How to trade during a recession
Rebecca Cattlin February 14, 2022 10:30 AM
Whenever rumours of a recession begin to swirl, there are two common reactions: how can I protect my assets and is there any way to take advantage of the slowdown? Find out how each market responds to a recession and what you can do to prepare your positions.
- What is a recession?
- What is a double-dip recession?
- What causes a recession?
- Trading a recession
- What happens to bonds in a recession?
- What happens to commodities in a recession?
- What happens to the stock market in a recession?
- What happens to forex in a recession?
- When was the last recession?
What is a recession?
A recession is a significant and sustained period of declining economic performance that impacts a single country or group of countries. It has far-reaching effects that are felt by governments, businesses, consumers and investors.
Although there’s no set definition of a recession, it’s commonly characterised by declining economic activity – including falling GDP, real income, employment rates, production and sales. Statistics agencies will often say there has to be two consecutive quarters of GDP decline, for example.
Recessions are considered a normal part of the business cycle and tend to happen (on average) every seven to nine years. But there’s also no agreement on how long a recession lasts. For the most part, a downturn lasting longer than 100 days would be classed as a recession and anything less would be a correction or bear market. But if it lasts longer than months or quarters, it becomes known as an economic depression – which can spread across years or even decades and has more social ramifications.
What is a double-dip recession?
A double-dip recession is an economic slowdown followed by a short-lived bounce back, followed by another slowdown. It happens when there are signs of economic recovery, such as a few positive quarters of GDP growth, that are derailed by another recession.
Double-dip recessions are quite rare. There’s only one example of a double-dip recession in the US which was 50 years ago in 1982. It was brought on by a rise in oil prices due to an OPEC embargo. As the economy began to recover, the Fed brought in a dramatic rate hike to curb inflation. Interest rates peaked at 21.6% and caused the second wave of the recession.
Europe has suffered a double-dip recession more recently amid the Covid-19 pandemic. The eurozone economy fell at the start of the pandemic, but growth returned at the start of 2021 – for example, the French economy grew by 0.4%. However, another surge of infections meant the bounce back was short lived and the eurozone had contracted 0.6% again by April 2021.
What causes a recession?
A recession is caused by economic contraction, which can be the result of a variety of factors, including:
- Economic shocks – this happens when an unforeseen crisis occurs that results in serious financial distress. The most obvious example is the coronavirus outbreak that caused economic slowdowns across the world
- Reductions in income and rising debt – when an individual’s income falls, they may have to resort to other sources of capital, mainly debt. With growing levels of debt, comes increasing numbers of defaults and bankruptcy that can cripple the economy. This is what happened in the housing market bubble that caused the 2008 recession
- Runs on the bank – when it’s widely believed a bank might fail, it can lead to large numbers of people withdrawing their money. An uncontrolled run on the bank can lead to bankruptcies and mass panic in the banking industry. The consumer panic can cause a recession
- Speculative asset bubbles – when the prices of investments become inflated beyond their reasonable value, it’s known as a bubble. Eventually, prices become unsustainable causing a dramatic decline. The resulting panic can lead to both individuals and companies selling their assets and reducing their spending
Trading during a recession
When you speculate on financial markets with derivative products, you can go long or short on the underlying. This means you can potentially profit from falling markets, as well as rising ones.
So, while most investors might fear economic slowdowns, traders can find opportunities in the volatility. Let’s take a look at a few asset classes and how they respond to a recessionary environment.
What happens to bonds in a recession?
Bond prices generally rise during a recession, so they’re considered a safe haven from the economic downturn. Research from MFS Investments showed us that global bonds rose 12% during the 2008 recession and gained 8% in the 2000-2002 tech crash.
This is because the bond market is forward-looking and reflects investors’ expectations for the future. So, by the time the recession actually hits, most of the damage to the bond market has already occurred and investors are already looking at the recovery stage.
Central banks also typically buy bonds as part of their efforts to stimulate the economy through monetary policy changes. This often coincides with lowering interest rates.
However, not all bonds experience downturns in the same way. It’s important to look at the bond’s yield and its relationship with interest rates. For example, older bonds that have higher yields typically do better in low-interest rate environments, because they’re more attractive than lower-yielding new bonds.
