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Recession - What Does That Mean?

Recession - What Does That Mean?

September 15, 2022
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As we have progressed through the year, Gradient Investments’ opinion is that the probability of a recession has increased. The term recession invokes unpleasant thoughts of high unemployment, bankruptcies and business failures.  The length and depths of a recession are typically the factors that determine the amount of pain in stock and bond assets. While all recessions feel some level of pain, due to the contracting economy, a brief and shallow recession is less painful than a long and deep recession.

The exact definition of recession is not an exact science. There is no formal stop sign that pops up indicating the economy has entered a recession, so observers don’t always agree on when and if we are in a recession. What qualifies as a recession is typically determined in one of the following ways:

  • By the NBER (National Bureau of Economic Research) 1
  • Rule of thumb of two consecutive quarters of negative growth in Gross Domestic Product (GDP)

The NBER is a private, nonprofit, organization dedicated to conducting economic research. It defines a recession as a significant decline in economic activity that is spread across the economy and that lasts more than a few months. The NBER uses a few variables to determine the health of the economy such as GDP growth rate, non-farm payrolls, personal consumption expenditures (PCE), and industrial production. The NBER has not declared a recession even with economic activity slowing.  Also, the NBER actually naming a recession can be quite delayed.

The historical “rule of thumb” recession is two consecutive quarters of negative GDP growth.  By this definition, the US economy is already in recession, as GDP growth in the first quarter of 2022 was down 1.6% followed by a second quarter contraction of 0.6%. 

As a result, whether we are currently in a recession, about to enter a recession, or avoid a recession all together is a debatable point.  What is certain, however, is that economic activity has slowed in the first half of 2022.  Economic slowing has also coincided with high levels of inflation, and a US Federal Reserve is actively raising interest rates in an attempt to control inflation. This combination has created a very difficult environment for both stocks and bonds in 2022.  The selloff in the stock market, considered a forward-looking economic indicator, may indicate a possible slowdown in economic activity and the increased likelihood of a recession.

Recessions are not a yearly occurrence, but they do happen from time to time. Since 1945 there have been 13 recessions. What may surprise investors is the S&P 500 2 performance during and after recessions (seen in the chart below).  During the time of recession, the S&P 500 finished in negative territory in only 7 of the 13 years (or 54% of the time).  Another interesting fact is in years following a recession the S&P 500 finished down only three times with an average return of 16.8% per year. There was only one occurrence of a recessionary year (2001) where the S&P 500 return was negative, and the following year was also down (highlight in yellow).

So, while it is our opinion that the likelihood of a US recession is increasing, and we may possibly be there already, what we do not know is how long and how deep a recession could last.  Further, how much of these recessionary conditions are “priced in” as we have faced a difficult market already in 2022.

At Gradient Investments, we believe the label of a recession is less important than future economic activity, which we believe will determine the direction of the markets going forward. Currently the data is mixed.  Positives include healthy corporate earnings and low unemployment, while negative data points include high inflation and a slowing housing market. We will continue to monitor economic activity, and any changes in trend, to determine if adjustments are needed to our portfolios.

Finally, we believe the best way to balance prosperity and difficulty in the US economy is to have an investment plan that fits your return objectives, risk tolerance, and time horizon.  During times of potential recession, it can be easy to get overly conservative in an attempt to “wait out” the potential storm.  This is a difficult thing to do as history has shown markets typically bottom and begin to rebound before economic data improves. A diversified plan that incorporates growth and safety assets will provide some level of protection in problematic markets, but also the opportunity to grow as the economy improves.