Recession. It's either the most dreaded or most loved word for investors. For some, it means being able to buy stocks at a great discount. For others, it could mean financial instability and job layoffs. Either way, a recession is filled with both high opportunities and high risks.
Learning about what recessions are can help you prepare for them, and navigate the volatile terrain. What are recessions and why do recessions happen? Will a recession occur in 2020? Let's find out.
What are recessions?
Recessions are generally defined as a period of a slowdown in economic growth or a decline in economic output. This sounds rather tame - but when this occurs on a global scale, the results can be disastrous.
When economic growth slows down, this means that companies aren't making enough money. With the reduced income, their short term liabilities will start to overshadow their assets, causing companies to be unable to pay off their obligations. As such, they would start to cut expenses to preserve their capital, resulting in mass layoffs.
This in turn causes the overall spending power of the population to go down due to people losing their jobs. With people spending less money, the economy has less money circulating in it to fuel growth. As such, goods and services will drop in prices due to decreased demand, resulting in even less income to companies.
With not enough money in companies, and not enough money in the population, the entire economy stagnates and beings to fall apart. Investors, companies and individuals all begin to lose confidence in the economy. Bonds, stocks and real estate start to drop rapidly in value. Companies struggle to have the liquidity to continue operations, filing for bankruptcy.
Recessions are terrifying. But how does a recession even happen? There's no singular reason but often the combination of multiple financial faults that simultaneously decide to manifest themselves together. Let us examine a few global recessions in the past to find out what happened.
The great depression (1930)
As the name suggests, this recession is the longest, deepest and most widespread recession in the 20th century. In fact, international trade worldwide fell by more than 50%, and unemployment rates globally rose as high as 33%. It was so bad that the worldwide gross domestic product or GDP (the monetary value of all goods and services produced) fell by an estimated 15%.
The world's total GDP now is approximately $90.5 trillion dollars. Imagine $13.5 trillion dollars being wiped out in the span of a few months!
To trace the cause of the great depression, we must first return to 1918, to the end of World War I. In post war America, industries flourished. Market optimism was high and the future of America seemed unshakable. In fact, the president at the time, Herbert Hoover was so confident that he stated:
United States would soon see the day when poverty was eliminated.
This period was known as "the roaring twenties". From 1920 to 1929, the U.S. economy expanded rapidly. In fact, the U.S. economy more than doubled during this period.
Due to the extreme bull market, investors had a rosy outlook on the future. As such, companies became overvalued for their "expected future growth" and investors all bought in, excited at the growth prospects. This created an overbought market, with sky high valuations for companies.
In light of this expectation of growth, creditors were willing to lend out debt at low interest rates, confident in the outlook of companies and individuals in the future. In fact, brokerages had a margin rate of only 10%, meaning that brokerages would lend you 9x the amount of money you had in your account. Today, the law stipulates a minimum margin of 50%, meaning you must have at least half the amount of money in your account for a trade to go through.
All this lending resulted in a total debt to GDP level in the U.S. of nearly 300% before the crash.
Companies and real estates rapidly expanded, confident in the future. Countless houses were built all over the place. Companies borrowed and scaled up operations. Everything seemed great. But no good news lasts forever.
Around 1925, a housing bubble burst in the U.S. There were around 25% more houses being built than the demand for real estate. Even so, sentiments remained high.
While companies yielded all time high profits, wages increased slowly, resulting in a widening income gap in the population. Due to the rapid expansion, consumer demand could no longer keep up with the growth of companies supply. As a result, consumer spending began to slow, and unsold goods began to increase.
Without the unceasing growth driving the companies, income fell dramatically and further expansion was no longer possible. Thus, many companies moved to protect their existing capital rather than invest in scaling up production or expansion.
With the bleak growth outlook, investors confidence waned. The overvalued stock prices, once deemed appropriate, were now being discarded as if they were taboo. On Thursday, October 1929, the stock market crashed spectacularly in an event known as "Black Thursday."
As millions of shares went from stratospheric valuations to being worthless, brokerages hurried to call back on margin loans, but they could not be paid back. The same went for banks. Countless debts were defaulted, resulting in huge losses to banks who themselves could not pay for their own obligations any longer.
Over the course of the next few weeks, the confidence in the economy fell apart completely. Many "bank runs" occurred as people withdrew their all their money from banks in fear that they would collapse. This exacerbated the situation as banks began to fail due to lack of capital. In total, 9000 banks failed during the 1930s.
Companies, in a bid to remain standing, began to conduct mass layoffs to reduce operating costs. This resulted in widespread unemployment, leading to even lower spending. The lack of income and profits caused even more debts to remain unpaid.
