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Categories
Market Volatility
Guide to recessions: 9 things you need to know
Jared Franz
Economist
Darrell Spence
Economist

When is the next recession?


That's one of the questions we hear most often. Although a recession has seemed imminent for a while, the economic picture has become muddied as industries have weakened and recovered at different times. If we do see a broad contraction, our expectation is that it will be less severe than the 2008 global financial crisis and other more typical recessions, followed by a strong recovery.


To help you prepare for these uncertain times, we researched more than 70 years of data including the last 11 economic downturns to distill our top insights and answer key questions about recessions:


1. What is a recession?
2. What causes recessions?
3. How long do recessions last?
4. What happens to the stock market during a recession?
5. What economic indicators can warn of a recession?
6. Are we in a recession?
7. How can you position a stock portfolio for a recession?
8. How can you position a bond portfolio for a recession?
9. What are ways to prepare for a recession?
 

1. What is a recession?


A recession is commonly defined as at least two consecutive quarters of declining GDP (gross domestic product) after a period of growth, although that isn’t enough on its own. The National Bureau of Economic Research (NBER), which is responsible for business cycle dating, defines recessions as a “significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales.” In this guide, we will use NBER’s official dates.
 

2. What causes recessions?


Past recessions have occurred for many reasons, but typically are the result of economic imbalances that ultimately need to be corrected. For example, the 2008 recession was caused by excess debt in the housing market, while the 2001 contraction was caused by an asset bubble in technology stocks. An unexpected shock such as the COVID-19 pandemic, widespread enough to damage corporate profits and trigger job cuts, also can be responsible.


When unemployment rises, consumers typically reduce spending, which further pressures economic growth, company earnings and stock prices. These factors can fuel a vicious cycle that topples an economy. Although they can be painful to live through, recessions are a natural and necessary means of clearing out excesses before the next economic expansion. As Capital Group equity portfolio manager Rob Lovelace has noted, “You can’t have such a sustained period of growth without an occasional downturn to balance things out. It’s normal. It’s expected. It’s healthy.”


Go deeper:


 

3. How long do recessions last?


The good news is that recessions generally haven’t lasted very long. Our analysis of 11 cycles since 1950 shows that recessions have persisted between two and 18 months, with the average spanning about 10 months. For those directly affected by job loss or business closures, that can feel like an eternity. But investors with a long-term investment horizon would be better served looking at the full picture.


Recessions are painful, but expansions have been powerful

The area chart shows cumulative GDP growth of all 12 expansions and 11 recessions since 1950. The expansions shown have a much higher magnitude and length compared to the recessions. Expansions ranged in duration from 12 months to 127 months. GDP growth during expansions ranged from 3% to 52%. The largest expansion lasted from 1961 to 1969 and had a 52% cumulative GDP growth. Recessions ranged from two months to 18 months. The steepest recession was in 2020 when GDP fell 10%. All other recessions had a GDP loss of less than 4%. A table shows that the average expansion lasts 69 months, has 24.8% GDP growth and adds 12 million net jobs. The average recession lasts 10 months, has 2.4% negative GDP growth and eliminates 3.6 million net jobs.

Sources: Capital Group, National Bureau of Economic Research (NBER), Refinitiv Datastream. Chart data is latest available as of 6/30/24 and shown on a logarithmic scale. The expansion that began in 2020 is still considered current as of 6/30/24 and is not included in the average expansion summary statistics. Since NBER announces recession start and end months, rather than exact dates, we have used month-end dates as a proxy for calculations of jobs added. Nearest quarter-end values used for GDP growth rates. Past results are not predictive of results in future periods.

Recessions have been relatively small blips in economic history. Over the last 70 years, the U.S. has been in an official recession less than 15% of all months. Moreover, their net economic impact has been relatively small. The average expansion increased economic output by almost 25%, whereas the average recession reduced GDP by 2.4%. Equity returns can even be positive over the full length of a contraction since some of the strongest stock rallies have occurred during the late stages of a recession.


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4. What happens to the stock market during a recession?


