Threats to the world economy appear to be mounting – the trade war between China and the United States continues, Germany’s GDP is shrinking, Brexit is causing angst and global tensions are spooking oil prices.
Some particularly nervous investors might be thinking in terms of a recession and stock market crash.
Yet, we remain in the longest period of sustained economic growth in post-Industrial Revolution history.
And the most recent predictions from the Federal Reserve are that US GDP growth will remain respectable – 2.2 per cent in 2019 and two per cent in 2020.
A recession is usually defined as two consecutive quarters of negative GDP growth.
When demand for goods and services softens, businesses seek ways to reduce costs. Jobs are axed, pay rises don’t happen, and workers’ hours are cut. The symptoms feed off each other and the result is a spiral of decline.
In theory, when the economy is strong, consumer and business spending increases and corporate profits improve. Greater profits support higher stock prices. Conversely, when economic activity slows, spending declines, profits wane, and stock prices fall.
But none of this is a given.
Although there is a correlation between recessions and stock market falls, the relationship is by no means perfect. While the effects of a recession often cause the stock market to fall, recessions don’t necessarily cause stock market crashes.
Sometimes markets “predict” a recession and stock sell-offs precede it. Other times markets fall following recessions. Large stock market corrections can also happen without there being a recession at all, for example Black Monday in October 1987.
It’s virtually impossible to predict how long they will last and how deep they will be.
Financial commentator The Motley Fool said: “Recessions typically start before anyone even knows they’re happening and end before economists have enough data to know they’re done.”
Encouragingly they are also usually pretty short.
Since the end of the Great Depression of 1929, which lasted 1,307 days, more than double the length of the 2007 Great Recession, the longest in the post-World War II era, there have been 13 recessions in the US, and nine of those lasted less than one year.
Recessions are a normal part of capitalist economies. Another will be along at some point.
But central banks are now much more willing to use aggressive monetary policy – ultra-low interest rates and quantitative easing – to prop up the economy and stock markets. Thus a recession has been avoided but at the price of lower growth.
Long-term investors are much better served by not trying to “time the market” but instead keeping their money invested. Stock markets often perform at their best, and can achieve significant returns, in the run up to corrections and in the recovery afterwards.
But, human nature can be perverse.
Claiming that the market actually posted gains during four of the last eight recessions, The Motley Fool stated: “Scary headlines often push the average investor to do the exact opposite of what they should do when a recession or stock market lull actually happens.
“Unfortunately, one of the biggest mistakes people make during a recession is to sell their stocks after the market has already fallen sharply, because they expect it to fall even more.”
Mike Patton, president of US firm Integrity Wealth Management, told Think Advisor: “Even though we should buy low and sell high, when fear kicks in, it will override logic. By the time stocks decline to the point where the investor wants out, it may be closer to the bottom than the top.”
As The Hitchhiker’s Guide to the Galaxy would say – Don’t Panic.