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How Does Recession Affect Financial Markets?

How Does Recession Affect Financial Markets?

2022-12-29 • Updated

Information is not investment advice

The economy never moves in a straight line. Economists closely associate economic development with cycles of ups and downs. Recessions are considered an unavoidable part of a business cycle. A recession is when GDP declines during two or more consecutive quarters. Moreover, it is usually followed by rising unemployment, falling retail sales, and contracting income and manufacturing indexes.

Today, almost every US CEO is getting ready for a recession, and most economists believe a downturn is coming soon. The reason is that rising interest rates, provoked by the inflation spike, choke off growth by raising the cost of credit cards, mortgages, car purchases, business loans, and any borrowing that fuels an economy. The last time the Fed delivered this much pain over a 12-month horizon was in 1980, which resulted in a severe economic downturn.

In European countries, the situation is even worse, as, in addition to high rates, the economy struggles from high gas prices ahead of winter. As businesses reduce gas spending, economic activity is slowing down.

How long do recessions last?

From 1854 to 1919, the average recession lasted 21.6 months. However, over the years, recessions have become shorter. According to The National Bureau of Economic Research (NBER) data, from 1945 to 2009, the average recession in the US lasted 11 months. Over the past 30 years, the US has gone through four recessions. Let’s go through them.

The Covid-19 recession

The last recession began in February 2020 and lasted only two months, making it the shortest US recession in history.

The Great recession (December 2007 to June 2009)

The bubble in the real estate market partly caused the Great Recession. The Great Recession wasn’t as severe as the Great Depression. However, its long duration and severe effects earned it a similar name. Lasting 18 months, the Great Recession was almost double the length of recent US recessions.

The Dotcom recession (March 2001 to November 2001)

At the beginning of the 2000s, the US faced several major economic problems, including the tech bubble crash and accounting scandals at companies like Enron, capped off by the 9/11 terrorist attacks. Together these troubles caused a brief recession, from which the economy quickly bounced back.

The Gulf War recession (July 1990 to March 1991)

At the start of the 1990s, the US went through a short, eight-month recession, partly caused by spiking oil prices during the First Gulf War.

Can you predict a recession?

Given that economic forecasting is uncertain, predicting future recessions is far from easy. For example, COVID-19 had appeared seemingly out of nowhere in early 2020 and within a few months, the US economy was party closed down, and millions of workers lost their jobs.

An inverted yield curve

The yield curve is a chart that plots the yield of a range of US government bonds, from notes with a term of four months to 30-year bonds. When the economy functions normally, yields on longer-term bonds should exceed short-term ones. As a result, investors worry about a recession when long-term yields are lower than short-term yields. This phenomenon is known as a yield curve inversion, and it has predicted past recessions.

Declines in consumer confidence

Consumer spending is the main driver of the US economy. When consumer confidence declines, meaning people don’t feel confident spending money, the economy slows down. If surveys show a sustained drop in consumer confidence, it could be a sign of impending trouble for the economy.

Sudden stock market declines

A significant decline in stock markets could signify a recession since investors sell off the securities to get cash in anticipation of an economic slowdown.

Rising unemployment

If people lose their jobs, it’s a bad sign for the economy. A few months of steep job losses warns of an imminent recession, even if the NBER hasn’t declared a recession yet.

How do assets perform during the recession?

Unlike investors, traders are not afraid of a recession because they can earn by trading in both directions, long and short. However, it is extremely important to understand the assets' behavior during a recession to make the right choice.

Recession kills oil

Historically, oil price increases lead to greater future inflation and vice versa. Energy fuel expenditures, which are also related to transportation and food prices, comprise a significant portion of the consumer goods basket.

When a recession occurs, consumers buy less, so producers reduce their spending. The demand for energy declines and the oil price drops substantially. Thus, oil traders must thus keep a careful eye on consumer spending to predict drops in oil prices.

Gold

In the past, gold prices and recessions used to have an inverse relationship. When the economy weakens, gold price usually goes up. During the last three recessions, 2020, 2007, and 2001, the price of gold increased while the value of the S&P 500 decreased.

It has happened because, for the past two decades, central banks have been supporting economies with key rate cuts and quantitative easing (purchase of external debt) during recessions, causing global inflation growth.

money supply_2.png

This time will not be an exception, especially ahead of the 2024 US presidential elections. The stock market usually follows the M2 money supply indicator. In other words, the Federal Reserve will have to print more money to boost stocks and the economy.