Following the downturn, when interest rates rise and monetary stimulus packages end, then newer bonds might have higher yields.
What happens to commodities in a recession?
As a general rule, when economies slow, industrial outputs decline due to fewer infrastructure projects and house building, causing the demand for commodities to fall and prices to decline.
The value of most commodities in a recession – such as industrial metals, agricultural products and energies – all comes down to whether they are perishable or not. If a material cannot be stored for long periods of time, then its value is likely to decline during a recession when demand falls. This would be met by a reduction in production and possible storage issues.
We saw the impact of storage facilities becoming too full in April 2020, when a record volume of crude barrels was left standing in ports. The surplus caused global panic and the price of West Texas Intermediate (WT) fell negative for the first time in history as investors feared being asked to take delivery of the barrels themselves.
However, some commodity prices respond differently – particularly if they are considered a store of value. This tends to refer to gold and silver, as well as other precious metals such as platinum and palladium.
Should you buy gold in a recession?
Precious metals are believed to maintain their value during recessions due to continued demand, whether that’s from central banks hoarding gold, or industries that do not necessarily experience the slowdown in the same way – such as medicine and technology.
However, this relationship has become somewhat of a self-fulfilling prophecy. Investors see gold as a safe haven, so it acts like one.
It’s important to note that gold may not consistently rise during recessions – as like other markets it will experience peaks and troughs – but it is considered more stable than stocks.
You could take a position on gold in different ways such as buying coins and bars from a precious metal dealer, trading CFDs or futures, or focusing on ETFs.
What happens to the stock market in a recession?
The stock market has always been considered a measure of economic health, as it shows us how easily businesses can access public capital, and how willing individuals are to invest in risk-on assets. During a recession, it’s not unsurprising that the stock market falls as investors move away from riskier assets.
However, there are classes of shares that become favourites in downturns, due to their profitability and growth regardless of the economic cycle. These are called defensive stocks, and they normally include consumer staples, healthcare, utilities and telecoms. The products they offer are regarded as essential, and so the companies continue to record high sales and profits while other sectors experience the full force of the downturn.
But a falling stock market doesn’t always equal a recession, especially if the declines are contained within the market – it could just be a correction or bear market. In fact, economists believe the stock market alone is a very poor measure of economic prosperity.
Do gold stocks go up in a recession?
Yes, gold stocks do commonly increase in value during a recession. While most of the stock market falls during a recession, gold often rises in price, which means companies involved in mining and producing gold receive a boost.
What happens to forex in a recession?
Forex isn’t recession proof. But unless every single country in the world is wiped out by the downturn, there will be a way for traders to exploit the difference in strength between two currencies.
Certain currencies or groups of economically-linked currencies will inevitably decline as their national economies fail. However, others will rise to take their place. Fundamentally, forex trading involves going long on one currency while shorting another, so FX traders can speculate on both struggling and prospering economies at once.
As economies enter a recession, interest rates are cut, which makes the currency less appealing to investors. Typically, these low-interest currencies are used to buy higher-interest currencies – in what is known as a carry trade.
Learn more about forex interest rate strategies.
And as the economy recovers, and interest rates rise again, national currencies will strengthen again as both domestic and international investors seek to deposit their money in the country’s banks.
When was the last recession?
The last recession in the UK was in mid-2020. The country officially its first recession in 11 years as the economy shrank by 20.4% between April and June 2020. The onset of the coronavirus pandemic caused household spending to plunge, factory and construction output to fall and travel to come to a halt, which lead to GDP falling for two consecutive quarters.
The economy did rebound, and although fears of a double-dip resurfaced in 2021, the GDP graph firmly remained a ‘V’ shape. However, lingering uncertainty has created fears that another recession could take place in 2022.
The last major recession was the 2008 financial crisis – the recession itself started in December 2007 and lasted until June 2009. It was the longest recession since World War II. It was caused by the collapse of the housing market, which was fuelled by the insufficient regulation of subprime mortgages.
The recession had global consequences. Although it kicked off in the US, it quickly spread to Europe – including the UK, France and Germany – as well as Asia, where it was heavily felt in Japan.
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