Understanding Recession, Inflation and Gross Domestic Product

As an investor, you might have come across economic terms like 'inflation' (CPI), 'gross domestic product' (GDP) and, more recently, 'recession'.

In a previous topic, we touched base on what inflation is. This is when the prices of products and services increase. The reasons for the price hikes may vary, from the supply or demand side.

Gross domestic product, or GDP, refers to the spending of government, business investments, net exports, and consumer spending locally. When inflation comes into play, the buying power of money is affected, pushing the cost of living up and bringing concerns about recession to investors and the global economy.

What is a recession?

In an economy where spending is rife, prices will rise. This hinders consumers' buying power and negatively affects GDP.

This is because when spending drops, money circulating becomes less over time and companies' earnings tend to decline. During this period, analysts may start downgrading their earnings per share (EPS) estimates for various companies.

For investors, such times bring about volatility, which may lead to a downturn in stocks as investors become more skeptical about future earnings.

Recession history

In the 1990s in the UK, the economy experienced what is referred to as a 'boom and bust' recession. During the boom period, interest rates tend to be low, while spending continues to rise – reaching a point of concern. Central banks may then hike interest rates, which reduces available money over the long term and makes it more expensive to borrow. This is referred to as the bust period.

A 'great recession', or 'balance sheet recession', happens when there's an increase in bad credit and a fall in asset prices. This may lead to a decline in investment spending. An example would be the global recession of 2008/09 after the credit crunch. 

Unlike a short-lived recession, which may last for only a few months, a great depression lasts much longer. This is when there's a global economic downturn that lasts for at least 10 years. An example of this would be the event that took place in the 1920s and 30s when the US stock market crashed on what has become known as Black Thursday. The ripple effect of the markets trickled down into the economy, causing banks to fail as they saw a rise in withdrawals. Because of the failure of the economy, the surviving institutions were unwilling to supply more money due to future uncertainties. Other factors were also in play, such as trade restrictions mixed with rising unemployment during the period. These factors had a snowball effect, causing the economy to go into a downward spiral.

In 2020, the globe experienced what could be referred to as a "pause" in economic activity due to the Covid-19 virus lockdowns and restrictions. In the US, this was declared a short recession. Fast forward to 2022, after soaring prices from the global dependence shift, the United States GDP was faced with a back-to-back decline, or what’s defined as a technical recession, fuelled by the high dollar and rising interest rates.

Is this a good time to buy?

With stocks, red doesn't always mean the end. When companies are in the red, this doesn't necessarily mean the company is closing down. During the period when a recession makes headlines, companies with pricing power may also find themselves in the crossfire of a rising cost of living and expectations of a decline in earnings. This may be an entry opportunity for new investors. It also gives investors who may have been invested for years the chance to safeguard their accumulated capital gains ahead of the uncertainties. Read more about companies with pricing power here.

“It's not about timing the market, but spending time in the market.”

When the period of earnings comes, investors are always ready to react, which may bring about a volatile environment. Companies that beat earnings tend to be "bullish", or move upwards, since this may also mean a higher chance for future dividends, where appropriate.

Companies that produce lower earnings during the earnings season may be faced with a sell-off as investors fear further declines. Contrary to the belief surrounding a sell-off, investors may stay optimistic depending on the fundamentals. These could indicate that the decline may be seasonal or part of a regular business cycle.

What are ‘business cycles’ and ‘seasonality’?

Seasonality refers to events that have a tendency to repeat themselves and which may affect earnings in a specific period of the year. An example would be retail and tourism stocks during the festive season when depending on how the company is positioned, it may benefit from high consumer spending. This, in turn, would result in higher earnings expectations. The business cycle, on the other hand, refers to the regular contraction or expansion of an economy, including employment and inflation numbers.

As the saying goes, "Storing your wealth only in money is not an option, since prices will always rise."

As time goes by and prices rise, there may come a time when people can't afford certain goods and services anymore and need the government to bring more money into the economy. While action by the government may reduce the value of existing money – because more money is available – this becomes another opportunity to cash in on earnings from stocks.

As an investor, think long-term. With the population growing, demand may also increase, and earnings may cash in, depending on how a company positions itself for today's generation and those to follow. And while the case may be that consumer spending has declined from a global perspective, the downtrend may present an entry opportunity when looking for long-term value.

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