How Does the Looming Recession Affect You?

The theme of the '20s so far has been forced expertise.

2020 turned us into health experts learning about pandemics and the miraculous power of bleach and hydroxychloroquine.

2021 turned us into stock experts learning about short squeezes, bull markets and bubbles.

And now 2022 has turned us into economic experts casually throwing out words like inflation, interest rates and the big r-word, recession in everyday conversation.

"There are three R words right now: It’s Russia, it’s recession and it’s [interest] rates” Jane Fraser, Citigroup CEO

An economic recession (as you probably already know) is when a nation's GDP falls for two quarters in a row. While the definition of a recession is pretty straightforward, the US has an agency called the National Bureau of Economic Research (NBER) which officially pronounces when a recession has begun. And that body defines a recession as a significant decline in economic activity spread across the economy.

In Q2 2022, the US recorded its 2nd consecutive quarter of negative growth, which meets the technical definition of a recession. But so far, there's been a bit of debate as to whether the US is really in a recession and, if yes, why this recession looks different. Many countries around the world are also staring down recessions.

In this article, we'll talk about what causes recessions (so you can probably prepare better for the next one), what recessions generally look like, how they affect you and how you can prepare.

What causes a recession?

Many things can cause a recession but let's focus on 3 key causes:

Sudden Economic Shock

This is what experts like to call black swan events. Events that no one could have reasonably predicted that have far-reaching impacts. The COVID pandemic and subsequent lockdowns led some nations into small recessions.

Too much Inflation

Inflation is an essential part of economic growth. As the price of goods and services increases, companies make more money, create jobs, create value for shareholders, pay higher taxes to governments etc.

While inflation is good, too much inflation isn't.

But who determines what is "too much"?

Central banks set inflation targets that allow for predictable, sustainable economic growth. Developed countries like the US and UK aim to achieve an average inflation rate of 2%.

When inflation exceeds those targets, it throws things out of balance. While initially, it can bring more economic growth, that growth is unlikely to be sustainable. For example, the US saw over 6% GDP growth in all quarters in 2021 except Q3 but has now recorded 2 quarters of negative growth.

Excessive Debt

Many countries borrow to fund their spending. Countries can generally afford to borrow money cheaply (definitely cheaper than the 25% APR credit cards individuals can get). However, when countries take on excessive debt, this can cause a recession.

How?

We can say debt has gotten excessive when the borrower can no longer afford to pay. Countries that get into excessive debt are generally those that can't fund their countries any other way. When they default, investors will stop lending to them, which causes them to be unable to fund government spending.

Government spending forms a part of GDP. If that falls, it could lead to negative GDP growth and eventually a recession.

Fun Fact: Global debt stood at $300 trillion as of 2021, about 356% of global GDP. For every $1 of goods/services produced, we borrowed $3.56.

How does a recession affect you?

Businesses

It starts with declining profits and sales. When this happens, businesses are forced to cut costs; stop hiring, stop buying new equipment and pause all development of new products.

To raise revenue, companies might reduce the quantity and quality of their products to maintain the same price or increase prices. Companies with excessive debt will be forced to file for bankruptcy, as some Crypto platforms have done.

PS: So far, sales and profits of large US companies have been resilient. Retail sales data was better than expected in June, rising by 1%, while May got an upward revision. This lends credence to the argument that the US is not currently in a recession.

Employment

The unemployment rate generally rises during recessions as businesses cut costs. Companies do mass layoffs and enforce hiring freezes, as many Fintechs have done recently.

Those rendered unemployed find it difficult to get jobs because other companies have stopped hiring. This forces people to start businesses or turn to crime to survive.

PS: Another argument for why the US is not currently in a recession. The US saw 372,000 jobs created in June and 528,000 in July, more than double the expectations.

US unemployment?rate fell to 3.5%, marking the lowest level since 1969, while average hourly earnings grew at 5.2% year on year. The University of Michigan showed that consumer confidence has been growing since June.

Borrowing

Because this current recession was caused by soaring inflation, Central Banks had to raise interest rates. Higher interest rates make debt more expensive to pay off. So fewer people can afford to take loans for their businesses or buy houses, causing house prices to fall.

Investment

Declining revenues and profits cause share prices to fall as we've seen in the last few months when companies report earnings. Falling profits also force companies to either reduce or completely stop paying dividends.

Unemployment will force retail investors to sell their investments even at a loss to get cash further causing companies' share prices to fall.

If homeowners become unable to pay their mortgage because they saw a reduction or loss of their income, they may lose their home and all the money they've previously paid towards their mortgage.

Health

Since 2020 forced us into becoming health experts, we might as well talk about the health impacts here too. Many studies have found that suicide and mental illnesses increase during recessions.

On the flip side, some researchers also found that the fall in income forced more people to reduce cigarette and alcohol consumption, reducing diseases linked to them. Another study found that reduced income caused fewer people to travel, slowing the spread of viral diseases.

How can you prepare or protect yourself in a recession?

Have an emergency fund

An emergency fund is simply 3-6 months of your monthly expenses saved up. This will give you a buffer if something affects your primary source of income. In the first article of 2022, we talked all about emergency funds.

Avoid short-term risky investments

Investments that are risky in normal periods of economic growth, like stocks and cryptocurrencies, will be riskier in a recession. If you must invest in risky assets, consider investing for the long term, so you don't lose money because you are forced to sell when the markets are down.

Diversify your portfolio

“Diversification is protection against ignorance, it makes little sense if you know what you're doing" - Warren Buffett

Risky assets suffer more during recessions. While lower-risk assets like bonds tend to offer low returns, they don't perform as poorly as riskier assets like stocks in the short term. Commodities tend to perform better in the short term than most other asset classes during recessions.

Exposure to a diverse pool of assets can reduce the losses you suffer during a recession. Consider diversified exchange-traded funds or mutual funds to get diversification benefits.

Final Thoughts

While the US has recorded 2 quarters of negative growth, it hasn't met the NBER's definition of a significant decline in economic activity spread across the economy because unemployment, sales, and consumer sentiment have been holding up or improving recently.

Recessions are a normal part of the market cycle. Most countries have experienced a few in their lifetime. According to the NBER, the US has experienced 33 recessions since 1857. The UK had one in 2020.

Recessions give markets a reset from euphoria. And recessions may not last for long. For example, the average US recession lasts for 11 months. If US inflation continues on the downtrend it's currently on, they might have a short recession or avoid one completely.