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Nov 9, 2023

What is a Recession?

By Team Stash
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What is a recession?

A recession is a period of decline in economic activity that persists for several months, impacting multiple economic sectors, a nation’s overall financial health, and often the average consumer’s personal finances.

While the exact parameters that distinguish an economic downturn from a true recession are debatable, the National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” The typical rule of thumb for determining whether a period constitutes a recession is whether it includes two or more consecutive quarters of decline in a country’s gross domestic product (GDP). Often, these periods aren’t officially labeled as recessions by economists until they are already well underway or have ended entirely. It’s important to remember that recessions are natural and temporary phases in the business cycle, and though they may come with hardships, they are typically succeeded by periods of economic growth.

In this article, we’ll cover:

What happens in a recession

Recessions are complex events that can be triggered by various factors, from financial crises to external shocks. While each recession has distinct characteristics and causes, varying in length and severity, a few trends are common across all of them.

  • GDP falls: GDP, which measures the total value of goods and services produced in a country, typically drops during a recession, indicating a weakening of the nation’s overall economic health.
  • Economic activity declines: Businesses might reduce production due to decreased demand, leading to a slowdown in various sectors of the economy.
  • Unemployment rate rises: As companies cut back on production or even shut down, job losses become more prevalent, leaving a higher percentage of the population without employment.
  • Interest rates may decrease: The Federal Reserve might choose to lower interest rates in an effort to boost economic activity.
  • Consumer spending shrinks: Uncertainty and financial concerns during a recession often lead consumers to cut back on their expenditures, further slowing down the economy.

Economic downturns vs. recessions vs. depressions 

Economic downturns, recessions, and depressions are all periods of economic contraction. Ultimately, their differences lie in their duration, intensity, and impact on the broader economy.

  • Economic downturns: These are short-term declines in economic activity, often accompanied by bear markets. While they can lead to recessions, it’s possible for the economy to recover before that happens. The U.S. has experienced a number of downturns throughout history, with bear markets lasting an average of about 9.5 months, though many are much shorter. 
  • Recessions: Going into a recession means that an economic downturn extends into a more prolonged and pronounced drop in economic activity. Since 1980, the U.S. has faced five recessions of varying durations, with the shortest lasting just six months and the longest extending to 18 months. On average, U.S. recessions have lasted about 11 months.
  • Depressions: Depressions are the most extended and severe economic contractions. The U.S. has experienced only one depression, known as The Great Depression, which began with a profound stock market crash in 1929 and lasted for about a decade. This period was marked by extreme unemployment, a significant drop in consumer spending, and widespread bank failures.
DurationLasts for monthsLasts for years
Global impactOften localized to a single economyMay have a global impact
Economic impactEmployment, income, spending, and manufacturing decreaseEmployment, income, spending, and manufacturing plummet
Occurrences in US history34 in the US since 1854One in the US since 1854

Examples of past recessions

Each recession in the U.S. has been unique in its cause, duration, and impact on the global economy. Three significant recessions identified by the NBER in the recent past have left a lasting mark on the country’s economic landscape.

  • Dot-Com Recession: Occurring between March and November 2001, this seven-month-long recession was a result of the bursting of the dot-com bubble of the 1990s. The overvaluation of tech companies led to a sharp stock market decline, impacting the broader economy.
  • The Great Recession: Spanning from December 2007 to June 2009, the Great Recession was primarily caused by the subprime mortgage crisis, leading to significant job losses and a global banking crisis. Lasting 18 months, it’s the longest recession the U.S. has experienced since World War II.
  • COVID-19 Recession: Triggered in early 2020 by the global outbreak of the COVID-19 pandemic, this recession saw a sharp decline in economic activity due to lockdowns, travel bans, and business closures. While its exact duration is still debated, the most severe stages occurred between February and April 2020.

What causes recessions

No two recessions are identical. They often arise from a unique combination of factors that work together to turn a mild economic downturn into a pronounced economic contraction. A few factors often contribute to the onset of a recession. 

  • Sudden economic shocks: Unexpected events that disrupt the normal flow of the economic cycle,  like natural disasters, terrorist attacks, or health crises, can shake consumer and business confidence, triggering a reduction in spending and investment.
  • Excessive, widespread debt: When households, businesses, or governments take on too much debt, they may need to cut back on spending in order to pay it off, leading to a significant dip in overall economic activity.
  • Asset bubbles: Bubbles occur when the prices of assets, like real estate or stocks, soar far above their fundamental value. Asset bubbles often arise in a specific industry or sector. When these bubbles inevitably burst, those who invested heavily can face significant losses, companies go out of business, and a ripple effect may impact other sectors of the economy as well, leading to an overall economic slowdown.
  • Excessive inflation: During periods of high inflation, prices of goods and services rise too quickly, eroding consumer purchasing power. The Federal Reserve may then choose to raise interest rates in an effort to curb inflation, which can result in reduced borrowing and spending.
  • Runaway deflation: The opposite of inflation, deflation is a prolonged drop in prices. While it might seem like a good thing, deflation can lead to reduced consumer spending as people wait for prices to fall further, causing a vicious cycle of economic contraction.

