A Guide to Recession: Everything You Need to Know

The dreaded “r” word – recession – is a normal, though unpleasant, part of the business cycle, which fluctuates between periods of expansion and contraction. In the good times, the economy is growing, and asset values are rising. Unemployment is low and cheap credit can gradually lead to an increase in debt.

But when this becomes too expensive to maintain, defaults occur which cause asset values to drop. In turn, this can lead to failures of businesses, slow or negative production and high unemployment. These short-term declines in general economic activity are known as recession.

Key Points

• A recession is typically marked by two consecutive quarters of negative GDP growth, though the NBER uses a broader set of criteria for official determination.
• Recessions can be triggered by various factors including economic shocks, high inflation, excess debt, or bursting of asset bubbles.
• Key recession indicators include rising unemployment, stock market selloffs, and leading economic indices, while the effects on individuals often involve job losses, reduced wages, and tighter lending standards.

What is a recession?

The often-cited rule of thumb in economics is that a recession is two consecutive quarters of negative economic growth, as reflected by gross domestic product (GDP). This may be handy and easy to classify for analysts, journalists, and the general public. But economists think slightly differently about business cycles.

In the US, the National Bureau of Economic Research (NBER) is generally recognised as the authority that defines the beginning and ending of US recessions. This can sometimes come a year or more after the fact. The NBER has its own definition of what constitutes a recession, namely:

“a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

In essence, there are three criteria which need to be met individually to some degree – depth, diffusion, and even duration – although extreme conditions revealed by one criterion may partially offset weaker indications from another.

The NBER will officially declare a recession, but it doesn’t necessarily rely on two straight quarters of negative economic growth using GDP data to call a recession. This is partly because GDP is a very broad measure that can be influenced by several wider factors like international trade or government spending. Instead, the Bureau will also study numerous other higher-frequency indicators such as a rise in the jobless rate, retail sales and other measures of manufacturing, services, and income. This data is released monthly and not quarterly like GDP.

Since 1950, the US has not experienced a two quarters-in-a-row contraction in GDP that was not in the end associated with a recession.

What causes a recession?

There is any number of ways an economy can fall into a recession, from sudden disasters like war to a fallout from uncontrolled inflation, or a combination of several factors. Some of the main drivers are:

• A sudden economic shock – this type of event can create serious financial damage to businesses and consumers. For example, the energy price shock in the last 18 months has been compared to the 1970s oil shock. The latter saw OPEC cut off the supply of oil to the US with no warning, causing a recession^[1].
• Elevated inflation – the steady, upward trend in prices over time is not a bad thing, all things considered. But excessive inflation often means central banks will raise interest rates quickly which can depress economic activity. Rampant price pressures were an issue in the 1970s which saw the Fed hike rates rapidly^[2], which in time, led to an economic decline. Sound familiar?
• Excess debt – if the cost of debt is too high, businesses and individuals may struggle to repay loans. This can lead to debt defaults and bankruptcies which can ultimately capsize the economy. The housing bubble that led to the 2008 crisis is the obvious example of excessive debt resulting in an economic recession.
• Asset bubbles – This situation is closely linked to excessive debt. Also driven by emotion, investors can drive up the prices of risky assets which inflate stock market and real estate prices way beyond reasonable valuations. When these bubbles pop, a recession and worse will follow.

Recession indicators

Here are some indicators that could provide some insight into the possibility of a recession:

• Rising unemployment: Job losses are a big warning sign of an imminent slowdown as this means businesses and companies are cutting costs, and reflect an economy that is not growing. In 2023, the labour market witnessed notable job losses, particularly in the technology sector, which experienced a significant downturn after years of rapid growth.
  
  These layoffs were attributed to a combination of factors, including a shift towards streamlining operations amid economic uncertainties and a recalibration of post-pandemic demand. While the broader economy also faced employment challenges, the technology sector’s job cuts stood out due to their scale and the sector’s previous boom.
  
