Lesson 11: Recession

02:00, 01 January 1970

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There’s no such thing as a “recession-proof” investment, but some types of stocks, funds and strategies could help your portfolio better weather a downturn or even economic crisis. However, the most effective way to manage your money in a recession can depend on several factors, including your risk tolerance and time horizon. 

There is quite a bit you should know before you dive in. If you want to trade and invest in a recession right away, here is a quick guide that can help: 

  • Open a CFD trading account if you want to hedge your risk or seize opportunities in falling markets (going short).   
  • Open an Invest Account if you want to buy defensive stocks or to invest the same amount constantly whether the market is trending up or down. 

 

Learn more about recessions – what they are, what causes them, how they affect the economy and, most importantly, what you can do to protect your investments. 

What is a recession? 

A recession is a period that a country, region, or the world is shrinking rather than growing. It is generally accepted that a country has entered a recession if an economy contract for two consecutive quarters, measured primarily by gross domestic product (GDP). 

Although recessions can have drastic effects on the economy, they are a necessary part of the business cycle: economies expand until they reach a peak, and then contract until they hit a trough before expanding once again, and so on. A country is in recession when it is going from the peak to the trough. 

Recessions may cause wild swings as stocks tend to be rather unstable, representing opportunities for traders and investors who are aware of the risks. 

Recession vs Economic Crisis 

An economic crisis represents a situation in which the economy of a country passes through a sudden decrease in its force, a decrease usually brought about by a financial crisis. The economic crisis may have the shape of a stagflation, a recession, or of an economic depression. 

Financial crises almost always lead to recessions, but not all recessions lead to financial crises. A fall in bond values, house prices, stocks, or currency markets do not by themselves create a crisis. 

Recession vs Depression 

An economic depression is a period of sustained, long-term downturn in economic activity in one or more economies. It is a more severe economic downturn than a recession, which is a slowdown in economic activity over the course of a normal business cycle. 

Depression is a more severe downturn that lasts for years. There's been only one depression in U.S. history: the Great Depression. It lasted a decade. 

What causes an economic recession? 

A recession can be sparked by any single area of the economy collapsing and creating a domino effect that starts to spread to other areas. A housing bubble could cripple the banks, which then struggle to serve businesses and customers, many of which would lose their homes, leading to a wider meltdown.

A lengthy oil crisis could push prices up and bring major industries to a halt, leading to job cuts that start to force large amounts of people to tighten their belts.  

Lenders could be too liberal with their lending when economic times are good only to be left out of pocket when times get tough, saddling people with large debts at a time when they might be losing their job or taking a pay cut.  

An economy is an amalgamation of multiple things – how many and what type of jobs are on offer, the state of the housing and construction market, how manufacturing is performing, and so on – and they are all heavily interlinked, so if one collapses then the entire economy is under threat. 

Key indicators and signs of a recession 

The fact there are so many ways a recession can start means there are several macroeconomic indicators that one could be on the way. Some indicators tend to raise the red flag before others. For example, sales tend to fall before a business sacks workers, meaning a decline in retail or wholesale sales is likely to be followed by a rise in unemployment. These are known as ‘lagging indicators’. 

Some of the key indicators of a recession are: 

GDP 

If economic growth has slowed, usually to below 2%, then this is regarded as a possible precursor to a recession. If GDP falls in one quarter but then rebounds the following quarter, then a country has technically avoided a recession, but it also suggests two consecutive periods of contracting GDP (ie a recession) could be more likely soon. 

Inflation and interest rates 

One of the key indicators of a recession is inflation, and how central banks respond to it using interest rates. Inflation measures what rate at the general price of goods and services is rising – and therefore the day-to-day costs of living.  

Some inflation is regarded as integral to an economy’s health, but if inflation rises too much too quickly then it can quickly cripple every aspect of the economy. Everything ends up becoming more expensive: consumers see the price of their weekly shop increase and businesses can see their production and energy costs increase. Debt becomes harder to service and the economy must tighten its belt as a result.  

Inflation will rise in the lead-up to a recession, but this will decrease (or deflate) during the actual recession itself. 

