What is a recession?
A recession is usually described as an extended period of decline in economic activity. Many economists would say that a recession happens when a country’s gross domestic product (GDP) has declined for two consecutive quarters, or six months. In other words, the economy has been shrinking rather than growing.
However, other indicators of a recession could be a decline in consumer spending or an increase in unemployment. Periods of economic growth are usually characterized by an increase in jobs, corporate profitsProfits A financial gain for a person or company. Equals the money left over after you subtract your costs from the money you made.+ read full definition, and consumer spending. When the opposite is true, this can lead to speculation over whether a recession is coming.
During periods of economic uncertainty, stock marketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or traded.+ read full definition activity as well as household finances can both be affected.
StockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition markets fluctuate up and down, but extreme market fluctuations can cause stress leading to emotional decision-making. Learn more about market volatility and behavioural bias.
The effect of rising inflation
Sharp increases in inflationInflation A rise in the cost of goods and services over a set period of time. This means a dollar can buy fewer goods over time. In most cases, inflation is measured by the Consumer Price Index.+ read full definition can also lead to speculation over a recession. Inflation is how quickly prices rise for goods and services, year-by-year. For example, the price of a loaf of bread today compared to the previous year. While some amount of inflation is normal, larger spikes in inflation can quickly affect the daily cost of living for average households.
An inflation rate of 1-3% is considered normal, since it is the target range used by the Bank of Canada. When inflation is within this range, many investors would also normally expect to see higher rates of return on their investments, than the rate of inflation. However, during times of high inflation it can be more challenging to see investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition returns out-pace inflation.
Dealing with inflation is a challenging task. Central banks try to rein in inflation by raising interest rates. In Canada, the Bank of CanadaBank of Canada The central bank that sets Canada’s money policies. These policies help keep the Canadian dollar stable. They also affect our economy and our money supply. The goal of the Bank of Canada is to keep currency and the financial system stable. They are the sole authority to issue banknotes – bills.+ read full definition makes adjustments to the overnight rate — the amount of interest charged to a financial institution by the Bank of Canada for borrowing money overnight. When interest rates continue to rise, this makes it more expensive to borrow the money to purchase larger assets like real estateEstate The total sum of money and property you leave behind when you die.+ read full definition. At the household level, rate increases make it more expensive to borrow, even while day-to-day spending is also becoming expensive.
Changes in interest rates can affect investments differently. Learn more.
How a recession can affect investing
Increases in the cost of living and borrowing, combined with the overall financial uncertainty over the impact of a potential recession, can be enough to cause personal and financial stress. There is no single best way to respond to such times.
It’s worth remembering that while a recession can negatively impact markets broadly, the stock market is made up of many different industries and investors. Every investment will not perform in an identical way. And, as markets recover, different sectors may emerge more strongly than others. For this reason you may want to review the diversification in your portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition — diversity of investment type as well as economic sectorSector A part of the economy where businesses provide the same or related products or services. May also refer to a group.+ read full definition.
While no one can predict the future, it’s worth keeping in mind that the stock market has recovered from market downturns and recessions in the past. Recovery can take time, but it’s likely that market performance will improve again in the longer termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition. For this reason, focus your attention on long-term investment goals. If your portfolio and asset mixAsset mix The percentage distribution of assets in a portfolio among the three major asset classes: cash and cash equivalents, fixed income and equities.+ read full definition are still relevant for these goals, it may be best to stick with your plan.
If your investing goals are coming up in the short-term, say within the next three to five years, it may be worth speaking to an advisor about how to manage your portfolio.
Ways to manage your saving and investing during a recession
- Pay off debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition. If borrowing has become more expensive, then any amount you owe will increase due to higher interest rates. Paying down debt will help reduce the financial burdens your future self may need to deal with.
- Manage your spending. If prices are rising, then it’s likely you’ve already started looking at your monthly spending habits. As much as possible, find ways to reduce your spending to help your budgetBudget A monthly or yearly estimated plan for spending and saving. You work it out based on your income and expenses.+ read full definition stretch further.
- Review your assetAsset Something of value that a company or an individual owns or controls. Examples: buildings, equipment, property, a car, investments, or cash. Can also include patents, trademarks and other forms of intellectual property.+ read full definition mix and diversificationDiversification A way of spreading investment risk by by choosing a mix of investments. The idea is that some investments will do well at times when others are not.+ read full definition. As an investor, one of the best ways to reduce risk is through diversification of your portfolio. For example, having a mix of asset classes or investment types, or, investments across different industrial sectors. If your time horizonTime horizon The length of time that you plan to hold an investment before you sell it. This may be a brief period of time or span as long as decades, depending on your financial goals.+ read full definition is long, then your portfolio may be able to handle some ups and downs even if a recession affects most parts of the market.
- Check in with your advisor. There are many ways a financial advisor can help, especially if you have a shorter time horizon to plan for or are retiring in the next few years.