The exact timing of a recession is hard to predict, but it’s still wise to think about how one could affect your portfolio. Bear markets (market declines of 20% or more) and recessions have often overlapped — with equities leading the economic cycle by six to seven months on the way down and again on the way up.


Equities have typically peaked months before a recession, but can bounce back quickly

The chart shows two lines comparing the average S&P 500 Index market cycle and the average economic cycle (using industrial production as a proxy). The S&P 500 market cycle has peaked several months before the economic cycle, and it also has accelerated from its bottom several months before the economic cycle. The S&P 500 line moved from around 87 to 105 prior to a cycle peak. After a cycle peak it moved from a low of around 93 to a high of around 115. The industrial production line increased from a low of around 93 to a high of 100 at its peak. After its peak it declined to around 94 before increasing to around 99.

Sources: Capital Group, Federal Reserve Board, Haver Analytics, National Bureau of Economic Research, Standard & Poor's. Data reflects the average change in the S&P 500 Index and economic activity (using industrial production as a proxy) of all completed economic cycles from 1950 to 2023. The “cycle peak” refers to the highest level of economic activity in each cycle before the economy begins to contract. Both lines are indexed to 100 at each economic cycle peak and indexed to 0 “months before/after cycle peak” on the x-axis. A negative number (left of the cycle peak) reflects the average change in each line in the months leading up to the cycle peak. The positive numbers (right of the cycle peak) indicate the average changes after the cycle peak. Past results are not predictive of results in future periods.

Still, aggressive market-timing moves, such as shifting an entire portfolio into cash, can backfire. Some of the strongest returns may occur during the late stages of an economic cycle or immediately after a market bottom. A dollar cost averaging strategy, in which investors systematically invest equal amounts at regular intervals, may be beneficial in down markets. This approach allows investors to purchase more shares at lower prices while remaining positioned for when the market eventually rebounds.


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5. What economic indicators can warn of a recession?


Wouldn’t it be great to know ahead of time when a recession is coming? Despite the impossibility of pinpointing the exact start, there are some generally reliable signals worth watching closely in a late-cycle economy.


The table shows five economic indicators that can warn of a recession, the average number of months between the signal and the start of a recession, and the current status of the indicator. Indicator 1 — An inverted yield curve, which occurs when 10-year U.S. Treasury yields fall below two-year U.S. Treasury yields. The average time between this signal and recession is 14.5 months. The threshold has been met. Indicator 2 — Unemployment rate rising from cycle trough. The average time between this signal and recession is 5.6 months. The threshold has not been met. Indicator 3 — Consumer confidence declining from the previous year. The average time between this signal and recession is 2.9 months. The threshold has been met. Indicator 4 — Housing starts declining at least 10% from the previous year. The average time between this signal and a recession is 5.3 months. The threshold has not been met. Indicator 5 — The Leading Economic Index (LEI) declining at least 1% from the previous year. The average time between this signal and a recession is 3.6 months. The threshold has been met.

Sources: Capital Group, Refinitiv Datastream. Reflects latest data available as of 6/30/24.

Many factors can contribute to a recession, and the main causes often change. Therefore, it’s helpful to look at different aspects of the economy to assess where imbalances may be building. Keep in mind that any indicator should be viewed more as a mile marker than a distance-to-destination sign.


Four examples of economic indicators that can warn of a recession include the yield curve, unemployment rate, consumer confidence and housing starts. Aggregated metrics, such as The Conference Board Leading Economic Index® (LEI), which combines 10 different economic and financial signals into a single analytic system to predict peaks and troughs, have also been consistently reliable over time.


These factors paint a mixed picture. The yield curve and LEI have flashed recessionary warnings since 2022, but a strong labor market has helped support the economy. However, consumer confidence and employment data have started to trend in the wrong direction, even as they remain above historical averages. The housing industry has essentially already fallen into recession but has since stabilized. However, these are just a few indicators and new economic data can quickly change the narrative


Go deeper:

  • Why macroeconomic predictions can be misleading

 

6. Are we in a recession?


While at times the market has become increasingly concerned about the possibility of a recession, the economy has kept one at bay so far. Despite the impact that high inflation and rates have had on consumer spending and corporate earnings, the economy has been relatively resilient, and now those forces are moderating.