M2 Money and S P 500.png

Thus, gold will most likely increase in value in the long term. The best time for gold purchases is the extremum of an economic recession when central banks reverse their policies and begin supporting economies with low interest rates and additional money supply. At such moments, big money purchases the yellow metal and its price goes up.

Stocks & Crypto

Recessions impact different stocks differently, depending on the type of company. Some companies like utility, healthcare, and consumer staples tend to remain stable during a recession. Companies with a large debt, such as travel and technology companies, along with industrial companies, tend to underperform in the markets.

The cryptocurrency market is a young sector. Thus, most of the projects have high debts. As a result, investors prefer to get rid of crypto when the recession begins and return when the economy starts growing.

Strong stocks during recession.png

On the other hand, sectors that underperform during a recession will perform well in a post-recession recovery. Examples include financials, real estate, consumer discretionary, industrials, and materials.

Strong stocks post recession.png

You can trade the increased market volatility that recessions cause by creating a trading account and taking a position with CFDs. These are financial derivatives, which enable you to speculate on the rising markets by going long, as well as on the falling markets by going short.

Currencies

During recessions, a country’s business activity falls, and the economy slows down. As a result, a currency is likely to fall because the country becomes a less attractive place to invest.

However, since major countries’ economies are connected, recessions do not happen in one particular country but spread among all of them. In this case, the currencies of the countries with the most stable trading balance and a large number of foreign currency assets (so that those countries may sell foreign assets and bring money back home when volatility picks up) benefit relative to others.

As of today, the US dollar (USD), along with the Swiss franc (CHF), are considered safe-haven currencies.

USD

If the US dollar is stronger against higher-yielding currencies, it means that markets are likely unhappy about recently released economic data or news. In this case, foreign investors buy US Treasuries as a haven. To purchase those, they need to buy USD. When many investors do this at the same time, this USD rises in value.

Swiss Franc

The Swiss franc is another currency that is considered a safe haven. Political stability, conservative monetary policy, and a steady economy make the CHF a stable currency, attracting international investors in times of crisis.

Despite the many crises in the global financial markets, Switzerland has always managed to persevere without much trouble.

If the European economy faces a recession, the Swiss franc (CHF) will likely strengthen against higher-yielding European currencies.

How to trade in a recession

Go short to seize opportunity in falling markets

Shorting is a way to seize an opportunity in markets that are falling. Many traders use financial derivatives like CFDs to go short, i.e. to sell an asset. These instruments enable traders to take speculative positions on an asset’s price movements without the necessity to own the asset itself.

The best assets to short during a recession are:

  • Travel, industrial, technological stocks, and cryptocurrencies. Investors leave risk assets and projects with high debt, so their prices fall.
  • Oil (Brent, WTI). When business activity rises, oil demand increases, pushing the prices higher. On the contrary, during recessions commodity prices tend to go down.
  • High-yield currencies (AUD, GBP) versus safe-haven currencies (USD, CHF). Investors switch from seeking higher income to looking for a refuge that would help them to preserve capital. As a result, higher-yielding currencies decline.

Go long as the market recovers

Going long during a recession can be risky. That’s why traders and investors wait for the initial rebound when many assets reach their minimums. Then they buy at these levels, trying to make the maximum reward from the eventual post-recession recovery.

The best assets to long on the economic recovery are:

  • Gold. Governments return to ultra-dovish monetary policy, printing money and buying assets on their balances and creating the risk of rising inflation in the future. The prospect of high inflation makes gold attractive.
  • Travel, industrial, technological stocks, and cryptocurrencies. These assets become cheap and, hence, attractive for long-term investors.
  • Oil (Brent, WTI). When business activity rises, oil demand increases, pushing the prices higher.
  • High-yield currencies (AUD, GBP) versus safe-haven currencies (USD, CHF). Investors return to risk-on sentiment and purchase higher-yielding bonds. The demand for currencies of these nations goes up as well.

Conclusion

A recession creates a lot of opportunities for both traders and investors. Having the opportunity to trade long and short (i.e. open buy and sell trades), traders can significantly increase their capital due to high volatility. At the same time, investors can purchase desired assets at low prices.

To succeed, you need to understand the cause of the recession and possible ways for the government to solve the problem (most often, this is an ultra-soft monetary policy). With FBS, you can earn on selling stocks, cryptocurrencies, and oil during a recession. Moreover, you can increase your capital by buying gold and other assets when the economy returns to growth.

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Gold trading is one of the oldest investment vehicles in the world. The precious metal plays an important role in the global economy.

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