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What Actually Happens During An Economic Recession And What Should You Do With Your Money

Jon
Jon

Four days after GE2020, Ministry of Trade and Industry (MTI) announces that we have entered a technical recession. Advance estimates for Q2 2020 indicated that the economy contracted a whopping 41.2%. Year on year, the economy has shrank by 12.6%. 

There is no hiding it, our economy is in deep, unprecedented recession territory. To help us navigate the uncharted waters, let us take a closer look at recessions and what they really are.

What is a Recession

Economists define recessions as a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in Gross Domestic Product (GDP) in two successive quarters. 

What is that in plain English? 

Here is an analogy.

Think of Singapore as a household. As with all households, working adults contribute to the household income. Daddy works in a factory, producing bicycles while Mommy runs her own online bakery selling cakes. During good times, the factory decides to give Daddy a raise. And with more and more people starting to know about her cakes, Mommy’s business expands. The household income increases, and the family now have more money to spend. 

Then, COVID hits. Factories shut down during the circuit breaker period and home bakeries were not allowed to operate. The bicycle factory cuts Daddy’s pay and the Mommy is not able to sell a single cake. The household income takes a big hit. 

Against the backdrop of a country, this household income is called the GDP – the market value of all the final goods and services produced. 

When the GDP falls by two consecutive quarters, the country is in a recession. 

What happens during a recession? 

When household income decreases, the family has less money to spend. They may decide to defer big ticket items like a car or even upgrading to a new house. On a lesser scale, discretionary spending such as holidays and eating out might have to take a back seat. 

Should the reduced income be insufficient, the household will either have to dig into savings, sell assets or borrow money to fund their expenses. Conversely, Mommy may decide to take up a cooking course or buy a bigger oven so that her business will be well positioned for the eventual recovery. 

The same happens to a country. When GDP decreases, we will need to rebalance the budget and cut down on discretionary spending big and small (NDP funpacks anyone?). We might need to dig into our reserves to help the more needy members of the society. We should also make investments, be it in our people or in our infrastructure, so that we can be prepared for whatever the future might hold. 

What does a Recession look like?  

Just like there are four seasons to a year, there are also four seasons in the global business cycle. A Recession is one of four scenarios, the others being Growth, Inflation and Deflation.

Entering a recession, the outlook is bleak and demand for goods and services tapers off. Production slows down, unemployment increases and people cut back on the non-essential items. As demand shrinks, so does production. In a recession, investors becomes more conservative and cash is king.

Recessions are best associated with Winter. The days are short and the nights are long. We crave for sunshine and warmth but it is always cold and gloomy. During winter, people hunker down, stay indoors and try to stay warm. They look forward to the first day of spring.

Unlike the four climatic seasons however, economic cycles do not happen sequentially. There is no fixed rule stating that growth will be preceded by recession which will then give way to periods of inflation or vice versa. There is also no fixed time frame for each economic season. After heady decades of post war recovery and growth, the Japanese economy remained in deflationary doldrums for nearly two decades.  While human beings are unable to influence climatic seasons, we are able, to a large extent, interfere in the natural workings of the economic cycles by adjusting money supply and interest rates. Recessions do not make for good voting dynamics and politicians do all they can to starve it off.

Now that we know what a recession is, let us take a look at what happens to money during a recession.

Interest rates during a recession 

Interest rates serves multiple purposes. For one, they are the interplay between demand and supply for credit; they indicate the price of liquidity. They also represent consumers’ preferences for present vs future consumption. 

Usually, when an economy enters a recession, the demand for liquidity increases. Businesses face a cash crunch and are more inclined to borrow to fund their operations. Individuals see dark clouds on the horizon and tend to hoard cash. Hence, interest rates are supposed to rise during a recession – theoretically at least.

In recent years however, central banks have utilised monetary policy to great effect. As a result, recessionary interest rates tend to be lower than average.

Since the COVID outbreak, the US Federal Reserve has lowered interest rates to near zero, hoping to stimulate spending and to restart the economy.

US Fed rates

Because the US is the world’s largest economy, everything the FED does has a trickle-down effect on the rest of the world. The local SIBOR is a derivation of the US rates.

Singapore SIBOR Rates

How will interest rates affect property prices? 

Falling interest rates affect many parts of the economy. Business owners have access to cheaper loans and consumers have less incentive to save.

Low interest rates is also keenly felt amongst homeowners as their monthly repayment decreases. Loans become cheaper to service and this will alleviate some pain for homeowners who have fallen into financial hardship. With a lesser monthly mortgage to contend with, they will find it easier to continue to upkeep their property.

The eagle eyed amongst you will notice that property price plunges in 1998, 2003, 2008 are associated with rock bottom interest rates.

A word of caution though. Correlation is not causation. Rather than low interest rates causing property prices to plunge and vice versa, there is a third factor – the undesirable economic condition that is causing both low interest rates and low property prices.

How will property perform in a recession?

The property market lags the overall economy. The transaction cost is high and the time required to buy and sell any property is too long for property owners to make casual decisions.

