Preparing for the next recession: 9 things you need to know
When is the next recession?
That's one of the questions we hear most often, especially now that the coronavirus outbreak has caused unprecedented disruptions, sparking the first bear market in 11 years. Although the full extent of its economic impact will not be known for some time, it seems clear to us that the U.S. will enter a recession in 2020, if it hasn't already.
Recessions can be complicated, misunderstood and sometimes downright scary. To help you prepare for these uncertain times, we've analyzed the last 10 economic downturns to distill our top insights. This guide will help you prepare for the next recession by attempting to answer nine key questions.
1. What is a recession?
A recession is commonly defined as at least two consecutive quarters of declining GDP after a period of growth. More formally, the National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales." In this guide, we will use NBER’s official dates.
2. What causes recessions?
Past recessions have occurred for many reasons, but typically are the result of imbalances that build up in the economy and ultimately need to be corrected. For example, the 2008 recession was caused by excess debt in the housing market, whereas the 2001 contraction was caused by an asset bubble in technology stocks.
An unexpected shock — such as the current health crisis — that is widespread enough to damage corporate profits and trigger job cuts also can be responsible.
When unemployment rises, consumers typically reduce spending, which further pressures economic growth, company earnings and stock prices. These factors can fuel a vicious negative cycle that topples an economy. We’ve already seen the first domino fall, as a record 3.3 million people filed unemployment claims in the week ending March 21.
3. How long do recessions last?
The good news is that recessions generally haven’t been very long. Our analysis of 10 cycles since 1950 shows that recessions have lasted between eight and 18 months, with the average spanning about 11 months. For those directly affected by job loss or business closures, that can feel like an eternity. But investors with a long-term investment horizon would be better served looking at the full picture.
Recessions are relatively small blips in economic history. Over the last 65 years, the U.S. has been in an official recession less than 15% of all months. Moreover, the net economic impact of most recessions has been relatively small. The average expansion increased economic output by 25%, whereas the average recession reduced GDP by less than 2%. Equity returns can even be positive over the full length of a contraction, since some of the strongest stock rallies have occurred during the late stages of a recession.
4. What happens to the stock market during a recession?
While the exact timing of a recession is hard to predict, it can be wise to think about how one could affect your portfolio. That’s because bear markets and recessions often overlap — with equities leading the economic cycle by six to seven months on the way down and again on the way up.
During a recession, the stock market typically continues to decline sharply for several months. It then often bottoms out about six months after the start of a recession, and usually begins to rally before the economy starts humming again. (Keep in mind, these are market averages and can vary widely between cycles.)
Aggressive market-timing moves, such as shifting an entire portfolio into cash, can backfire. Some of the strongest returns can occur during the late stages of an economic cycle or immediately after a market bottom. It’s often better to stay invested to avoid missing out on the upswing.
5. What economic indicators can warn of a recession?
Wouldn’t it be great to know ahead of time when a recession is coming? Despite the impossibility of pinpointing the exact start of a recession, there are some generally reliable signals worth watching closely in a late-cycle economy.
Many factors can contribute to a recession, and the main causes often change. Therefore, it’s helpful to look at several different aspects of the economy to better assess where excesses and imbalances may be building. Keep in mind that any indicator should be viewed more as a mile marker than a distance-to-destination sign.
Four examples of economic indicators that can warn of a recession include the yield curve, corporate profits, the unemployment rate and housing starts. Aggregated metrics, such as The Conference Board Leading Economic Index®, have also been consistently reliable over time.
Overall, these factors seem to indicate that the U.S. entered 2020 in a late cycle, but in a generally strong position. Obviously, much has changed since then, and economic data will start reflecting that more clearly in the coming weeks and months.
6. How close are we to the next recession?
Even though the U.S. economy was relatively healthy a few months ago, the coronavirus outbreak has significantly altered that view.
Our base case is that a recession is a near certainty in 2020. While the full economic impact may not be known for some time, a combination of global supply chain disruptions and lower consumption will materially impact corporate earnings in 2020. Certain industries such as travel and hospitality are expected to be hit the hardest, but the effects will likely be felt across sectors.
If the government and Federal Reserve continue to respond with strong fiscal and monetary stimulus, it could go a long way toward mitigating the economic impact and length of a downturn. How long it takes to contain the spread of the virus will, of course, also be a key factor.
7. How should you position your stock portfolio for a recession?
We’ve already established that equities often do poorly during recessions, but trying to time the market by selling stocks can be ill-advised. So should investors do nothing? Certainly not.
To prepare for a recession, investors should take the opportunity to review their overall asset allocation — which may have changed significantly during the bull market — to ensure that their portfolio is balanced and broadly diversified. Consulting a financial advisor can help immensely since these often can be emotional decisions for investors.
Not all stocks respond the same during periods of economic stress. In the eight largest equity declines between 1987 and 2019, some sectors held up more consistently than others — usually those with higher dividends such as consumer staples and utilities. Dividends can offer steady return potential when stock prices are broadly declining.
Growth-oriented stocks still have a place in portfolios, but investors may want to consider companies with strong balance sheets, consistent cash flows and long growth runways that can withstand short-term volatility.
Even in a recession, many companies may remain profitable. Focus on companies with products and services that people will continue to use every day such as telecommunication services and food manufacturers.
8. How should you position your bond portfolio for a recession?
Fixed income is key to successful investing during a recession or bear market. That’s because bonds can provide an essential measure of stability and capital preservation, especially when equity markets are volatile.
Over the last six market corrections, U.S. bond market returns — as measured by the Bloomberg Barclays U.S. Aggregate Index — were flat or positive in five out of six periods.
Achieving the right fixed income allocation is always important. But with the U.S. economy entering a period of great uncertainty, it’s especially critical for investors to ensure that core bond holdings provide balance to their portfolios. Investors don’t necessarily need to increase their bond allocation ahead of a recession, but they should review whether their fixed income exposure is positioned to provide elements of the four roles that bonds play: diversification from equities, income, capital preservation and inflation protection.
9. What should you do to prepare for a recession?
Above all else, investors should stay calm and keep a long-term perspective when investing ahead of and during a recession. Emotions can be one of the biggest roadblocks to strong investment returns, and this is particularly true during periods of economic and market stress.
If you’ve picked up anything from reading this guide, it’s probably that determining the exact start date of a recession is ultimately impossible, but also not that critical. What is more important is to maintain a long-term perspective and make sure your portfolio is designed to be balanced enough to benefit from periods of potential growth before it happens, while being resilient during those inevitable periods of volatility.
Key investor takeaways
- Stay calm and keep a long-term perspective.
- Maintain a balanced and broadly diversified portfolio.
- Balance equity portfolios with a mix of dividend-paying companies and growth stocks.
- Choose funds with a strong history of weathering market declines.
- Use high-quality bonds to help offset equity volatility.
- Advisors can help investors navigate periods of market volatility.
Securities offered through Securities America, Inc., member FINRA/SIPC. Advisory services offered through Securities America Advisors, Inc. William R. Pintaric & Associates and Securities America are separate entities.
Written by American Funds for distribution by David Pintaric.
Securities America and its advisors do not provide tax advice. Please consult with your tax professional regarding your individual tax situation.