How to spot a recession

October can be a scary month for investors, as volatility brings with it memories of past market crashes, recessions and speculation about future downturns.

But it takes more than a slowdown to create a full-blown crash, so it’s important to keep warning signs in perspective.

“Recessions happen (when) the balance is thrown off,” said Rose Devli, a finance lecturer at Queen’s University who previously worked as a portfolio manager at BMO Asset Management.

“People stretch for returns, over-lever themselves then growth stalls cannot justify payments and everything falls down. It’s like a deck of cards.”

The difference between a small crisis or economic slowdown and a full-blown recession will often come down to the risk of contagion.

On October 19, 1987, for instance, stock markets crashed worldwide, with the Dow Jones Industrial Average falling by 22.6 per cent in what became known as “Black Monday” – a term that had previously been used on October 28, 1929, to describe the crash that led to the Great Depression.

But unlike the years of hardship that followed the 1929 crash, the massive drop in 1987 didn’t last. Markets bounced back quickly, and while there were several factors that led to Dow Jones’ big losses, many blamed a technological glitch: automated trading machines saw declines and started selling, making the losses worse.

More recently, Greece triggered a European financial crisis in 2009 after high levels of debt forced the Greek government to seek a bailout from the Euro-zone and the International Monetary Fund, or the IMF. The Greek government debt-crisis came on the heels of the 2008 financial crisis, which had already created a lack of trust in the financial system, and led to a crisis of confidence.

“That was … the one card that made the entire deck fall when everyone started panicking (and thinking they should) get all their money out of all European countries. It was run on the European banks,” said Devli.

That level of contagion was limited, however, when compared to the U.S. financial crisis that preceded it. The 2008 credit crisis was triggered when big U.S. banks had to take huge losses on mortgage-backed securities after lending money to would-be homeowners who didn’t have the means to pay back those loans – all with little to no oversight.

“What was really horribly wrong or scary in the financial crisis was the contagion risk because you had household debt attached to property values that were attached basically to banks’ balance sheets,” said Devli.

The 2008 crisis hit not just the biggest economy in the world but also “the most important sector of the biggest economy in the world,” which was the financials, she added.

“When you look at the banks, all this devaluation of the balance sheet, all the write-offs they were taking at the time, and also the correlations between the two and how much each bank lent to one another,” she said.

“It snowballed.”

While the 2008 credit crunch involved levels of debt and a disregard for rules that was “almost unbelievable,” it left behind several lessons and has led to regulatory changes that should help prevent a big of a recession from happening again, said to Pedro Antunes, director of national and provincial forecast at the Conference Board of Canada.

“The difference between the Great Depression (of 1929) and the Great Recession (or the 2008 financial crisis) is that we’ve learned a lot about what not to do in terms of policy when there’s an economic crisis,” Antunes said.

“In 2008-2009 … we saw a concerted effort from the IMF to increase fiscal stimulus. Every country was expected to spend on infrastructure … and we saw in terms of the central banks all sorts of very creative measures to get yields as low as possible … with quantitative easing programs. This went along to avoid the much deeper, longer recession that we might have had.”

That’s not to say that jittery investors or questionable political decisions can’t throw a wrench into the economy.

While economists look at the unemployment rate and income gains, as well as geopolitical events and interest rate movements, to gauge the health of the economy, intangibles like consumer and investor confidence are harder to measure.

“We always need to be aware of some of the global risks (and) understand how interconnected the global economy is,” said Antunes.

“If we start to have problems in emerging markets, people at first worry about Turkey and Argentina, then they start worrying about other emerging economies – these things do spread.

And as soon as you start having an impact on confidence – and we saw this clearly in 2008-2009 – we see the impact on those intangibles like business confidence and that has an impact on equity markets, that has an impact on people’s perceptions and businesses’ perceptions of their wealth (which) has important implications on how people consume.”

Investors worried about a possible slowdown should proceed with caution, and look for investments that offer value or lower risk, and avoid chasing growth, since companies promising returns based on projected data wouldn’t see that growth materialize if a downturn hits, Devli said.

“A typical recession – not a crisis – is a actually a pretty healthy occurrence for an economy … essentially, it’s like a survival of the fittest,” she said.

“You can proceed with added caution, but don’t press the panic button just yet.”




2 years ago