What is a recession and how is it defined?
The word "recession" can be unsettling for many, even though they can be a normal part of an economic cycle. Let's explore what the term recession means.
It's a word many investors may prefer to do without, even though recessions can be a normal part of an economic cycle. This can be especially true if you are new to investing and have questions about investing during a recession. What does it mean when an economy is in recession? More importantly, what can you do as an investor to help you prepare for a recession?
As defined by Beata Caranci, chief economist at TD, the most basic definition of recession is two consecutive quarters where the economy contracts, which usually equates to a reduction in gross domestic product (GDP). A recession can vary in length, however, it typically ranges between two and four quarters.
It can help to see a recession a bit like a thunderstorm. They're not that much fun while they last, but given time, they always pass.
Early signs of Recession
Historically speaking, there are several key warning signs that typically precede a recessionary period. Although none of these indicators on their own can determine the inevitability of a recession, taken together they help paint a picture.
- Decline in consumer confidence: In a volatile economy, consumer confidence typically becomes shaky. This may be the result of a variety of contributing factors, but the key ones are often: high inflation, rising interest rates, layoffs and a general sense of economic uncertainty. When consumer confidence declines, spending slows and the economy follows suit.
- Sudden declines in the stock market: Whenever consumer spending is slowing, corporate profits may also be falling. This can lead to a decline in investor confidence, which can cause stock prices to fall. As stock prices soften, investor concern may grow, prompting further stock sell-offs.
- Layoffs: Layoffs are both a consequence and an indicator of economic decline. As companies tighten their belts in response to lower consumer spending and economic volatility, employment is often negatively affected. Similarly, when people lose their jobs, they slow their spending as much as possible to make up for their loss of wages.
- Inverted yield curve: In a typical non-recessionary economy, the yields (or interest paid) on long-term government bonds are generally higher than those on short-term bonds. This is because investors expect to be compensated for additional risk when purchasing longer-term bonds. When investors become pessimistic about the near-term outlook for the economy, they expect higher yields for shorter-term bonds versus longer-term bonds. This causes the yield curve to flip. This observed pessimism among investors can often be a precursor to a recession.
What can causes a recession?
Unfortunately, there's no simple answer to this question. A variety of economic events can lead up to and contribute to a recession, and they aren't always well understood. Some of the most common recession instigators include:
- Unexpected economic events: An unexpected shock to the economy can increase the likelihood of a recession, and the shock doesn't have to be economic in nature to make an impact. In March 2020, for example, the COVID-19 pandemic led to a brief recession,1 while an oil crisis led to a more prolonged recession in the 1970s2. In many cases, downturns can be triggered by a combination of factors rather than a singular "shock".
- Unaffordable Debt: If debt and debt repayment become core components of our economy, what happens when that debt becomes unmanageable? When too many corporations or households hold high levels of debt, it can spark a recession, particularly if those companies or individuals start defaulting en masse.
- Asset bubbles: When certain sectors of the economy become overvalued, it creates an "asset bubble." When the bubble pops (as they often do), much of the inflated value is lost. For example, In 2021 and 2022, the global auto industry became an asset bubble, caused by a spike in consumer demand and an international chip shortage during the COVID-19 pandemic. When a critical economic sector (such as housing) grows to a bubble, the inevitable pop can lead to a recession.
- Inflation: In the U.S. and Canada, central banks typically aim for a target of 2% to 3% inflation per year. When inflation exceeds that range, the cost of living may become too high for many households to absorb. To account for the rise in expenses, many families may slow their spending. This, in turn, affects corporate bottom lines, and can lead to layoffs. In June 2022, Canada hit a high of 8.1% inflation from the same month in the previous year.
- Deflation: In contrast with inflation, deflation can also cause the economy to stall. When prices are so low that companies yield little profit and cannot support their overhead costs, stock prices can decline, layoffs or wage cuts and other events can ensue.
- High interest rates: High interest rates can cause a recession if they spike too quickly and make everyday debts like mortgages, business and other types of loans expensive to maintain. In the early 1990s, the Bank of Canada hiked interest rates to offset inflation and inadvertently contributed to the recession that followed.
What happens during a recession?
Recessions can be like a game of dominoes: When one tile tumbles into another, it can trigger another economic event.
For example, after the initial instigating economic event (or even a series of events), consumer spending may decrease. That decrease in consumer spending can lead to lower sales which, in turn, may encourage corporations to tighten their belts. That may result in layoffs for employees or cut wages. If that leads to higher unemployment, it may lead to further declines in consumer spending. All of this together can cause an economic slowdown that is often cyclical in nature.
History of recessions in Canada
1970s Recession (November 1973 – March 1975) An oil crisis was largely to blame for this recession. As the price of oil rose in the 1970s, industrial production around the world slowed, leading to job losses and economic decline. This recession was also marked by a period of "stagflation" — that is, persistently high inflation despite high unemployment and slowed economic growth.3
The Iran and Volcker Recession (January 1980 – July 1980) In 1980, a different oil crisis led to a global recession. This time, the Iranian Revolution of 1978 led to a significant decrease in oil production, which caused a significant slowdown in industrial activity and high inflation. Paul Volcker, then U.S. Fed chair attempted to combat high inflation by raising interest rates sharply.