The likelihood of a recession has declined since its peak in 2023

The chart shows a line tracking the New York Federal Reserve’s probability of a recession within 12 months since 1962, using monthly data. It also shows when past recessions occurred and the 30% threshold that has been reached before every recession. The probability of a recession has risen shortly before each of the eight recessions shown on the chart. Before the 1970 recession the probability peaked around 42%. Before the 1973 recession the probability peaked around 68%. Before the 1980 recession the probability peaked around 94%. Before the 1981 recession the probability peaked around 95%. Before the 1990 recession the probability peaked around 33%. Before the 2001 recession the probability peaked around 46%. Before the 2008 recession the probability peaked around 42%. Before the 2020 recession the probability peaked around 38%. The probability has been increasing in recent months. It peaked around 71% in May 2023, and was 66% in July 2023.

Sources: Federal Reserve Bank of New York, Refnitiv Datastream. As of 6/30/24. Shaded bars represent U.S. recessions as defined by the National Bureau of Economic Research.

Currently, we’re not seeing anything that would suggest a sharp drop-off or a change in the fundamentals of the U.S. economy. Most of the data suggests a slowing in the pace of economic activity, but not necessarily a contraction.


Instead of an official recession, what we may see is a continuation of a rolling recession, where parts of the economy contract and recover at different times. Housing had a slowdown deeper than many past recessions but has started to stabilize. Goods production, however, remains sluggish as spending continues to shift away from goods back toward services. Most countries can’t withstand declines in multiple sectors and still avoid a broad recession, but the U.S. economy has shown remarkable resiliency and flexibility, so avoidance remains a real possibility.


If economic data continues to weaken across the board, such as unemployment rising toward 5%, that could lay the groundwork for steeper interest rate cuts from the Federal Reserve. Other unexpected events — such as a geopolitical shock — could also arise to darken the near-term outlook.


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7. How can you position a stock portfolio for a recession?


We’ve already established that equities often do poorly during recessions but trying to time the market by selling stocks is not suggested. So should investors do nothing? Certainly not.


To prepare, investors should take the opportunity to review their overall asset allocations, which may have changed significantly during the bull market, to ensure their portfolios are balanced and diversified. Consulting a financial advisor can help immensely since these are often emotional decisions for investors.


Through 10 declines, some sectors have finished above the overall market

The chart shows how many times each of the sectors in the S&P 500 have outpaced the index during the last 10 largest market declines between 1987 and 2023. Consumer staples outpaced 10 times; utilities and health care outpaced nine times; telecommunication services outpaced eight times; energy outpaced five times; materials outpaced four times; consumer discretionary, financials and information technology each outpaced three times; and industrials outpaced twice. The chart also shows that the sectors that beat the market index during declines, on average, had higher dividend yields than those that usually lagged the index during declines. Dividend yields for each sector were as follows: consumer staples 2.5%, utilities 3.4%, health care 1.7%, telecommunication services 5.7%, energy 3.8%, materials 2.0%, consumer discretionary 0.9%, information technology 0.8%, financials 1.8%, industrials 1.6%.

*In September 2018, the telecommunication services sector was renamed communication services, and its company composition was materially changed. The dividend yield shown is for the telecommunication services industry group, a subset of the newly constructed communication services sector. The communication services sector’s dividend yield was 0.9% as of 6/30/24.

Sources: Capital Group, FactSet. Includes the last 10 periods that the S&P 500 Index declined by more than 15% on a total return basis. Sector returns for 1987 are equally weighted, using index constituents from 1989, the earliest available data set. Dividend yields are as of 6/30/24.

Not all stocks respond the same during periods of economic stress. In the eight largest equity declines between 1987 and 2023, some sectors held up more consistently than others — usually those with higher dividends such as consumer staples and utilities. Dividends can offer steady return potential when stock prices are broadly declining.


