We all hoped that energy prices and overall inflation would fall this summer but then Russia invaded Ukraine.
Since the war in Ukraine has started, prices for food, gasoline, metals, and other raw materials have risen sharply, dashing all hopes of inflation going down, at least for a while.
And, to make matters even worse, economists are now saying recession might be on its way.
Should you be concerned about your portfolio in light of these warnings?
Or is it worth taking a more upbeat approach?
Let’s take a look.
What is a recession?
Numerous theories attempt to explain when and how economic recessions occur.
The general (read boring) definition of a recession is two consecutive quarters of negative economic growth as measured by a country's GDP.
Take a look at the chart below:
As you can see, the recession is a tipping point of a business cycle when continuous economic growth reaches its peak and then reverses, becoming a continuous economic contraction.
But in real life, a recession could mean 4 things:
- slow or even negative growth in production.
- a rash of business failures and sometimes bank failures.
- high unemployment.
- social upheaval resulting from all this economic distress.
So even though recessions are temporary, the economic pain they cause can have major effects on an economy.
What causes a recession?
One of the causes of a recession is a loss of business and consumer confidence. As confidence falls, so does demand. As a result, retail sales slow, producers cut back in response to falling orders, and the unemployment rate rises.
Among other key causes are a stock market crash, high interest rates, food and oil shocks, and inflation.
Key causes of recessions in the past:
- The late 1960s: inflation
- 1973-1974: oil and food shocks
- 1980: oil prices
- 1990-1991: inflation
- 2001: the tech bubble
- 2008: housing bubble
And what could be one of the causes of a possible recession today? Apparently, it’s inflation again.
According to Bank of America strategists, “Inflation causes recession and inflation is out-of-control”.
What countries risk falling into a recession?
A growing number of analysts see a recession coming to at least 3 of the world’s largest economies:
Recession risk in the United States
Economists at Deutsche Bank were the first to say that the U.S. could sink into a recession in 2023.
“Our call for a recession in the U.S. next year is currently way out of consensus,” economists David Folkerts-Landau and Peter Hooper said in their report last Tuesday. “We expect it will not be so for long.”
And it wasn’t.
Bank of America warned that rising inflation could tip the U.S. into a recession: “Inflation shock’ worsening, ‘rates shock’ just beginning, ‘recession shock’ coming,” the bank’s chief investment strategist, Michael Hartnett, said.
And Goldman Sachs sees a 35% risk of recession in the U.S. in 2022, up from just 10% last year.
Recession risk in the United Kingdom
While Deutsche Bank doesn’t specifically see the U.K. falling into recession this year, it does suggest that the possibility of a recession is growing.
Deutsche Bank’s chief economist, Sanjay Raja, explains: “We continue to think that the risk of recession remains on the rise. This is something we will be tracking very closely in the coming months. Consumer confidence data is already consistent with recessionary levels.”
Rising household energy bills are one reason why the bank expects the U.K. economy to "flatten" by the end of 2022.
Recession risk in Germany
Germany could face a sharp recession if gas supplies from Russia were suddenly cut off, the country's leading economic institutes warned.
"If gas supplies were to be cut off, the German economy would undergo a sharp recession," said Stefan Kooths, vice president at the Kiel Institute for the World Economy.
With mounting civilian deaths in Ukraine after Russia's invasion, Germany is now under pressure to wean itself off Russian oil and gas, as critics say the oil cash provides Moscow with vital funds to wage war.
But, apparently, Germany's gas reserves would only be enough to last until late summer or early autumn should Russian supplies stop now.
Should investors worry about a possible recession?
In short, not really. Especially if their portfolios are well-diversified.
Firstly, because we can’t know precisely when a recession could be coming.
Secondly, it’s impossible to know for sure which asset classes will do well if it eventually shows up.
There’s a general agreement, however that, during a recession, riskier assets like stocks and high-yield bonds tend to decrease, while gold and U.S. Treasuries usually go up.
For example, the Great Recession of 2008 boosted the price of gold, even though it fell in the aftermath of the Lehman Brothers' bankruptcy.
But, as the chart below shows, gold clearly outdid S&P 500 right after the crisis began.
Will gold act the same way if another economic squeeze unfolds? No one knows for sure.
But one thing is clear: diversifying your portfolio and taking measured steps to control risk can help preserve your wealth and savings.