Getting through a recession: Decoding economic ups and downs

We often hear about markets being down, or the ever-approaching recession. Just over the past year we’ve heard countless people talk about how “(Economic) Winter is coming”.

But what exactly is a recession, why does it happen, and why should you care about it?

You may feel the last question is obvious, markets being down means the job market will be tough, and equity markets will take a dive, with people exiting left and right. You’re not wrong, and most people will probably be satisfied with this surface-level understanding of economic cycles.

But as an investor, a slightly more nuanced understanding of economic cycles can help you make more informed decisions when deciding how to manage your wealth.

Here’s a simplified summary of economic cycles:

The Economic Cycle

1. Expansion: During expansions, businesses invest in new projects, consumers spend more, and overall economic confidence is high. Banks are confident as well, so they offer credit at low interest rates, further boosting the economy. Incomes soar as spending grows, and the cycle continues.

An important concept to understand here is that of real value and perceived value. To draw a parallel, real value is like the book value or face value of a share (what it is worth in terms of real assets), and perceived value is the market value (what people are willing to pay for it) of the same share.

1. Investors may be more willing to pay a premium for assets, and the overall optimism can drive perceived values above their real counterparts. The resulting disparity in real value and perceived value of assets further increases consumer confidence, and on paper, things look great.
2. The Peak: Eventually, things change. Central banks see a risk of rapid inflation and increase repo rates. As we saw in the last edition , this leads to an economic cooldown, with people spending less. This is further accelerated as incomes start stagnating, while interest on credit keeps growing. This gradually reduces economic confidence, triggering a contraction.

2. Contraction (Recession): As people become thriftier, the money circulating in the market reduces, further driving down incomes and market confidence. This is seen in the form of increasing unemployment, markets falling, etc.
3. Perceived values of assets come down closer to their real values, so the holders of those assets see losses in their wealth, again driving down spending; since on paper, value is disappearing from the market.

A simple parallel here would be if you hold 1000 shares of a company, with a market value of ?1000 each, you are more willing to spend your liquid money, because you have a backup in the form of shares. But during a recession, people are less willing to spend, driving down demand of your shares, and hence, the value, say to ?800. Since your shares only had value on paper, you lose confidence in your backup. This will reduce your willingness to spend, resulting in a domino effect.

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1. The Trough: This continues, as consumer confidence keeps dropping, until it hits a trough, before some new fiscal stimulus triggers the next cycle of expansion.

This fiscal stimulus often comes in the form of government and central bank intervention.

But hownbsp;can the government help?

Logically, as incomes drop, so would taxes, and hence, the spending power of the government. So how can they help?

An important thing to remember here is that while perceived values of assets have reduced, the real value still exists. It is simply that the holding pattern of these assets is redistributed, usually with the rich getting richer.

A simple way for the government to help here would be to increase taxes on the rich and use the extra income as a stimulus. But this leads to its own set of social problems and cannot be the sole method for the government to help.

Here’s where a new financial instrument comes in - Bonds.

What is a bond? The RBI defines bonds as follows:

?? A bond is a debt instrument in which an investor loans money to an entity (typically corporate or government) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities. Owners of bonds are debt holders, or creditors, of the issuer.

Bonds are essentially a form of borrowing from future income, like a loan. The RBI issues bonds on behalf of the government, and they are sold to Commercial banks, Scheduled UCBs, Primary Dealers, Insurance Companies, Provident Funds, and even Retail Investors.

The RBI and Government exchange funds through Bonds; the RBI and the public do so indirectly through loans; and the public and the government do this through tax collection and tax expenditure. The direction of cash flows changes with different phases of economic cycles.

Through these bonds, governments raise funds to finance infrastructure projects, social programs, or other initiatives aimed at boosting economic growth. Investors may buy these bonds with the expectation of earning stable interest income, since government bonds are considered low risk.

This leads to the obvious question - is a bond just a government FD? Well… not exactly.

Bonds and FDs

While bonds and assets are similar in the sense that they offer fixed returns, there are a few key differences between the two.

Bonds

Arguably, the biggest difference is that unlike FDs, which are bound to a depositor, bonds can be traded in markets like any other asset. But why would someone trade a fixed return asset? The returns are fixed, so why would its value vary? We can see this through an example.

Two important rates here are coupon rates and yield:

• Coupon rate is the rate of interest you will receive periodically and is fixed at the time of issuing the bond.
• Yield is the expected rate of return on a bond if it is held until its maturity. Specifically, yield is influenced by the level and changes in interest rates in the economy and other macro-economic factors, such as, expected rate of inflation, liquidity in the market, etc.

The price of a bond is calculated by discounting future cashflows with present yield.

Say you buy a bond with a face value of ?1000, having a coupon of 7% p.a. for a 10Y tenure. The yield at the time of issuance is equal to the coupon rate, so you buy the bond at par value. Now, let’s say the yield for 10Y government bonds drops to 6% p.a. on account of rate cut by MPC in monetary policy.

As there is an inverse relationship between yield and price of bonds, a lower yield increases the price of the bond in secondary markets.

The same logic works the other way, so if yield rises, the price of bonds decreases.

FDs

To compare with the previous example for bonds, say you book an FD with a principal amount of ?1000, having an interest rate of 7% p.a. for a 10Y tenure.

Now, let’s say there is a rate cut by MPC in monetary policy. The fall in repo rates will cause FD rates to fall, but your original FD remains unchanged.

A few other points to note:

Since bonds are tradable, they can be seen as more liquid than FDs, which usually incur penalties for early withdrawal. Other than this, tax treatment of bonds may differ from FDs as well.

While bonds are similar to FDs, in that the risk associated depends on the creditworthiness of the issuer, an important point to keep in mind is that FDs are usually insured by the RBI, while this may not necessarily be the case for bonds.

Overall, while bonds may be similar to FDs in many aspects, they undoubtedly have merits of their own, making them worth exploring independently of FDs.

You will soon be able to invest in bonds on Stable Money. Join the exclusive Golden Ticket club to avail early access to such offerings.

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Food for thought: We’ve discussed economic cycles and bonds. How do you think bond prices vary in different phases of the economic cycle?

In today’s edition, we’ve shown you how economic cycles work, and how the government can regulate the economy even if they have a budget deficit. At Stable Money, we’re going to keep you informed and ensure that you make the best investment decisions.

Best,

Team Stable Money