An economic recession can be an anxious time for many households and businesses. While recessions are an expected part of the business cycle, it is difficult to predict exactly when one will hit. Being proactive and preparing in advance can help mitigate the risks associated with an economic downturn. This guide covers what a recession is, signs pointing to a looming recession, how to ready your personal finances, and strategies to protect your money should a recession come to pass.
What is a Recession and How Common Are They?
A recession refers to a contraction in economic activity that lasts for at least two consecutive quarters or 6 months. It is indicated by a decline in key economic metrics like GDP, employment, retail sales, and manufacturing activity.
The National Bureau of Economic Research (NBER) is the official arbiter of recessions in the United States. They use monthly data on employment, personal income, industrial production, and sales to determine peaks and troughs in the business cycle.
Recessions occur frequently as part of the normal ups and downs of the economy. Since 1945, there have been 11 recessions in the United States that have lasted about 10 months on average. The Great Recession from 2007-2009 was the longest at 18 months.
Recent data from 2023 suggests another recession could be on the horizon. GDP declined 0.9% in Q2 and 0.6% in Q3 of 2022. The Fed forecasts near zero GDP growth of 0.2% in Q4 2022. Meanwhile, inflation hit a 40-year high in June 2022 at 9.1% and has remained persistently high above 6% into early 2023.
Signs That Point to an Impending Recession
There are a few key indicators that typically foreshadow a looming recession:
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Inverted yield curve – This refers to when long-term interest rates fall below short-term rates. The yield curve inverted in mid-2022 and has predicted past recessions.
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Falling GDP – When GDP growth slows for two consecutive quarters or more, it signals declining economic activity and points to a likely recession. GDP fell for two straight quarters in 2022.
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Rising unemployment – As spending slows, businesses cut back on hiring and lay off workers. The unemployment rate rose to 3.7% by October 2022, its highest level since February. In January 2023, unemployment ticked up to 4.0%.
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Declining retail sales – When consumer spending drops significantly, it suggests people are pulling back financially and correlates with recessions. Retail sales fell 0.6% in December 2022.
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Bear stock market – A drop of 20% or more in stock prices indicates an ongoing bear market. In 2022, the S&P 500, Dow Jones, and Nasdaq entered bear market territory, declining over 20% from their highs.
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Plunging consumer confidence – Polls showing consumers are pessimistic about the economy’s future outlook hints that a recession may be imminent. Consumer confidence hit a 10-year low in June 2022.
How to Ready Your Finances Before a Recession
When signs point to a looming economic downturn, making some proactive money moves can help brace your finances:
Review Your Budget
Analyze your income and expenses to look for areas to save, then make cuts where possible to non-essential spending. Sticking to a frugal budget during a recession is key.
Pay Down Debt
Work on paying off credit cards, loans, and other high-interest debt to improve your cash flow. Having less debt obligations provides greater financial flexibility.
Boost Your Emergency Savings
Ideally, you should have 3-6 months’ worth of living expenses set aside in a savings account. Emergency funds help tide you over if you lose your job.
Diversify Investments
Ensure your investment portfolio is well-diversified across stocks, bonds, real estate, and cash. Diversification helps limit losses when markets decline.
Strategies to Mitigate Risk During a Recession
Once in a recession, applying protective money strategies can help you weather the economic storms:
Invest in “Recession-Resistant” Stocks
Look to consumer staples (WMT, PG, KO), healthcare (JNJ, PFE, UNH), and utilities (SO, DUK, NEE) stocks which tend to be more insulated from downturns. Their dividends also provide ongoing income. You can also used advance strategies like Michael Burry as mentioned in my article here.
Maintain Safe Haven Investments
Park some money in assets like cash, gold, U.S. Treasuries, and the Swiss franc which offer relative safety in their price stability. The price of gold rose over 8% in 2022 amid stock market volatility.
Create Multiple Income Streams
Bring in side income through a small business, monetizing a hobby, renting out unused space, or via gig economy apps to offset potential job loss. The number of small business applications jumped dramatically in 2022.
Reduce Expenses
Cut back discretionary spending on dining out, entertainment, vacations, and other non-essentials. Downsize your home if the mortgage is too burdensome. Mortgage rates climbed above 7% in 2022 leading to an affordability crisis.
Network and Upskill
Connect with professionals in your industry and keep your skills sharp. This helps ensure you are attractive to employers if you need a new job. The quits rate remains elevated showing workers still have bargaining power.
Conclusion and Key Takeaways
While challenging, recessions are a natural part of economic cycles. Staying vigilant to signs of a downturn and taking preventive measures can help you manage the risks. Key steps include saving aggressively, minimizing debt, diversifying assets, having adequate insurance, and controlling costs. With the right defensive posture, your finances can remain healthy even through periods of recession.