Growth-oriented stocks can still have a place in portfolios, but investors may want to consider companies with strong balance sheets, consistent cash flows and long growth runways that can better withstand short-term volatility.


Even in a recession, many companies may remain profitable. Focus on companies with products and services that people will continue to use every day such as telecom, utilities and food manufacturers with pricing power.


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8. How can you position a bond portfolio for a recession?


Fixed income is often key to successful investing during a recession or bear market. That’s because bonds can provide a measure of stability and capital preservation, especially when equity markets are volatile.


The market selloff in 2022 was unique in that many bonds did not play their typical safe-haven role. But in the nine previous market corrections, bonds — as measured by the Bloomberg U.S. Aggregate Index — rose five times and never declined more than 1%.


Average returns during prior equity corrections (%)

The bar chart shows two bars comparing the average decline of the S&P 500 Index, with the average decline of the Bloomberg U.S. Aggregate Index over the nine equity market correction periods since 2010. The S&P 500 Index declined 17.4%, whereas the Bloomberg U.S. Aggregate Index declined only 1%. Fixed income returns were positive in five out of the past nine stock market corrections.

Sources: Capital Group, Morningstar. As of 6/30/24. Averages were calculated by using the cumulative total returns of the S&P 500 Index and the Bloomberg U.S. Aggregate Index during the nine equity market correction periods since 2010. Corrections are based on price declines of 10% or more (without dividends reinvested) in the unmanaged S&P 500 Index with at least 75% recovery. 

Annual returns for stock and bonds since 1977 (%) 

This scatter plot shows plot points representing the annual returns for stocks and bonds since 1977. Most of the points are in the upper right quadrant showing that stocks and bonds have gained the majority of the time. However, the point for 2024 sits in the lower right quadrant, showing that stocks gained but bonds declined.

Sources: Capital Group, Bloomberg Index Services Ltd., RIMES, Standard & Poor's. Returns above reflect annual total returns for the S&P 500 ("stock returns", depicted on the x-axis) and the Bloomberg U.S. Aggregate index ("bond returns", depicted on the y-axis) for each year between 1977 - 2024. Year-to-date (YTD) figures as of June 30, 2024.

Achieving the right fixed income allocation is always important. But with the U.S. economy entering a period of uncertainty, it’s especially critical for investors to focus on core bond holdings that can help provide balance to their portfolios. Investors don’t necessarily need to increase their bond allocation ahead of a recession, but they should review their fixed income exposure with a financial professional to ensure it is positioned to provide diversification from equities, income, capital preservation and inflation protection — what we consider the four key roles fixed income can play in a well-diversified portfolio.


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9. What are ways to prepare for a recession?


Above all else, investors should stay calm when investing ahead of and during a recession. Emotions can be one of the biggest roadblocks to strong investment returns, and this is particularly true during periods of economic and market stress.


If you’ve picked up anything from reading this guide, it’s probably that determining the exact start or end date of a recession is not only difficult, but also not that critical. What is more important is to maintain a long-term perspective and make sure portfolios are appropriately balanced to benefit from periods of potential growth, while being resilient enough to minimize losses during periods of volatility.


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Jared Franz is an economist with 18 years of investment industry experience (as of 12/31/2023). He holds a PhD in economics from the University of Illinois at Chicago and a bachelor’s degree in mathematics from Northwestern University.

Darrell R. Spence covers the United States as an economist and has 31 years of investment industry experience (as of 12/31/2023). He holds a bachelor’s degree in economics from Occidental College. He also holds the Chartered Financial Analyst® designation and is a member of the National Association for Business Economics.


Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.
 

The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.
 

The S&P 500 Index is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks. The S&P 500 is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2024 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.
 

Bloomberg U.S. Aggregate Index represents the U.S. investment-grade (BBB/Baa and above) fixed-rate bond market. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg’s licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
 

Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor's, Moody's and/or Fitch, as an indication of an issuer's creditworthiness.

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