If a person loses his job and needs cash quick, it would be easier to sell other items rather than a physical property. If an investor or a business person needs to raise funds, they might sell off some shares or explore other forms of loans. A property, especially one in which the owner is residing in, will usually be the last asset to go.

As such, it will take a while before any correction in property prices is reflected the URA data. This is usually after the stock market has corrected – when everyone who needs to sell has already sold.

Job losses will usually exacerbate the fall in property prices. When property owners are no longer able to afford paying for their mortgages, they have no choice but to sell.

Interest Rates and Bond Prices

Bond prices and interest rates are inversely related. When interest rates increase, bond prices are expected to fall. This is because previously issued bonds with their lower rates are no longer as attractive as new ones to be issued with the higher coupon rates.

The converse is also true. With falling interest rates, current bonds with their higher pay outs have become more attractive than bonds to be issued in the future. As a result, bond prices increase. Academically speaking, bond and stocks prices are inversely correlated. When bond prices rise, stock prices fall. However, there are times when both stocks and bonds can go up at the same time. This is usually an indication of too much liquidity in the market chasing too few investible assets. This does seem to be the case in recent times.

When it comes to bonds, investors have the tendency to speak of all bonds in one broad brushstroke. This is furthest away from the truth. The safest US government bonds are a far cry from corporate junk bonds.

In trying times like these, number of defaults will increase. It is in the investor’s best interest to first consider the risk for each bond offering, and not invest blindly based on the promise of high(er) returns.

What about Gold? 

Gold is a very interesting asset class. As an investment, it is an unproductive asset on two accounts. Firstly, it pays neither interest nor dividends. Secondly, unlike investing in stocks and shares, the pile of gold you have invested in does not contribute to any economic activity. It remains the same pile of gold even after decades.

Any growth in value depends entirely on the greater fool theory – the belief that someone else will pay more for it eventually. Consequently, gold holds its value only because of a four letter word that begins with F – Fear.

When investors buy gold (physical gold at least), they are hedging against unknown scenarios. Should your local currency, be it the USD, the EUR or the SGD, weakens and loses its value, the potential fallout can be mitigated by hoarding gold.

Besides acting as a currency hedge, gold is also excellent protection against inflation. Gold, as a commodity, tends to increase in price when the cost of living increases.

Finally, in a stock market correction, the huge amount of money flowing out of the equities will have to find a new home. While some will remain in cash, investors will also park significant amounts in safe heaven assets such as bonds and gold. This will cause Gold prices to increase in a recession. To further validate the point, gold ended positive after six out of eight of the biggest market declines in the S&P500,

Hence, if you are expecting a deep recession, keeping a portion of your portfolio in Gold might just be the conservative move.

What about stocks?

A recession is a period where the economic outlook is grim. Demand for goods and services taper off. When factories produce lesser goods and people consume lesser services, revenue decreases. Some companies may run into cashflow problems and shut their doors, resulting in workers’ being laid off. The cycle perpetuates itself.

During the early days of COVID19, the is a lot of talk about the shape of the recovery. Some predict a shape V shape uptick, others are forecasting a more prudent U. The bears insist that it will be a long drawn L shaped winter. Three months later, we are none the wiser. What is certain though is that the stock market has reclaimed some of its lost ground.

The stock market leads the economy by six months to a year. Does it mean that the worst is over? Just by purely looking at the stock market alone, that definitely seems like the case.

However, many have also made the case for the stock market rise as due to liquidity. The trillions the Fed has injected into the economy has to find a home. It has found  a safe harbour in the stock market.

So what should the stock investor do? We believe in time in the market rather than timing the market. The Dr Wealth portfolio is 40% in cash and we are constantly looking out to buy good stocks at the right price. Instead of asking whether a particular stock would go up next month, we ask if it is worthy by the set of rules we have laid out for ourselves.

Even during a recession, there are some sectors that will do better than others. They include healthcare, consumer staples, grocery stores and discount retailers and alcoholic manufacturers. We can give ourselves this margin by buying fundamentally sound stocks holding valuable assets with solid earnings at a great price.

Let me put things into perspective. If you had taken a nap in Jan 2020 and had woken up only now, you would not have realised just by looking at the stock market alone that much of the world has just emerged from an unprecedented and massive shutdown during the past few months. Any panic during March 2020 would have been thoroughly unfounded.

What do we do in a recession?

First up – do not panic. Do not panic buy, do not panic sell. If you are a long term investor, take a long hard look at your investment objectives and see if you are still on track. If you are, there is no point trying to fix something that is still working.

Refinance your housing loan to take advantage of the low interest rates. It is the closest thing to free money. Do not walk away from it.

Balance out your portfolio with bonds and gold. They are defensive assets and will do well when the market corrects to reflect its true value. Buy the right stocks. Buy them with the right mindset and hold on to them until they have either realised their potential or their fundamentals have changed.

This will be our fourth recession since Singapore’s independence in 1965. It will be the deepest and most serious one yet. During this time of upheaval it is extremely crucial to make the right money decisions. Only then can we ride through the storm and emerge on the other side unscathed.

Jon
Jon
Dive, snowboard and have moved house five times in the last ten years. Miraculously filled up every single page in my passport before it expired. Manage risk for a living.
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