13 May 2020
Understanding Economic Recessions
Whether we like it or not, recessions are a normal part of the economic cycle. They are a fact of life and they serve a good purpose. Having a good understanding of recessions can help investors make the right decisions with their portfolios and reduce the fear that comes with uncertainty.
So what is a recession? It is a generally defined as a fall in economic growth in at least two successive quarters. There are many things that can cause a recession ranging from financial and economic causes to psychological causes such as fear and uncertainty. These factors can build up slowly over a period of time or they come in the form of a sudden economic shock, such as the forced closure of businesses due to the COVID-19 lockdown. Each time there is a recession, there is a different trigger and often it is the psychological response to a trigger event that leads to a cascade of events that have a negative impact on growth. Consumers lack the confidence to spend, businesses lack the confidence to expand, and investors retreat to the safe haven of cash in the bank.
Economists take a very philosophical view of recessions. If you follow a graph of economic growth over a very long period, you will see a wave pattern which is the economic cycle. Cycles are irregular and unpredictable, but there are two things we know for certain. A period of sustained economic growth will always be followed by a downturn and a period of recession will always be followed by an upturn. What we don’t know is when the turning points will be and how long each part of the cycle will last. We just know and trust that each part of the cycle eventually comes to an end and reaches a turning point.
Recessions play a key role in helping the economy’s long-term sustainability. During a recession, weak or badly managed businesses will fail, along with individuals who make poor financial choices. Economic resources – people, raw materials and money – are freed up from these inefficient uses and, over a period of time, are reallocated to growth areas. I’ve often thought of the economy as being a bit like a garden. Every now and then, it needs a thorough weeding and trimming back to get rid of the dead wood. Once this is done, new and stronger growth emerges.
Many readers will remember the “Rogernomics’ era, when tariffs were reduced or removed on such things as clothing, footwear and motor vehicles. This was a huge economic shock for New Zealand, resulting in the closure of many textile and clothing companies, shoe manufacturers and car assembly plants. Unemployment increased and some very large companies lost a lot of money. But over time, the resources released from those closures were redeployed into other growth industries such as agriculture and tourism. As a result, we have a more efficient economy with the benefit of lower priced goods for consumers. Painful as it was for the affected individuals, there were long term benefits to the economy.
We are heading in to what might be a deep and sustained recession. There will be winners and losers over the coming months. The tourism, hospitality and retail sectors are likely to be severely hit. However, some sectors, such as healthcare and communications will see huge growth. Over a period of time, as resources are re-allocated from areas of decline to areas of growth, we will start to emerge into a period of economic upturn.
Recessions are defined by their shape. They can take the shape of a V (a sharp drop and sharp rebound), an L (a drop and long period of low activity before a gradual upturn) or a U, which is somewhere between V and L.The Global Financial Crisis was a V shape, with an upturn occurring within about 18 months. The Great Depression was an L shape. What we are experiencing now is likely to a U shape, taking 18 months to 3 years before we get a recovery. But that’s a guess. All we know is that recovery will come….one day!
What does all this mean for investors? Asset prices will follow the same trend as economic growth. However, we know that at an individual business level there will be winners and losers. The best defence against a recession is therefore diversification of an investment portfolio. Within a diversified portfolio there will be some individual securities and asset classes that do better than others but overall a well-diversified portfolio will follow the trend of the markets as a whole. There should be no need to alter your investment strategy unless you long term goals have changed. Trying to time the market by selling before a dip and buying before an upturn has been proven to be an unsuccessful strategy. That’s because, in amongst the volatility, it is very hard to pick the turning points until long after they have passed. Investment is not the same as speculation. Confident investors see recessions as an inevitable and necessary part of the cycle and focus their attention on long term returns.