Prices of goods and services began to plummet due to the decreased spending and demand. This deflation increased the value of the dollar, which in turn caused outstanding debt to be "worth more" and thus even harder to repay. This self-feeding cycle resulted in the recession worsening into the great depression.
At that point of time, the entire world's economy was valued against the value of gold, something known as the "gold standard". Due to the U.S.'s economy collapsing, individuals began to hoard gold obsessively, causing the entire world's economy to fall as gold went into short supply. This caused a global economic collapse.
All in all, nearly 15 million people in the U.S. alone became unemployed, roughly 20% of the population at the time. It wasn't until 1932, when Franklin D. Roosevelt took over presidency that many governmental financial reforms were introduced to correct and prevent the situation from occurring in the future.
The great recession (2009)
Now that we have examined the causes of the great depression, let us look at the great recession, which occurred in a timeline closer to us. This recession was the most severe global recession since the great depression. Although the effects didn't even come close to the great depression, it's known as the second worst recession of all time.
It starts back in the early 2000s, from... you guessed it, the U.S. again. After all, as the world's largest economy, if the U.S.'s economy doesn't fall, it can't really be called a global recession, can it?
Following the wake of a 2001 recession and the 9-11 terrorist attacks, the U.S. government reduced interest rates to an extremely low level (1%) to stimulate the economy. This allowed businesses to borrow more money and use this leverage to grow again. But it also resulted in some side effects.
There was a burgeoning growth in something called the "shadow banking system". In essence, many non-bank financial institutions were performing functions akin to banks, except without being under the regulation of government policies.
What the shadow banking system did was provide an extra avenue for people to get credit. They did this by circumventing much of the financial restrictions imposed on proper financial institutions, allowing for otherwise unqualified people to take on loans as well. Some examples of this include peer to peer lending or mortgage lending, which are unregulated. This allowed for shadow banks to take on riskier credit loans without the required capital needs in hopes of higher returns.
Why were shadow banking allowed to exist? They provided extra liquidity and a way for traditional banks to shift their riskier investments off their balance sheets and off regulation. In this manner, financial institutions could pursue riskier investments without having the capital needs for them.
The shadow banking system was allowed to grow by the government. As a result, it rapidly expanded and even matched the actual banking system by financial institutions in scale and value.
At the same time, a housing bubble was forming in the U.S. Due to the low interest rates, many individuals and institutions took up loans to finance their investments. Many home owners were able to finance their purchase using mortgage even if they were actually unqualified for such a loan amount. This was partly due to the low interest rates at that time, which allowed greater confidence in loan repayment, as well as other avenues for loaning such as the shadow banking system.
This resulted in two outcomes. First, it allowed many people to buy a home that they would otherwise not be able to afford. Secondly, as a result of a large demand for real estate, housing prices were pushed up to high valuations and overpriced.
This allowance was a fatal mistake. At the start, many home owners signed up for mortgage loans fixed at the low interest rate. However, as the fix rate terms ended, loans reverted back to their regular interest rates, now pushed up by the economy. The large increase in interest rates meant that home owners could not afford to pay back their loans due to the large amount they had borrowed originally.
By 2007, large amounts of home owners began to default on their mortgage loans. Even when their properties were repossessed, due to the overvaluation, property values had fell from their sky high valuations to basically nothing. As more and more people began to default on their loans, the housing bubble burst in full force.
At this time, shadow banks which lent out much of the money, were in dire straits. As financial institutions made use of these shadow banks to fund their risky investments, much of the investments were tied up in illiquid assets. With the large amount of defaulters, these shadow banks quickly found themselves without the liquid capital to cope, resulting in shadow bank runs.
This disrupted the credit market for companies, individuals and financial institutions alike. Banks like Lehman Brothers, which had assets of $680 billion with only $22.5 billion of firm capital, found themselves unable to deal with the mortgage defaults as they had over leveraged themselves (taken on too much debt) using these shadow banks. They went bankrupt in 2008.
In the wider economy, as housing prices came crashing down, wealth generated by owning property fell as well. This resulted in consumer spending slowing, causing a recession. Additionally, as many people took on loans when the interest rates were low, when the crisis revealed itself, most households focused on saving to pay down their debt instead of spending into the economy. This further exacerbated the economic crisis.
Banks, particularly in U.S. and Europe bore the brunt of the impact, having heavily invested into mortgage-backed securities that were now being defaulted left and right. Several banks collapsed or had to be bailed out by governments and taxpayers money.