Manufacturing 

GDP represents the value of everything that is made in a country, so the manufacturing sector, as the producer of goods, makes a huge contribution. In most major economies, this is measured by some form of manufacturing purchasing managers index (PMI) or another similar piece of data. Importantly, these PMIs are usually calculated more often than quarterly GDP, often monthly, which means a decline in manufacturing can be seen before it begins to feed through to GDP. This means manufacturing PMIs can indicate a potential drop in future GDP. 

Retail/wholesale sales 

Similarly, a decline in the number of goods being purchased by businesses and people can also be a sign that the economy is slowing and heading for a recession. Wholesale sales represent the amount of goods being purchased by businesses, usually with the intention of selling them on to consumers through retail sales. If businesses start to buy less at a wholesale level, then this should eventually feed through to a drop in retail sales, which again are usually calculated more often (monthly) than GDP – helping them act as an indicator.

What are the effects of a recession? 

It's easy to go wrong during a recession if you forget or don't understand how certain investments perform during a downturn and how they are related. 

Stock prices often fall months before a recession begins, which also means that they often bounce back up before the recession is declared over. You can miss an entire downturn if you only follow the news. That is why it is vital to know the signs of a recession and recovery and how assets perform during those periods: 

Stocks 

 

Stock markets, unsurprisingly, suffer during a recession. If the economy is struggling, then businesses are struggling, and this hurts valuations. Publicly listed companies, under the scrutiny of investors, turn their attention to cutting costs and focus on efficiencies to improve profitability to offset any slump in sales. Growth stocks, especially profitless companies that are tied to high growth prospects, do worse during recessions. 

Prices for stocks tend to fall before the downturn begins and almost always before a recession is called. If you're trying to make use of lower prices, you'll likely benefit most if you buy before the recession starts or during its early phase. Also, stocks that pay cash dividends can provide income, which can help offset some market losses in your portfolio. 

Bonds 

 
Prices for bonds tend to rise during a recession. Bonds are less popular when the economy is doing well because investors are willing to seek higher returns even if it comes with more risk. But the stable returns offered by government bonds become more enticing as the returns on things like equities begins to fall as an economic downturn starts to take hold, and they can act as a refuge for investors much like gold. 

Real estate  

 

Home prices tend to increase when the economy is growing and decline during recessions. Owning a rental property can provide owners with a steady monthly income from tenants even in recessionary periods.  

However, there is an opportunity for those willing to buy during downturns. Many people are forced to sell their homes at discounts if they experience financial difficulty, which can present an opportunity for others to swoop in. Investors can gain exposure to this without directly investing in property, through the likes of a real estate investment trust (REIT). 

Commodities 

 
Different groups of commodities have different drivers. Most metals are used to build things, such as houses or electronics. Energy commodities like oil and gas are used to power buildings, machinery, and transportation. Agricultural goods are mostly consumed as food. While things like construction and the number of new technological products being launched can fall during a recession, people still need food and energy. 

High oil prices have contributed to previous recessions, pushing the energy bills for businesses and squeezing the purses of consumers by raising the cost of their energy and petrol bills. 

Most investors see gold as a safe-haven asset during a bear market. The price of gold often rises as markets plunge. Investors begin buying stocks again when things are looking up and sell their gold. That pulls gold prices back down again in another mass sell-off.  

Currencies 

 

The effect of a recession on the forex market is much more complex – but an area ripe for the taking. It really depends on where the recession is happening, whether it is in one major nation or in a bloc of countries that, in terms of trade and finance, are heavily intertwined – like the eurozone. Currencies always trade in pairs, meaning one must go up if another is to go down, creating opportunities for traders. 

How to trade and invest in a recession 

During a recession or economic downturn, where to invest your money can be both challenging and stressful. Certain investments, such as stocks, can be riskier in a down market. However, you might be able to achieve stable returns in a recession if you follow these basic and timeless strategies. 

  • Hedge your risk 
  • Go short to seize the opportunity in falling markets
  • Rebalance your portfolio
  • Use Dollar Cost Averaging
  • Go long as the market recovers 

Hedge your risk 

Traders might consider using a hedging strategy to manage risk in a recessionary environment. 

A hedging strategy includes the use of more than one asset in its formation. For example, an investor who has an underlying portfolio of blue-chip stocks listed on the New York Stock Exchange might consider trading the Dow Jones index to hedge or protect their portfolio. 

If the investment portfolio had a total value of $100,000 then the investor could take a short position of equal size on the US30 index. 