How recessions fit into the business cycle

The business cycle is a natural ebb and flow of economic activity, characterized by periods of growth and decline. Recessions are a pronounced form of natural contractions, representing a significant dip in the cycle. The NBER plays a pivotal role in determining the start and end dates of U.S. recessions by breaking the business cycle into four primary phases:

  • Expansion: Marked by increasing economic activity, the expansion phase is a period of economic growth and prosperity. This is an ideal economic stage for business growth, often featuring rising employment rates and bolstered consumer confidence. As demand increases, businesses raise prices, causing inflation.
  • Peak: The peak of the business cycle is the zenith of the expansion phase, where economic activity reaches its maximum, right before starting to fall off. This phase is characterized by high levels of production, employment, and the highest prices, with no room for further expansion.
  • Contraction: Following a peak, the economy starts to slow down. This period sees a decline in GDP, employment, and other economic indicators. If this contraction is prolonged and severe, it can lead to a recession.
  • Trough: The trough is the lowest point of the contraction phase, when economic activity bottoms out before starting to rise again. From here, the business cycle moves back into the expansion phase, marking the beginning of economic recovery.

Signs of an impending recession

While it’s impossible to predict recessions with absolute certainty, economists and financial experts often turn to specific indicators that hint at economic turbulence ahead. 

  • Inverted yield curve: Typically, long-term bonds have a higher yield compared to short-term bonds. But when short-term bonds yield more than long-term ones, it’s called an inverted yield curve. Historically, this inversion has preceded recessions, as it indicates a lack of economic confidence.
  • Declining consumer confidence: When consumers are pessimistic about the future of the economy, they tend to spend less and save more. A sustained drop in consumer confidence can lead to an economic contraction.
  • Increasing unemployment: A rising unemployment rate can be a sign that businesses are cutting back on staff due to decreased demand or revenue. Persistent high unemployment can contribute to reduced consumer spending, which may exacerbate an economic slowdown.
  • Stock market drops: While stock markets can be volatile regardless of the larger economic landscape, a prolonged and significant drop in stock prices overall can sometimes precede a recession and might be a sign of continued decline.

How a recession may affect you (and how you can prepare)

A recession affects the average person in a variety of ways. You might feel a financial pinch, as job security becomes uncertain and daily expenses seem to loom larger. While it’s natural to be concerned, there are proactive steps you can take to navigate challenging times and prepare for an impending recession.

  • Build an emergency fund: An emergency fund acts as your financial safety net, ensuring you have funds to cover unexpected expenses or income loss. Especially during uncertain times, having three to six months’ worth of expenses can provide peace of mind and financial stability. 
  • Pay off debts: Reducing debt, especially high-interest credit card debt, can free up income and reduce stress on your personal finances. By tackling your debt, you’re not only improving your financial health, but also making yourself less vulnerable during an economic downturn. 
  • Start saving money: Plan for what a recession would do to your current budget and savings goals and take action ahead of time. By cutting down on expenses and setting aside a portion of your income regularly, you’re building a buffer that can be invaluable during tough times.

How to invest if you’re worried about a recession

When economic clouds gather, it’s natural to feel uneasy about your investments. Remember that market fluctuations are a part of the investment journey, and before making any hasty decisions, you might want to consult with a financial advisor who can provide tailored advice for your situation. Instead of panicking when the stock market dips, consider these strategies to safeguard, and possibly even grow, your portfolio during a recession.

  • Ride out the downturn with long-term investing: Historically, markets have shown resilience over extended periods. Focusing on long-term investing may allow you to weather short-term volatility and potentially benefit from the average stock market return over time.
  • Seek out “recession-proof” stocks and funds: Some sectors tend to be more resilient during economic downturns. Identifying and investing in stocks that tend to hold value in a recession might help shield your portfolio against market turbulence. 
  • Consider defensive stocks for your portfolio: Defensive stocks are shares in companies that provide essential goods and services, like utilities or consumer staples. Because of their relatively stable demand, adding them to your portfolio may reduce your vulnerability in the face of economic flux.
  • Capitalize on inflation before it drops: Some securities can actually benefit from inflation. Investing in things like Treasury Inflation-Protected Securities (TIPS), I-bonds, and value stocks when inflation is rising before a recession might offer a hedge against decreasing inflation rates later. 
  • Evaluate short-term investment options: If you’re apprehensive about locking your money into long-term investments during uncertain times, consider short-term, lower-risk options. Instruments with fixed interest rates, such as CDs and T-bills, can be a way to secure higher interest rates before they potentially drop in a recession. 
  • Diversify your portfolio: Spreading your investments across various asset classes and economic sectors can reduce risk. Especially during a recession, a diversified portfolio can help mitigate losses and position you for growth when the economy recovers.

Holding steady in the face of a recession

Economic downturns and recessions are inherent phases of the business cycle. Though they present challenges, remember that they’re followed by seasons of growth and rejuvenation. When you understand what a recession is, you’ll be more prepared to anticipate downturns and prepare.

As an investor, maintaining a clear strategy, staying informed, and resisting the urge to make impulsive decisions can help you pave the way for long-term success. With a good grasp of the cyclical nature of the economy, you can navigate the turbulence of recessions with more confidence.

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Written by

Team Stash


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