  Some notable examples of technology companies which had massive workforce reductions in 2023 included Amazon which eliminated 16,000 positions, Alphabet (the parent company of Google) with 12,000 job cuts, and both Microsoft and Meta, each dispensing 10,000 roles ^[3]. 
  
• Consumer confidence surveys:  A bellwether for reading how consumer spending will fare. If one of the main drivers of the US economy is not feeling assured, lower spending may slow down the economy at a later date. For example, personal consumption for May this year showed spending and disposable income falling, which increased speculation that a downturn and possible recession is coming ^[4].
    
• Sharp stock market selloffs: Nine of 12 bear markets, or falls of more than 20%, that have occurred since 1948 have been accompanied by recessions. Nervous investors will sell stock holdings in anticipation of a slowdown in economic activity.  
  
  This correlation between bear markets and recessions stems from the stock market’s role as a forward-looking mechanism. Investors and traders constantly assess current conditions, future prospects, and potential risks. When they become pessimistic about the future, believing that economic conditions will worsen, they tend to sell their holdings to avoid potential losses. This collective action can lead to sharp sell-offs. 
  
  Several other factors can also trigger such sell-offs, including but not limited to, geopolitical tensions, significant policy changes by governments or central banks (such as sharp increases in interest rates), financial crises, or sudden economic shocks (like the COVID-19 pandemic). 
  
• Leading indicators: There are numerous other monthly data releases which can tell us if the (US) economy is slowing. These include The Conference Board Leading Economic Index and the ISM Purchasing Managers Index. There also lagging indicators and the US Treasury yield curve which can give advance warnings of an economic decline.

Recessions in the past

According to NBER data, there have been 34 recessions in the US since 1854. The average recession which took place between 1945 and 2009 lasted 11 months. Economic downturns in earlier eras tended to last over 20 months^[5].

Some recent examples are:

• The Great Financial Crisis which occurred between December 2007 and June 2009. This economic decline was almost double the length of recent US recessions. It was caused in part by a bubble in the real estate market and defaults in subprime mortgage.
• The Dot Com recession took place from March 2001 and November 2001. The fallout from the tech bubble stock market crash, plus the 9/11 terrorist attacks and accounting scandals all combined to push the US economy into recession.
• The COVID-19 Recession, spanning from February 2020 to April 2020, was marked by its unprecedented brevity and intensity, largely due to global lockdowns and public health measures implemented in response to the COVID-19 pandemic. This recession, the shortest on record, was characterised by a sharp decline in economic activity, massive job losses, and significant market volatility. Despite its short duration, the economic and social impact was profound, prompting rapid and substantial fiscal and monetary interventions aimed at stabilising and stimulating the economy.  

Effects of a recession on you

The real impact from economic recessions comes in the form of job losses, falling wages and business closures. Finding another job becomes harder while existing employees may experience cuts to pay. With many people finding it harder to pay their bills, lenders will tighten standards for mortgages and other loans.

Investments in the stock market, real estate and other assets can lose value. Interestingly, the benchmark S&P 500 has fallen as low as 23.6% from its January record high this year, in line with the 24% median decline the index has registered in past recessions^[6]. This could be indicating that at least some of the recent challenging environment is reflected in stock prices.

Conclusion 

Understanding recessions is crucial as they represent a significant aspect of the economic cycle, marked by contractions in GDP, rising unemployment, and a host of other challenging conditions.  

While daunting, recessions are also periods of adjustment and recovery, setting the stage for future growth. Recognising the causes and indicators of recessions can help individuals and policymakers alike to mitigate their impact and prepare for the eventual upturn in economic activity. 

Navigating through recessions requires not only resilience but also a strategic approach to identify emerging opportunities amidst economic downturns. Specifically, in the realm of financial markets, understanding the dynamics of recessions opens up unique trading possibilities.  

Open a live account with Vantage today and start trading over 1,000 contracts for difference (CFDs) assets ranging from forex, stocks, indices, and more. By employing CFDs strategically, traders can utilise the volatility and downward trends in asset prices often seen during recessions to their advantage.  

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