All in all, an estimated $19 trillion of net worth were lost due to the stock market crash, and the U.S. alone had 8.7 million people fall into unemployment.
Factors causing a recession
Now that we've examined what caused the two largest recessions in financial history, let us pick out some of the key factors that caused them.
- An optimistic outlook leading to an overvalued economy
Generally, something in the economy (or the entire economy) is being overvalued. This could be due to a high confidence in the industry's growth in the future, or simply government measures to boost confidence in the economy. This phenomenon is what makes markets crash, since it's being held up by investors confidence alone.
- A high percentage of debt or leverage
This occurs, usually simultaneously, with the point above. When the economy is doing well, companies and individuals tend to take on more debt to grow their wealth aggressively. This is great in a bull market - not so much when everything crashes and you suddenly find yourself being unable to meet your liabilities.
- A limit or breaking point
This is the final spark that kicks off a recession. It could be income inequality and slowing economical spending during the great depression, or the housing bubble bursting and over leveraged risky loans in the great recession. Either way, something had to give to cause investors confidence to swing to fear, causing a drop in economic spending, which in turn causes all the other effects of a recession like falling stock prices and an economic downturn.
Will there be a recession in 2020?
Here we are, back at the question again. The short answer: Yes. It does seem extremely likely that a recession is in order. Let us look at the three factors we have identified above and link it to the economic situation in 2020.
An optimistic outlook: Up till 2020, the stock market has been in the longest bull run in history. From March 9, 2009 to March 11, 2020, the market has been steadily increasing for 11 consecutive years. In fact, in 2019 alone, investors confidence was so pronounced that most stocks experienced an immense growth despite bleaker economic outlook. The S&P 500 even grew by 29%! This all pointed at a singular conclusion - the market was being heavily, heavily overvalued. In fact, famed investor Warren Buffet sat on $129 billion in cash, stating that:
Prices are sky-high for businesses possessing decent long-term prospects.
High percentage of debt: According to the International Monetary Fund, global debt is high compared to historical standards. Public debt is higher than 2008 (before the last recession) in around 90% of advanced economies. In particular, corporate debt in the U.S has reached a record peak in 2018. This level of debt is not good. If debt continues to increase dramatically, sooner or later the general population and industries will choose to reduce their debt (saving) instead of funding expansion and growth (spending). This will result in an economic slowdown, leading to a recession.
The breaking point: We all know what the breaking point is. The coronavirus outbreak in 2020. This virus is spreading across the world, shutting down production and reducing incomes of business dramatically as shops, events and large congregations such as shopping streets are all closing. You can read our article about the coronavirus to find out more. As businesses' incomes start to plummet due to lack of sales and the stoppage of operations, the high level of debt and overvaluations will come crashing down. This will fuel investors fears, causing stock markets to crash spectacularly. In fact, this is already happening.
Investors now are reacting with extreme fear due to the uncertainty of the markets and falling financials of many companies. As a result, stock prices and indexes are falling across the board, losing their valuations quickly. If the outbreak continues on, which it will for at least a year, the economic impact it brings will ensure that a recession will happen in 2020.
With all these factors considered, it is almost inevitable that the stock market will have a recession in 2020. It's just a matter of how large the economic fallout will be. Will the virus be contained? If it is, then we should see gradual improvements in a year or less. If the virus continues unchecked, or if the fallout lasts longer, than we can expect a long recession ahead of us.
Summarizing the recession cycle
Recessions are predicted to occur every 9-10 years. That's why the bull market that was 11 years long was kind of a red herring to investors. Why is there such a thing as a recession cycle?
As we have examined, recessions tend to start from the same source - reduced spending. When investors lose confidence and the general economy loses confidence, people spend less and save more. This usually occurs at a point of economic growth so high that it cannot be sustained any longer.
After all, at some point, the amount that people spend simply cannot keep up with the amount of spending required for continuous growth. This is especially true if the economy is perpetually overvalued, with higher and higher expectations of growth every quarter.
Eventually, this disparity of growth and spending will reach a tipping point - causing a recession. Thereafter, the economy quietens down to a low as overvalued stocks come back down, and then spending picks up again as the economy recovers.
This is what is known as the recession cycle. We are clearly now at the peak in 2020 and with the coronavirus, the tipping point has probably been hit. With investors at maximum fear, we are now primed for a ride back down low.
For investors and economists, this is an invaluable learning opportunity as a recession caused by a pandemic is indeed rare. Hold on to your stocks and cash, get ready to buy on the low, and keep learning as an investor.
As always, please comment down below your thoughts on this article. I would love to read them!
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