It’s very likely that you’ve already experienced the effects of a recession firsthand. After all, the whole world experienced a huge financial downturn from February to April 2020, thanks to the massive lockdowns and economic inactivity caused by the COVID-19 pandemic.
Now, as inflation continues to soar and the Federal Reserve struggles to tame it, there’s been heavy speculation that a new recession may be forthcoming.
If all of this talk is making you nervous — don’t fret.
In this piece, we’ll go over everything you need to know about recessions, including whether we’re actually headed toward one, and how to prepare yourself financially to weather the storm.
What’s Ahead:
What is a recession?
The National Bureau of Economic Research — the entity responsible for declaring whether we’re in a recession or not — offers the following definition of a recession:
“a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”
Although most recessions are short, one of the key factors signaling that one may be underway is when the GDP experiences a sharp decline for two consecutive quarters.
The term “GDP” stands for gross domestic product, which is a measure that tracks the growth or decline of the market value of the goods and services produced by a country during a specific timeframe.
But what causes the GDP to fall?
Well… a combination of things, including:
- High inflation.
- High interest rates.
- Shifts in demand for goods and services.
High inflation forces people to cut their spending, as everything costs more. Likewise, rising interest rates make borrowing more expensive, so many consumers, as well as businesses and government agencies, refrain from taking out loans or applying for credit.
Tightened budgets cause the demand for certain products and services to fall (at least temporarily), so companies start cutting employees’ hours or laying them off to stay afloat, which also slows down production. This, in turn, causes investors to shy away from investing in certain sectors.
The combined lack of spending, borrowing, trading, and investing shrinks the economy and causes the GDP to fall.
Are we headed toward a new recession?
Back in April, Deutsche Bank was the first major financial institution to say that a recession may be coming our way. In its report, “Prepare for a hard landing,” the banking giant predicts the U.S. will be entering a recession in 2023, citing high inflation and rising interest rates as the key drivers.
Leon C. LaBrecque, executive vice president and head of Planning Strategy at Sequoia Financial Group, considers himself a “student of recessions.” He agrees with Deutsche Bank’s prediction.
“We are gaining warning signs, like the 10-2 inversion. This time it’s demand induced versus supply induced, but it is there nonetheless. The Fed is in a predicament that the real interest rate is still vastly too low and has now turned hawkish with more rate increases,” LaBrecque says.
“With the pandemic perhaps exacerbating the supply chain disruptions, and the fact that low unemployment is somewhat inflationary (to hire, you need higher wages), I could see a recession by early 2023,” he adds.
6 ways to protect yourself against a recession
Although there’s nothing you can do to stop a recession from knocking on your door, there are a few things you can do to protect your finances in case one comes our collective way.
Review your budget
LaBrecque says a key part of coming up with a good financial strategy to weather any recession is asking yourself the following: “What’s your cash flow? Good, bad, or ugly? What if your income goes down 20% or 40%?”
Recessions are often marked by high unemployment rates. According to the International Labour Organization, it is estimated that 114 million jobs were lost worldwide as a result of the COVID-19 recession, even though it only lasted about two months.
Now is a good time to assess whether you can afford your fixed expenses — such as your rent, utilities, groceries, and minimum debt payments — in the event that your income is substantially reduced.
If you have a habit of maxing out your budget each month, identify opportunities to cut back any unnecessary spending.
This includes: getting rid of subscriptions you don’t need or rarely use, switching to a cheaper cellphone plan, and evaluating your insurance coverage if you haven’t made any changes to your policy in years. That way, you’ll have some wiggle room in your budget if things go south.
Related: How to make a budget: Our step by step guide to managing your money
Bulk up your emergency fund
“Always have three to six months of expenses saved in an emergency fund in cash,” Kirsten Crane Cadden, CFP and associate advisor at Warren Street Wealth Advisors, says.
“If you are in a high-turnover industry or a field that is prone to layoffs or furloughs during economic turmoil, consider leaning toward a fund that could cover at least six months or up to one year of necessary expenses,” she adds.
Although this may be easier said than done, especially when you have many bills to pay, like student loans, rent or a mortgage, and insurance, it is essential that you try to bulk up your emergency fund as much as possible. That way, you’ll have a cushion to fall back on if you suddenly find yourself unemployed or working fewer hours than usual.
Related: Emergency funds: everything you need to know
Regulate your investor anxiety
The stock market might experience dramatic swings during a recession, which can make anyone nervous, particularly if that’s where all your retirement money is invested.
However, Jessica Goedtel, CFP and founder of Pavilion Financial Planning, advises against adjusting your portfolio in anticipation of a recession.
“Before making changes to your 401(k) investments, think big picture. The average recession lasts 1.5 years, which is just a blip on the radar if you’ve got more than 25 years until retirement,” Goedtel says.
“If you’re trying to sell gains before the market drops, remember it’s almost impossible to time the market. Even if you do time that correctly, you still have to decide when to get back into the market. Too many times people get this wrong when they would have been better off staying on course with their current strategy,” she adds.
If you’re unsure whether you have a well-balanced portfolio that can withstand the ups and downs of the market, the best thing to do is have someone you trust — either a CFP or an investment advisor — take a look at it, so they can make any necessary adjustments.
Otherwise, making rash investment decisions based on fear could lead to long-term losses and a smaller retirement nest egg.
Read more: When is it time to hire a financial advisor?
Live within your means
Do you have a tendency to use your credit card for purchases, even when you don’t have the immediate cash to repay it later? If so, a recession is the right time to do some financial soul-searching and finally change this habit.
Read more: How to use a credit card responsibly
One of the ways banks and other financial institutions try to protect themselves and their assets during recessions is by implementing “credit crunches.” If you’ve never heard the term before, it basically means that banks will tighten their lending requirements. So you’ll only get access to credit if you can prove you’re an excellent borrower.
The last thing you need in a recession is to be knee-deep in unnecessary debt, as this could hurt your chances of being approved for more essential financial milestones, like loans for buying a house or a car.
Generally speaking, it’s a good idea to aggressively cut back on any high-interest debt you’re carrying (e.g., credit card debt) before a recession. If your income is reduced, you don’t want to end up in a position where you can’t make the minimum payments on what you owe.
If you’re currently carrying credit card debt, think about paying it off with a personal loan, since you’ll most likely get a lower interest rate for the loan than you’re paying for the credit card. You can alternatively see if you qualify for a balance transfer credit card, which will allow you to transfer your credit card debt to a new card with a low-interest rate (preferably 0%) for a period of a year or more.
Think about your income source(s)
During the COVID-19 recession, the retail, restaurant, hospitality, entertainment, manufacturing, travel, and leisure industries were amongst the most affected, while other industries, like healthcare and technology, thrived.
If you work in an industry prone to layoffs or furloughs during economic downturns, it may be time to research whether or not you can perform the same job in a different industry that’s more resilient.
Likewise, this may be as good a time as any to finally pick up a side hustle. That way, if something goes wrong with your day job, you still have another stream of income to tide you over until things improve.
Related: Side hustle ideas
Don’t panic
Okay, you’re probably like, “What? How am I not going to panic if my financial security is at stake?” But hear me out.
Recessions are bad news, yes. But they’re also temporary. Sometimes they can be super short. For example, the COVID-19 recession only lasted about two months, while the Great Recession, which is considered one of the longest in U.S. history, lasted 18 months. So, even if things get tight for a bit, it won’t last forever.
Summary
Recessions can’t be avoided, but that doesn’t mean you can’t protect yourself against them. Although some of the strategies listed above can be harder to implement than others, they’re all worth at least a try, as they can go a long way when things get tight.
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