Double-Dip Recession (July 1981 – November 1982) The 1981 and 1982 Recession was actually a tale of two recessions. The first, a smaller dip and recovery, was followed by a second longer decline. Both dips were inadvertently caused by interest rate hikes introduced by the Bank of Canada to fight inflation.4
The Gulf War Recession (July 1990 – March 1991) In the early 1990s, Canada experienced a recession that coincided with the U.S. Gulf War of 1990-1991. In truth, a variety of factors played a role, but economists often single out actions taken by central banks (including the Bank of Canada) during this time to fight inflation and a series of federal tax increases.5
Early 2000s Recession (March 2001 – November 2001) Historically, whenever the U.S. experienced a recession, Canada tended to experience one soon after. In the case of the early 2000s recession, however, this was not the case. After the September 11 terrorist attacks, the U.S. economy experienced a recession. Canada did not, although the economy did experience a downturn during this time. This may be because Canada was not directly affected by the events of 9/11, though some economists believe Canada's federal government was also more fiscally responsible in its aftermath.
The Great Recession (December 2007 – June 2009) The 2007 – 2009 recession is considered one of the worst recessionary periods for Canadians since the Great Depression in the 1930s. The economy's plummet can be attributed to a number of factors, but many economists point to an overall loosening of economic regulations, particularly in the U.S., as one of the primary causes. A proliferation of high-risk mortgage lending was one of the factors that ultimately lead to an economic free-fall that was felt deeply around the world.
The COVID-19 Recession (February 2020 – April 2020) When the COVID-19 pandemic hit in February 2020, stock markets reacted quickly and stock prices fell across the board. At the same time, governments around the world instituted strict lockdowns that crippled consumer spending and economic activity almost overnight. This recession turned out to be short-lived and the market rebounded to new highs within months after restrictions were eased and people could return to work.
Recession vs. depression?
People often conflate the idea of a potential recession with an economic depression — particularly when fears of the former abound.
It's important to understand that a recession is not the same thing as a depression. While recessions are part of a regular economic life cycle, depressions are not. If we consider economic activity to exist on a spectrum, a depression would be on the far end, while a recession might be closer to the middle. During the worst years of the 1930s Great Depression, approximately 19.3% of the Canadian workforce was unemployed. 6 Since then, unemployment levels have rarely risen beyond 7-8%, even during recessionary periods.
Recession vs. stagflation
"Stagflation" describes an economic state that is characterized by both high inflation and a persistently stagnant economy. Prior to the 1970s, it was believed that there was a direct correlation between inflation and a growing economy. After all, when inflation is high, wages and employment are often high as well. But that's not always the case. In the event of a critical supply constraint (like an oil crisis), stagflation can occur. That's what happened in the 1970s, and it can be a concern during periods when inflation is persistently high.
Like an economic depression, stagflation is a relatively rare economic event that can last for years on end. Recessions, on the other hand, are quite common and typically last less than a year.
Key things to consider during a recession
You may wonder, "How might a recession affect me?" While experiences will undoubtedly vary, a recession can often spell job losses, wage cuts and reduced portfolio value. At the same time investors who have a longer investing time horizon, a recessionary period can offer opportunities such as discount prices on stocks. It can be important to remember that recessions are temporary economic phases and any financial pain felt now may typically pass in time.
There are several key ways you can prepare for a recession to help minimize its impact on your lifestyle and savings. Here are a few of them:
- Spend a bit less (and build a budget) Spending a little less on discretionary expenses and putting off purchases on big ticket items to a future date, can help you weather an impending recession — particularly if you're able to save the extra cash. To figure out where you may be able to save, it can help to build a monthly budget to track your cashflow (i.e., counting how much money comes in and how much goes out).
- Start an emergency fund No one expects to be laid off, but it can happen to the best of us. To help offset the impact of income loss on your lifestyle, you can start contributing to an emergency fund. How much you need to save will depend on your circumstances, but one rule of thumb is to save three to six months-worth of expenses.
- Diversify income streams and investment portfolio Diversifying your income streams and/or investment portfolio to avoid putting all your eggs in one basket. A diversified portfolio may be better situated to withstand the impact of a recession on your investments versus one that is not.
- Consider staying invested So-called bear markets tend to make investors nervous. That doesn't mean you should make a knee-jerk reaction when you see the market dipping. Historically speaking, markets have rebounded even from deep downturns. Selling investments will crystallize any losses. Those who can stay invested may have the opportunity to see their portfolios rebound in the months or even years ahead. It is important to identify what works for you.
When was the last recession?
How long does a recession typically last?
Historically, most recessions have lasted between six and 10 months on average.9
Is Canada in recession?
In most cases, by the time economists have observed two consecutive quarters of GDP decline – the technical definition of recession – an economy may already be in recovery. As of November 2022, when this article was written, the Canadian economy was not in recession.
Who benefits from recession?
Recessions aren't fun for most people. Having said that, recessions can present opportunities for younger investors with long time-horizons to purchase investments they intend to hold for a long time at discounted prices.
Share this article