This article is a revision to our previous article A Recession is Coming (Eventually).
Last August, as the market took a small dip, we wrote an article about widespread concerns of a pending recession even though the economy was quite strong at the time. We suggested that things like the trade war and a yield-curve inversion weren’t immediate risks to the global economy. Shortly after we went to print, the market recovered and moved to an all-time high. That was then.
It now appears that the economy has entered a recession, although we won’t be able to say so definitively for several months. With the spread of COVID-19 around the globe, significant portions of the economy have quickly ground to a halt. We know recessions can be complicated and we know many of you have questions. We’d like to answer some of those questions here. Let’s start at the beginning.
In simple terms, a recession happens when the economy stops growing and starts shrinking. More technically, economists generally define a recession as two or more consecutive quarters of falling GDP. GDP, or Gross Domestic Product, is the total value of all goods and services produced and is often used to measure the size of an economy. Watching the rate of growth or decline in GDP is an easy way to gauge economic health.
We are probably in the first quarter of a recession which is likely to continue at least into next quarter (and possibly longer). We won’t know the severity until GDP numbers are released after the end of each quarter.
Fundamentally, a recession starts when consumers and businesses start spending less either because they have less to spend or because they expect difficult times ahead. It is usually a confluence of factors that could include excessive debt, rising interest rates, inflation, mismanagement, asset bubbles, or government intervention.
Today, we are in a situation where much of the world is stuck at home, spending less money, and causing a significant contraction in economic activity. While a situation like this is extremely unusual in modern times, it is not the first time a disease has impacted daily life so completely.
When corporate profits begin falling, recessions can tumble into a self-reinforcing cycle where we see the following:
Finally some good news. Recessions don’t usually drag on for years and years, while economic expansions do. Since 1900, there have been 22 recessions ranging in length from six months in 1980, to forty-three months during the Great Depression. Since the end of World War II, recessions have lasted less than a year on average. Meanwhile, economic expansions have usually persisted for several years.
Recessions are important for stock returns as the market generally reacts positively or negatively to changes in the health of the economy. Ideally, we would be able to reduce our exposure to stocks in anticipation of a recession and then increase our exposure to stocks in anticipation of the subsequent resumption in economic growth. The tricky part of calling a recession is that stocks tend to start falling before the economy has peaked.
In the current situation, stock markets around the globe started selling off before most governments began imposing restrictions on businesses and individuals. In this case, a recession can’t become official until after the second quarter—nearly half a year after stocks began selling off.
Another reason it is hard to time a recession is that the stock market dips by some amount almost every year, even when there aren’t recessions (see chart below, Annual returns and intra-year declines). Nearly all recessions are preceded by a market selloff but not all market selloffs precede a recession.
Further complicating an effort to time a recession, stocks tend to start recovering before the economic rebound begins. In 2009 during the financial crisis, stocks started rising in March though the recession wouldn’t end until June. History has demonstrated that it is exceedingly difficult to time the market and move out of stocks as a recession is starting and then move back into stocks as the economic recovery begins. We don’t know of any investor able to do this with any sort of consistency. As famed money manager Peter Lynch once said, “It would be wonderful if we could avoid the setbacks with timely exits, but nobody has figured out how to predict them.”
While we all feel like we’ve become virologists over the past month, there is still so much we just don’t know. We don’t know how long the US and the world will effectively be closed for business. While some believe that the spread of COVID-19 will slow as the weather warms up, many experts predict that it will return again in the fall. The race is on to develop a vaccine for the virus even as researchers are working around the clock testing drugs that might treat symptoms and reduce the severity of the disease.
It seems obvious that the longer the world remains disengaged from business activity, the worse the recession will be. As time goes on, layoffs, particularly in service industries such as hotels, travel and restaurants, will rise. Some businesses that scrape by month to month will be forced to shut their doors for good. We may reach a point where the pain and outcry resulting from the shut-down of huge swaths of the economy force a different approach to the virus. In more individualistic Western societies, individuals and businesses may decide that we have “shut down and quarantined the wrong people” or that the “cure is worse than the disease.” If our approach changes, it will do so even as it is acknowledged that eliminating social distancing and failing to “flatten the curve” will result in our medical system being overwhelmed and in more deaths. We will learn a lot about viruses and about human behavior in the next three or four weeks.
We have had numerous new viral outbreaks over the past two decades. While COVID-19 is proving to be more widespread and is expected to result in more deaths, it is worth studying market action during past viral outbreaks. You can learn more about past pandemics at the website for Centers for Disease Control and Prevention.
Recently Russia would not agree with the rest of OPEC to cut oil production to maintain higher prices. Saudi Arabia responded by pumping more oil into the economy sending oil prices spiraling down to 18-year lows. The S&P 500 Energy sector has fallen by over 50% over the past month and ancillary industries are feeling the effects as well. This will only exacerbate the contraction in economic activity caused by COVID-19.
There are some positives to focus on right now. Luckily after over ten years of economic expansion, many of the businesses we invest in have built up strong balance sheets and are well-positioned to endure a situation like this. As odd as it sounds, the cause of this recession may also lead to its end. Economic activity has stalled because most of us around the globe are stuck at home not spending as much as normal—meaning we are saving money. Most of us will be ready to resume spending as normal if the “all clear” is given. Obviously, not everything will return to normal right away (think travel), but many planned purchases will still happen, just at a later date.
Also, the Federal Reserve has stepped in to stimulate the economy, cutting rates to near zero and initiating another round of quantitative easing. Unprecedented fiscal stimulus is in the works in Congress and state governments are creating new supportive programs to supplement existing unemployment programs. Another shock absorber will be the fact that many private landlords will forgo rent and many private business owners will absorb losses to keep employees from suffering. Finally, charity will serve as a shock absorber. All of these measures will help get the economy up and running more quickly when everyone goes back to work.
We don’t recommend making adjustments to portfolios in anticipation of economic events. As we stated earlier, stocks tend to fall before recessions begin and rise before recessions end. Expansions tend to run for much longer than contractions and the risk of being wrong and on the sidelines can be very expensive. Staying the course and riding out a market decline and recovery can be painful but it’s far less harmful to your portfolio than being in cash while the market goes away from you.
So are we saying investors should sit by and do nothing? We are not. Now is as good a time as any to make sure your asset allocation is appropriate for your needs.
Your personal asset allocation should provide you with enough liquidity to cover your cash needs in case the market declines further. If you are dependent on your portfolio for your cash flow or if you expect to be dependent on your portfolio in the near term (five years), we advocate having enough liquidity in your portfolio (bonds and cash) to easily make it through a lengthy market decline. If you would like to discuss your portfolio allocation, please give us a call.
The truth is we worry about recessions and bear markets as much as you do. As Frank Bragg reminds us at Bragg Financial, “Our clients pay us to worry about the market so they don’t have to!” Having an appropriate allocation and a long-term perspective has gotten us through past recessions and will get us through this one as well.