What is a recession?

Introduction

With soaring inflation fuelling a cost-of-living crisis, talk has turned to recession. A hugely emotive word, the very mention of recession might see you scrambling for the lifeboats, but it’s worth being reminded of what it actually means and what the implications might be.

So, what is a recession and how can it affect you, your savings and investments, and your mortgage?

What happens in a recession?

A recession is a temporary downturn in economic activity. This is where the economy ceases to grow and begins to shrink. In the UK, we define a recession as a decline in Gross Domestic Product, or GDP, for two consecutive quarters (six months). This is regardless of how slight or severe that decline may be.

GDP refers to the total value of a country’s output over a set period. This means the goods and services produced. Under normal circumstances, GDP expands. In times of economic uncertainty or crisis, this can be reversed.

When a recession hits, the consequences can prolong the decline beyond the initial six months. Although far from a certainty, a list of what could happen in a recession might include:

• Loss of consumer confidence
• A fall in business profits
• Pay cuts and recruitment freezes
• Job losses
• Businesses closing

The combination of job cuts and business closures results in lower tax takings for the government. This can lead to reduced public spending. Further job losses and the national mood can continue to affect consumer confidence too.

Again, it's important to stress that 'recession' is simply a word to describe negative growth in the economy. The consequences mentioned in this article may not come to pass during a recession.

What causes a recession?

Any of the following can cause a recession:

• Financial crisis – can be caused by a combination of financial assets seeing a sharp decline in value, while both consumer and business debts go unpaid, and some banks and other financial institutions experience issues with ready access to cash and other liquid assets
• Loss of consumer or business confidence – spending falls and less money goes into the economy
• Interest rate rises – as the cost of borrowing goes up, demand for goods and services goes down
• Sudden supply issues – a sharp rise in prices caused by higher production costs or disruption
• Credit crunch – banks stop lending, due to a shortage of funds
• Unexpected events – an unforeseen crisis, such as the COVID-19 pandemic, has a negative effect on the economy.

There is often a combination of factors feeding into an economic downturn. For instance, supply issues could lead to high inflation, which in turn leads to a rise in interest rates. This creates the grounds upon which the economy can shrink.

The most significant UK recession of recent times was in 2008-2009, during the global financial crisis triggered by events in the US. It lasted five quarters (15 months), was the most severe since WWII, and included a credit crunch, surging oil prices and the resulting loss of both consumer and business confidence.

It’s too early to predict the severity of any potential downturn this time around, but recessions aren’t a one-size-fits-all occurrence. Just because a previous one was particularly deep doesn’t mean to say any future recessions will follow suit.

How does a recession affect my investments?

Although stock markets often endure a dip during a recession, history has shown they also tend to bounce back. For instance, the markets quickly recovered following the recession of 2008-2009, going on to make significant returns over time.

If you invest in the stock market, perhaps via a  stocks and shares ISA, it might be tempting to pull your investments when facing a recession. Seeing the value of your assets or savings pot fall is frustrating, but it isn’t necessarily the time to panic. It can pay to keep a level head throughout, with a focus on the bigger picture as opposed to short term losses. Staying invested can be better for a long-term return, as it gives your money more time to grow and recover from volatility in the markets.

That’s why with a stocks and shares ISA, you should be looking at a minimum of a five-year investment – to help your money weather any storms encountered along the way.

Keep in mind that investment values are not guaranteed, and can go down as well as up. You could get back less than you invest.

How does a recession impact on house prices?

It’s difficult to predict how the housing market will react to a recession. Sometimes, due to the increased risk of unemployment, mortgage lenders err on the side of caution. That isn’t always the case, but a reluctance to lend can sometimes have a knock-on effect that reduces demand, affecting house prices.

Recession and mortgages

Getting a mortgage during a recession can potentially be more challenging. There is a higher risk that homes with a loan to value (LTV) ratio of 95% could fall into negative equity.

• Loan-to-value ratio – How much you borrow in relation to a property's value at that time, expressed as a percentage. For instance, if you intend to buy a home worth £200,000 and have a deposit of £10,000, you would need to borrow £190,000. The LTV would be 95%, as you are borrowing 95% of the property's value.
• Negative equity – The value of your home falls below the balance left to pay on the mortgage. For instance, you take out a mortgage with an LTV ratio of 95% on a £200,000 property. Within a few months, the value of your home falls below £190,000 due to a recession. You are now paying back more than the home is worth and the property is in negative equity.

At times of recession, lenders may reduce the LTV ratio they are willing to lend at due to the risk of house prices falling. This requires buyers to  find a bigger deposit to secure a mortgage.

Homeowners can also see their mortgage repayments increase. If you are on a variable rate (tracker or standard), you could find yourself paying more each month, due to a  change in interest rates.

Interest rates are increased by the Bank of England as a measure to curb inflation. The logic being that the rise will encourage less consumer borrowing and more saving. If people aren’t spending, the price of goods and services tends not to rise at a rate that feeds inflation. This is because those selling goods and services often lower their prices to match reduced demand.

The rise in interest rates can also see more people being turned down for a mortgage, due to lenders' concern that higher costs will make potential borrowers unable to keep up with repayments.

How long does a recession last?

Recessions are typically brief and are seen as a natural part of the ‘business cycle’. This is the term that refers to the natural expansion and contraction of an economy over time. Since the 1960s, the UK has seen seven recessions, with the average length being 10 months. None have lasted more than five quarters (15 months). Three lasted two quarters (six months).

In the modern era, recessions have become less frequent.

How will a recession affect me?

Despite the temptation to take fright at the first mention of recession, it’s better to remember that the consequences discussed here are not etched in stone. Different degrees of recession mean they must be taken on a case-by-case basis.

In times of uncertainty, professional financial advice can really come into its own.  Speak to a Specialist Financial Adviser from Wesleyan Financial Services for tailored advice and support.