If the broader market fell, the loss in value of these blue-chip stocks should be at least partially offset by the gains from the short position on the index. The use of an index to protect or hedge a portfolio will often be a more cost-effective solution to the alternative cost of liquidating the entire equity position. 

Sector indices can also be used to hedge sector-specific stocks. For example, a banking index could be traded against a portfolio of banking stocks, and a resource index could be used to hedge against a portfolio of mining stocks. 

Many people will use CFDs in a hedging strategy because losses can be offset against profits for tax purposes. 

Go short to seize the opportunity in falling markets 

Shorting is a way to seize opportunities in markets that are falling. Many traders will use financial derivatives like CFDs to go short. These enable you to take a speculative position on an asset’s price movements without having to take direct ownership of the asset. 

So, let’s say for the purpose of this example that we’re in a recession. You’ve identified some companies that might not be able to weather the storm, and you think their share price will suffer. As a result, you decide to open a short position on that company’s shares – which will make a profit if the share price drops. If the share price rise you will suffer a loss. 

Rebalance your portfolio 

Recessions will impact different stocks differently, depending on the type of company you’re looking to trade. Some companies will remain stable during a recession, like utility companies, healthcare companies, and consumer staples companies. Others tend to underperform, and their value will drop, including travel companies, and industrials. 

  • Utility companies: Utilities provide services to nearly every home and business, supplying them with electricity, natural gas, and water. These heavily regulated companies are among the largest and most stable equity investments available in the stock market. Some of the most recession resilient are NextEra ENERGY, E.on, Enel, Engie, and Iberdrola. 
  • Healthcare companies: Healthcare stocks belong to companies that develop pharmaceuticals, manufacture medical devices, or provide medical care or health insurance. Some of the most recession resilient are UnitedHealth Group, Pfizer, Astra Zeneca, Sanofi, Roche, and BioNTech. 
  • Consumer staples companies: Consumer staples are the basic goods that people buy to support their everyday lives. Companies in this industry manufacture, distribute, and sell products like food, beverages, and personal hygiene products, which are typically less sensitive to economic cycles. Some of the most recession resilient are How to buy BioNTech stock & shares to invest in BNTX | CAPEX.com, Procter & Gamble, Nestle, Altria, PepsiCo, Estee Lauder, or British American Tobacco. 

There are also utilities ETFs like Utilities Select Sector SPDR Fund, healthcare ETFs like Health Care Select Sector SPDR Fund, or consumer staples ETFs like Consumer Staples Select Sector SPDR Fund available for investors. See our range of ETFs here. 

Other sectors, usually those which will underperform during a recession, will perform well in a post-recession recovery. Examples include financials, real estate, consumer discretionary, industrials and materials. 

Use Dollar Cost Averaging 

Dollar-cost averaging is an investing strategy where you buy a fixed amount of an investment on a regular basis, regardless of the current price. 

Recessions are great opportunities to use a dollar-cost averaging approach because you’ll buy shares as the price declines. You can dollar cost average with new money or simply set your dividends to automatically reinvest in the security, which would serve the same purpose. 

Go long as the markets recover 

Buying shares of stocks or going long using derivatives during a recession can be risky, especially if you time it too soon and the market falls even more. What many traders and investors will do is wait for the initial rebound, when many stocks will be at their lowest point for several years. Then they’ll buy at this level, in the hopes of reaping the maximum reward from the eventual post-recession recovery. 

You can go long with CFDs, just as you can use them to go short. Or you can try to profit from a post-recession recovery by investing directly in a company’s shares. This will make you a shareholder, eligible to receive voting rights and dividends if the company pays them. 

Create a trading account to trade with CFDs or open a share dealing account to start investing. 

The Bottom Line 

Certain investments have performed in similar ways during recessions of the past. However, no one can predict what will happen in the market in the near term. Stock prices can suffer a large fall over one month, then rise again the next month, only to fall again a month later. 

Since no one can predict what the stock market will do and how people will react in the short term, it's wise to commit to your investment strategy during a market recession or even economic crisis so you can participate in the recovery. 

Free resources 

Before you start investing and trading during a downturn, you should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader or make more-informed investment decisions. 

Our demo account is a suitable place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for stock investors who are looking to make a transition to leveraged trading. 

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