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What is a recession?

November 18, 2022

What is a recession?

November 18, 2022
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You may have heard in the news recently that many western countries are facing a possible recession. But what actually is a recession and how does it affect you as an investor? Let’s find out. 

What is a recession? 

Using the definition that the UK government has outlined; a recession is when a country experiences two consecutive financial quarters of decline in gross domestic product, this would then constitute a recession. 

In other words, when a country sees a decline in its total market value for more than six months, this can be classed as a recession, which is important in the long term health of an economy. 

As a result of this prolonged downturn in activity, a recession will often cause a further decline in consumer demand, increase unemployment rates and lower economic output. 

Many economists agree that a recession must be ‘deep, pervasive, and lasting’ to qualify as a recession. It’s important to note that a market cycle isn’t just deemed a recession using a mathematical formula, it’s decided by consensus by many different economists, researchers and government departments.

An example of this is when the National Bureau of Economic Research (NBER) designated the time of economic decline caused by the Covid-19 pandemic as a recession, which lasted just two months. As definitions might vary, you will notice that when a recession is spotted, it won’t always follow the same defining rules. This recession was noted as the shortest on record. 

In the US the NBER will look at data from non-farm payrolls, industrial production and retail sales as indicators to help pinpoint the start and finish of a U.S. recession. 

It’s important to note that definitions of a recession will vary depending on the country or institution. The EU has a similar definition as the NBER as they use GDP and other macroeconomic variables like employment. 

The Organisation for Economic Co-operation and Development (OECD) understands a recession as a minimum of two years during which the cumulative output gap reaches 2% of GDP and the output gap is at least 1% for at least one year. 

What causes a recession?

Theories circulate on the exact causes of a recession and most of these fit into either psychological, financial or economic factors, the following examples can be deemed as causes for a fall of growth, resulting in recession. 

  1. Economic 

An event that would constitute as a huge shift in a single industry or a geopolitical change could be the cause of a recession, many researchers tend to focus on this area. 

Examples of this could be a surge in oil prices due to political instability in the Middle East, rising gas prices due to pipelines being shut off or even a new technology like blockchain replacing large swathes of a workforce or making entire industries obsolete. 

  1. Financial

Some economists look at the financial factors that downturns are dependent on occurring first to be deemed a recession. This category has a focus on rising credit and increasing financial risk which happen during economic growth or credit contraction and money supply.

As individuals and businesses overextend into more risk and take on greater credit, people could begin to default on these loans, institutions then can’t pay back other creditors, which quickly snowball into deeper financial issues for the economy as banks default on their own loans. An example of this would be the 2008 credit crunch.

A popular example of this theory would be monetarism which puts across the idea that recessions can be caused by a lack of growth in the money supply.  

  1. Psychological 

Extreme emotions such as excitement or pessimism during market cycles can deepen and prolong cycles such as recession. If people see the economy is in a state of recession, they’ll often take years before they can regain trust in the markets. If the trust doesn’t come back for the workforce, they’ll be less likely to spend and invest, further lengthening the market cycle. 

The same goes for times of economic boom, as more money flows into a market or economy, and conditions are improving, the average person will experience FOMO and begin investing more into the market and economy, with enough people deploying capital, the market moves further and further in an upward trajectory, investor confidence grows and becomes overextended. 

An example of this would be Keynesian economics which focuses on psychological and economic factors and will deepen economic growth or decline. Euphoria within a bull market is what leads to unsustainable speculation.  

How does a recession impact the real estate market? 

Recessions will often have a major impact on the real estate market as those that can afford a property fear the significant decline in property prices, worrying that prices will continue to fall and then devalue their initial investment. 

On the other end of that, you have those that want a home but can’t afford it due to rampant unemployment. In both the UK and US, experts have warned of a housing recession, with data pointing towards this risk increasing.

When the economy is in decline and a recession happens, this leaves a high supply in homes with a lowered demand, more properties come on to the market and property prices fall to try to entice buyers back into the market. 

During tough times like this, people will struggle to pay loans and mortgage delinquencies and foreclosures will rise. To take back control of the market, the central bank of that particular country will often lower interest rates in an attempt to spur economic growth. 

For investors that hold large sums of capital, they can take advantage of these times by purchasing properties at a lower price and then benefiting once the recession ends and markets recover. 

Even for the average first time buyer, it can be a great time to buy a property that interests them, the issue is the rising mortgage rates which make it harder to repay the initial mortgage loan. 

What are the drivers of the real estate market? 

Home sales, housing starts and mortgage rates are all major drivers of the real estate market. 

“Housing starts, or homes newly under construction, plunged 9.6% in July, 2022. The number of new construction projects totalled just 1.4 million, or 100,000 fewer than expected, while building permit applications fell 1.8% from June levels.”

There are two main reasons for driving the housing market recession of today and that is increasing interest rates and the increase in construction costs. 

These are the highest interest rates the US and UK have seen in many years and new buyers are reluctant to buy a property fearing rising mortgage rates. 

Supply chains are still suffering from the Covid-19 pandemic as prices haven’t returned to pre-pandemic levels due to rising inflation rates keep driving prices higher. These two factors. 

The Housing Market Cycle

The recession is just a stage in a four part journey for the housing market. Recovery, expansion, hyper supply and recession are how the market flows. As the market is currently staring into the eyes of a recession, Paul Esajian of FortuneBuilders suggests that a good time to invest would be in the next recovery stage as prices are typically at their lowest, and the economy is recovering meaning the end of decline is over. Properties will be below-market value and if you can understand when this phase begins, you’ll be able to take advantage. 

 

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Disclaimer

Nothing in this article constitutes financial advice or guidance. The content in this article is an opinion and is for general information purposes only. This article is not intended to be relied upon to make financial decisions. It is not intended to be financial advice. The value of your investment can go up or down so you may get back less than your initial investment. The article may contain links to third-party websites or resources. Hedgehog provides these links and resources only as a convenience and is not responsible for the content, products, or services on or available from those websites or in those resources, the links displayed on such websites or the privacy practices of such websites.‍