When Peaks Turn to Troughs: What You Need to Know about Recessions

What is a recession?

The National Bureau of Economic Research (NBER) defines a recession as a significant decline in economic activity that lasts more than a few months. This decline is visible in a country’s gross domestic product (GDP) as well as indicators like industrial production, employment, real income, personal consumption and wholesale and retail trade. A technical recession – the most common term used in the media – is two consecutive quarters of negative growth in GDP, although this definition doesn’t capture the full scope of a recession’s economic effects.

A particularly severe and long-lasting recession may come to be known as a depression, although there is no hard and fast formula for defining one. Each recession has unique characteristics and impacts, influenced by the global economic landscape, domestic policies and consumer behavior.

What causes a recession?

Recessions are complex phenomena with multiple contributing factors. Understanding these causes is essential for strategic planning and risk management.

Economic factors

Inflation and high interest rates often go hand in hand as leading contributors to recessions. Inflation erodes purchasing power, making goods and services more expensive for consumers and businesses. To combat inflation, countries’ central banks may increase interest rates, which can slow economic growth by raising the cost of borrowing. This combination can reduce spending and investment, potentially triggering a recession.

Market speculation can also play a role. When investments are driven more by the expectation of future gains than fundamental value, bubbles can form. Eventually, these bubbles can burst and lead to sharp corrections in asset prices and significant financial losses – factors that can also contribute to recessions.

External shocks

Unforeseen events such as natural disasters, geopolitical instability or pandemics can create sudden and severe impacts on the economy. These events can disrupt supply chains, halt production and reduce consumer confidence, leading to economic contractions. For example, the COVID-19 pandemic caused global economic challenges and demonstrated how external shocks can prompt recessions.

Financial crises

Banking and financial crises are potent triggers of recessions. When key financial institutions face liquidity shortages or insolvency, confidence in the financial system declines. This loss of confidence can spread throughout the economy and lead to reductions in lending, spending and investment. The 2008 Global Financial Crisis, sparked by a combination of predatory lending and risk-taking by financial institutions and the collapse of the housing bubble in the United States, is a unique example of how financial instability can lead to a widespread economic downturn.

What are the impacts of a recession?

Recessions ripple through an economy and can affect nearly every sector and demographic. While some recessions only last a few months, others can last more than a year. The impacts of recessions can influence both short-term operations and long-term strategic planning.

Short-term and long-term economic effects

In the short term, recessions typically result in a cycle of reduced spending and income across the economy.

Key short-term effects of a recession include:

• GDP contraction GDP measures the market value of all final goods and services produced over a specific period. During a recession, this number declines, reflecting decreased production and spending.
• High unemployment rates Companies facing lower demand often reduce their workforce, contributing to an increase in unemployment rates. This rise is a clear signal of a struggling economy.
• Reduced consumer spending Uncertainty about the future and higher unemployment rates typically lead to a decrease in consumer spending. Since consumer spending drives a significant portion of economic activity and therefore GDP, a reduction can further exacerbate a recession.
• Falling stock prices The stock market often reacts negatively to signs of an economic slowdown, with falling stock prices reflecting investor pessimism about future profitability.

Over the long term, a recession can result in:

• Higher rates of business closures Many businesses are unable to remain viable and exit the industry during recessions. These casualties can be particularly costly losses if those businesses held specialized knowledge or production capacity, were especially innovative, or formed a key component of a supply chain.
• Strategic shifts Some businesses use the downturn as an opportunity to reassess strategies, innovate and emerge stronger.
• Changing purchase habits Consumer purchasing preferences may shift towards more cost-effective or essential products and services, leading to changes in market demand that persist even after the economic recovery.
• Increased national debt Governments often provide social and business support and stimulus packages during recessions while contending with lower tax revenue from income and purchases. As a result, national debts can increase during recessions and remain high over the long term.

Societal impact

Beyond the economic indicators, recessions profoundly affect societal well-being. Increased unemployment rates can lead to higher instances of mental health issues, including anxiety and depression. Young professionals entering the job market during a recession may face lingering career setbacks. Many people who lose their jobs as a result of a recession go on to face long-term unemployment. Additionally, public services may experience funding cuts due to decreased tax revenues that affect education, healthcare and social support programs.

Industries that withstand recessions

While recessions can challenge the stability of many sectors, others have historically shown resilience or even growth during these periods. Identifying these sectors can help you mitigate risks and spot potential opportunities for investment and development.

Essential services

Healthcare, utilities and consumer goods are sectors that typically maintain stability during economic downturns. While consumers may take measures to reduce their spending, demand for medical services, electricity, water and basic household products remains broadly constant regardless of the economy’s status. These industries provide essential services that consumers prioritize even when tightening their budgets. For example, despite a recession, individuals will still need medical care and will continue to purchase food and hygiene products, ensuring steady demand for businesses within these sectors.

