Explainer: What is a recession?

As more commentators talk about a potential recession, investors should understand what a recession is, how common they are, and why it is important to remember that not every recession leads to a crisis.

Factors leading to a recession

The output of an economy usually increases over time. However, growth in output fluctuates, forming a ‘business cycle’ in which there are peaks and troughs in activity.

The “contraction” phase of the business cycle is where recessions form. In this period households demand fewer goods and services, businesses reduce the number of workers they employ, and growth in wages and prices slows.

What constitutes a recession is a nebulous concept. Generally, two straight quarters of real GDP contracting meets the classic “technical” definition. This is what is normally found in textbooks and quoted by the media.

But these contractions could be a very modest 0.1 per cent and/or driven by volatile external forces like inventories or trade, with the labour market not showing any strains. This is hardly recessionary.

Equally, there could be periods where GDP is propped up by a growing population or export volumes, and yet unemployment rises and there are hardships on households and businesses because private demand is weak.

However, because GDP swings from negative to positive the classic definition isn’t met. This is what happened in Australia in 2015/16.

In the US, the National Bureau of Economic Research makes the call and dates the business cycle based on a “significant decline in activity spread across the economy”.

Arguably, this is a better way of doing things as it considers a wide range of factors, especially with regards to the labour market.

True recessions are periods where there is a sustained period of subdued or negative GDP, and this leads to job losses, a jump up in unemployment, increased bankruptcies, and weaker corporate profits.

Historical recessions

Mention the word recession and memories of COVID or the global financial crisis (GFC) are stirred up as this was the last lived experience. This is human behaviour, but what is quickly forgotten is these weren’t ‘typical’ downturns.

Unlike Australia, US business cycles are shorter, and recessions occur regularly.

Since WWII the US has averaged a recession around every 5 years. And old-fashioned ones triggered by the Federal Reserve (Fed) tightening too much because the economy was overheating, have been common but also far less destructive. Of the 12 business cycles since WWII, eight were ended by Fed ‘over tightening’.

Recessions are clearly painful for those directly impacted. But it must be remembered that not every recession leads to a crisis ― and context is important.

• The GFC was an implosion of the housing market and banking system, and households undertook significant deleveraging.
• The Tech bubble was more isolated, but it had larger earnings and wealth effects.
• COVID was engineered by government-mandated lockdowns but had a significant and fast policy response.

Context for the current environment

Relative to how things were placed ahead of previous US recessions, the underlying fundamentals now look better, and systemic stress points are less obvious.

US consumer and business balance sheets are in solid shape. A large stock of excess savings has been accumulated, private sector leverage is lower, lending standards have been higher, banks are well capitalised, and the starting point for the labour market is historically strong.

Although we think the US will experience a recession on the back of an extended period of ‘restrictive’ Fed policy settings, we believe the odds of a ‘deep’ one due to a crisis are low.

However, at the same time, the fundamental offsets mentioned, combined with the monetary and fiscal policy response constraints imposed by high inflation and divided US politics ― and the time it will take for the very tight labour market to correct and for inflation to then come down ― suggest this upcoming recession could be shallower but take longer to fully unfold.

Tackling inflation, which has become much more than just a supply-chain goods issue, remains the US Fed’s focus. From a risk management perspective, central banks understand that the long-term benefits of bringing down inflation outweigh the short term hit to growth. This is the price that needs to be paid to tame inflation.

Markets on the other hand may be too short-sighted to the challenges that exist. This is the first tightening cycle in 40 years when the Fed is battling inflation, so this is the first cycle where avoiding recession is not the highest priority.

Conditions will continue to change, and investors are encouraged to stay close to their adviser.