Volume 93 No. 8 - August 2022
What is a Recession and Why Does it Matter?
The word “recession” can cause uneasiness and sometimes fear. News articles and media reports can exacerbate the potential and current impact of a recession on our daily lives. It is important to understand what a recession is and how it impacts our investment strategy.
Although they are rather straightforward to sense, recessions can be difficult to define. One of the most common methods used to define a recession uses gross domestic product (GDP) as a barometer. Simply put, GDP measures the total value of goods and services produced in one year. In times of economic growth, GDP increases, and in times of economic decline, GDP decreases. One of the most commonly accepted and widely used definitions of a recession is two consecutive quarters of negative GDP. U.S. GDP figures declined -0.9% in Q2 2022 and -1.6% in Q1 2022. By this definition, the U.S. is now technically in a recession.
When we review historical data, recent recessions have come regularly—about once every seven or eight years—and have lasted an average of eleven months. Because history gets written retrospectively, there’s a delay in marking time periods, defining generations—and declaring the signposts of economic cycles. We need historical data to determine the long-term trendline of the markets and it takes time to create, collect, and analyze that data.
Recessions impact our economy, the stock market, and our investment strategy. This month’s newsletter provides context to each of these three items.
Economy vs. Markets
It is important to note the distinction between markets and the economy. Although they are often used interchangeably, there are key distinctions between the two.
Market performance and recessions do not always correlate perfectly. Stock markets typically track investor expectations about the economy for the next twelve months, sometimes over much shorter periods. They are a predictive mechanism, often reflecting the next stage of the business cycle that investors see on the horizon. Markets typically go down in anticipation of recession and tend to rally when a recession actually begins. This time has been no different. As of August 10th, the S&P 500 has gained about 10% since the beginning of July, when Q2 GDP data was reported.
Economic expansions do not last forever. Pullbacks and slowdowns in economic growth are part of the business cycle. In contrast to the forward-looking data of the stock market, stages of economic cycles look at trailing data—and are usually not identified or confirmed until months after they begin. While markets fluctuate by the minute, economic cycles are slower moving. The data used to define economic cycles spans months and quarters, rather than daily price changes of the stock market.
Although they naturally occur as part of our economic cycle, each individual recession can begin in a variety of ways. Recessions have been caused by a financial crisis as we saw in late 2007, pandemics as we saw both in 1918 and, much more recently, during the COVID-19 pandemic, and an oil crisis combined with wartime deficit spending as we saw in the mid-1970s.
Similar to the declaration that a recession has begun, the announcement that a recession has ended often happens with a lag time that can be measured in weeks or months. Economists generally mark the beginning of a recession as the peak of the most recent expansion and declare its end at the low point, or trough, of the contraction. The difficulty with predicting when a peak and trough will occur is that we cannot know when a bottom is reached until it’s clear that we’re not there any longer.
This recession follows two recent and remarkable expansion periods, separated by the COVID-19 recession of 2020, the shortest on record. Because recessions do follow a period of economic expansion and even prosperity for many, the sharp contrast and launch into uncertain times can shock many individuals. This can come in the form of loss of employment, declining spending ability, and sinking market values in real estate, retirement accounts, and other assets that represent an individual’s or household’s wealth.
How Do We Address a Recession?
Now that we have defined what a recession is and determined that, technically, we are currently in a recession, we can discuss how this impacts our investment strategy.
The foundation of our investment strategy is two primary principles, which aim to:
· Preserve purchasing power
· Seek long-term growth
Our multi-step process is designed to endure through all stages of the business cycle:
1. Determine Business Cycle and Establish Sector Weights: The first step in our process is to determine the current stage of the business cycle. To accomplish this, we evaluate several economic data points. In the current environment, negative GDP growth is a key data point. Next, we look to the Standard & Poor’s 500 sector weightings and determine, based on the current stage of the business cycle, which sectors to overweight, underweight, or market-weight. For example, in a recession, the Consumer Staples and Health Care sectors have historically outperformed the market, while the Information Technology sector has underperformed.
2. Adjust Positions Across Sectors. Once we have established the percentage weight of each sector, we determine how many individual companies we need to populate each sector.
3. Fundamental Research. We then review companies based on our stringent criteria, which focuses on fundamental data such as strong cash flow and balance sheets, and tested management.
4. Constantly Monitor. We constantly monitor the health of the economy and its sectors, as well as the companies within our approved stock list.
The first step of our investment process is to determine the current stage of the business cycle. As a result, defining a recession is critically important. This step of the process forms the foundation of how we structure portfolios. Our disciplined investment strategy has been tested through previous economic cycles. Just as we have in previous recessions, we hold steadfast in our investment strategy. The companies we target on our approved list are high quality companies that can weather challenging economic environments.
We are here to help you navigate this economic environment. We have been here before and will be here again. Although recessions are painful, history tells us that our disciplined, long-term investment strategy positions us to navigate this environment.
Investment Counsel Inc., a Division of LaFleur & Godfrey, is a registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.