Education

During economic downturns, individuals often seek to improve their skills or attain new qualifications, leading to stable or increased demand for educational services. This trend reflects a strategic move by many to better position themselves for employment opportunities once the economy recovers.

Repair services

Repair services tend to see steady business because in addition to demand when the economy is healthy, in times of economic unrest there’s a marked shift toward maintenance and preservation over capital expenditure. In a practical response to financial constraints, consumers and companies opt to repair existing equipment and machinery rather than invest in new purchases.

Technology sector

Certain segments within the technology sector have shown not just resilience but also significant growth during recessions. This is partly because companies in these industries often offer cost-effective solutions or innovations that cater to changing market needs. For instance, cloud computing services can become more attractive to businesses looking to reduce operational costs. Moreover, technology that enhances productivity or enables remote work can experience heightened demand.

Understanding which industries are better able to withstand recessions can guide your decisions around diversification, marketing and investment. By focusing on sectors that offer essential services or those that adapt to meet changing consumer needs, your business can navigate economic downturns more effectively and position itself for recovery and growth.

Examples of recessions

Most advanced economies record a technical recession every seven to 10 years. Let’s take a look at a couple of significant historical examples of recessions.

The Great Depression

A particularly severe and long-lasting recession may come to be known as a depression, although there is no hard and fast formula for defining one. Deflation was a major contributing factor to the Great Depression of 1929 to 1941. During the Great Depression, industrial production plunged and the stock market’s value ultimately sank by 89%. Unemployment skyrocketed to 25% and many people couldn’t afford basic essentials despite prices having drastically declined due to deflation. From 1930 to 1933, the money supply declined by nearly 30% in response to widespread collapse in the banking system. The catastrophic effects of the Great Depression began in the US and spread around the world.

The GFC

The Global Financial Crisis (GFC), or Great Recession in the US, was a period of extreme volatility in 2008 and 2009. During the mid-2000s in the US, housing credit expanded as multiple lending companies offered high-risk mortgages to borrowers with impaired credit histories (also known as “subprime” mortgages), which helped fuel a significant rise in home prices. The collapse of this housing bubble – with house prices declining alongside an increase in the number of borrowers who couldn’t meet loan repayments, partly due to significant debts – brought about the Great Recession. Banks incurred losses on repossessed homes as house prices continued to fall, and investors were less willing to purchase mortgage-backed securities (MBS). The subsequent collapse and near-failure of many major financial firms in 2008 triggered a widespread financial panic, leading to significant dysfunction in the US financial system. This panic spread, partly due to foreign banks’ investment in the US housing market and MBS, prompting recessions all over the world.

Australia fared relatively well during the GFC due to the state of the country’s financial system, low exposure to the US housing market and US banks, strong export connections to the growing Chinese economy and a significant policy response that included cash rate cuts and economic stimulus to cushion the effects of the global downturn. While GDP only declined in one quarter in Australia, many still felt the effects of the crisis as unemployment rose to almost 6% and underemployment rates soared.

Preparing for a recession

While recessions are difficult to navigate, with foresight, planning and adaptability they don’t have to spell disaster for your business. For businesses and professionals aiming to mitigate the impacts of a recession, consider taking practical steps such as those outlined below.

1. Strategic planning

Analyzing market trends, industry performance and economic indicators can provide valuable insight into potential downturns. It’s essential to assess your business’s vulnerabilities and strengths in this context in advance. Developing a flexible strategic plan that includes contingency measures, such as cost reduction strategies and alternative revenue streams, can prepare your organization for various economic scenarios. This approach ensures you’re not merely reacting to challenges but proactively managing risks.

2. Diversification

Diversification is a critical strategy in risk management. By expanding your product lines, services or markets, you can dilute risk and reduce dependence on a single income source. Consider exploring new markets or customer segments that may be less affected by economic downturns, such as those outlined above. Additionally, diversifying investments across different asset classes can protect the financial health of your business from market volatility.

3. Financial health

Maintaining a strong financial foundation is paramount in any circumstance, but especially when preparing for the possibility of a recession. This includes managing debt levels to ensure they are sustainable even in less favorable economic conditions. Building your business’s cash reserve will provide a financial buffer that allows you to navigate short-term challenges without compromising long-term viability. Regularly reviewing and optimizing operational costs can also bolster financial stability by enhancing efficiency and reducing unnecessary expenditure, which is beneficial at all times regardless of the state of the economy.

The best time to prepare for a crisis is before you’re in one. Adopting these practices helps safeguard your business ahead of potential recessions and will serve to strengthen its overall resilience and capacity for growth.