With less income coming in, businesses stop expanding and hiring new people. This leads to unemployment which, in turn, decreases consumer spending even further and some businesses start to shut down.
Without any employment or income, some people can not afford their mortgage payments so end up losing their homes. Investors aren't looking to lock cash up in real estate so reduce their levels of purchases and university graduates can’t find employment so don't embark on purchasing a new home. These factors all contribute to the reduction in prices in the housing market.
Some Things to Consider During a Recession
If a recession is truly around the corner or you find that one has already started, here are some things that you may want to consider or reconsider:
Property and Mortgages
If you are currently looking to purchase a house, an adjustable-rate mortgage may not be the best idea for you. If you have budgeted for the current rate and it increases then you might find yourself with a shortfall in your monthly budget. Furthermore, a 100% or 95% mortgage may also be ill advised. If that value of the property depreciates, you may end up with something something known as ‘negative equity’ which is where the loan you have against the property is greater than the value of the asset itself.
Borrowing Versus Saving
It is always sensible to have access to three to six months worth or cash available. This doesn't need to be in actual cash, it could be in a liquid asset or investment (such as stocks and shares) but it would need to be accessible. If a recession is likely to effect your income (if you are a business owner or employed in an industry that can be effected badly, then having the cash will prevent you from needing to take on further debt.
If you are considering taking debt on in the near future, ensure that if your business or employment is effected, you can afford the extra payments to pay off the debt. One other thing that you should avoid is cosigning a loan. Ensure that if the person you have cosigned for defaults, you are able to cover the debt yourself as during a recession there is an increased chance of them not being able to honor their debt. If you do think you may end up needing to take a loan, then now would be a good time to start increasing your credit score/ rating and paying off some outstanding debts.
Education and Entrepreneurialism
During a recession, it is usually the people with the least qualifications that get effected the most in terms of employment. Those that are qualified or work in professional services tend to be more secure and employable as the services that they provide are always in need. Furthermore if employment levels drop and a company has an increased number of applicants for a job, they may immediately filter the applicants through their levels of education.
If you are currently employed and are considering setting up a new business, now may to be the best time to do it if a recession is truly in the near future. Giving up the security of an income should only be considered if you have sufficient reserves.
Investments & Pensions
If you are eight years or more away from retirement then making any changes to your investment portfolio may be a mistake. Leave these decisions up to your financial advisor or wealth manager. One thing that we would recommend is ensuring that your investment strategy is well up to date. Know what your investment goals are and communicate these to your advisor.
If you are in the position to save then saving money on a regular basis through a recession is a very good way to achieve a good dollar cost average price per unit of investment. Without trying to buy the bottom, you may be able to ‘purchase’, through saving, a number of units at all the levels of pricing on the way down and then back up again. This is known as dollar cost averaging.
