Back in 2008, I was a young prospective economics student, observing the ultimate case study. As the madness of the financial crisis took hold, I remember avidly watching the news and markets each day. I couldn’t believe my eyes. How could things change so much and so quickly?
At that time, I had no skin in the game. With barely £500 to my name and a place in university for the next three years, my personal risk was minimal. But regardless of personal stake at the time, anyone old enough, engaged enough or affected enough should have learnt lessons from it.
As the economy has slowly bounced back and kicked on into record-breaking territory, it’s been easy to put those lessons to one side. After all, most of us have benefitted from a surge in economic growth over the last decade.
But our global economy is at a precipice once more now. We will inevitably have a recession soon – and the vital signs of our global economy suggest it could be severe and prolonged.
Why are we close to another recession?
What goes up must come down (a bit).
No, really, it’s that simple. While severity and duration may vary, recessions are an inexorable feature of the business cycle. And the bad news is we’ve just concluded the longest bull market in history and are potentially entering bear market territory. That’s significant because 5 of the last 6 recessions have been accompanied by a bear market. So if the historical evidence is anything to go by, it could be the prelude for our next recession.
What’s more, if we take the biggest economy in the world – the United States – its previous longest period between recessions was 10 years, during the recessions of the early 1990s and 2000s. So in other words, given that the last recession concluded in 2009, probability suggests we’re teetering on the brink.
But the reality is that right now lots of economic indicators suggest the global economy is still quite healthy. And if that’s the case, how can we possibly be heading for an imminent recession?
It’s not unusual for peak economic strength to be followed by a recession just several months later. In fact, that’s a very typical economic pattern. So as we look at peak levels of employment, for example, in many Western economies, this may actually provide clues that we’re nearing a recession.
Why could the next recession be worse than 2008?
A recession in some form is inevitable, but there’s something potentially more troubling this time around. The next recession could oddly be troubled by the characteristics of our recovery from the last one. You see, the problem with our recovery since 2008 is that it’s been underpinned by unprecedented monetary and fiscal stimulus.
That’s not unusual during a recession in order to aid economic recovery – in fact, it’s pretty typical. But what’s different about this recovery is that it’s been supported by on-going and prolonged cheap credit, as well as tranches of quantitative easing (where central banks inject freshly created money into economies). In addition, major economies across the globe have failed to address burgeoning national debt levels.
In normal circumstances, a monetary response to an economic downturn is followed by a monetary correction to normal, higher rates of interest once the economy starts to recover. Similarly, conventional economics suggests we should be running national budget surpluses during steadier economic times.
Only recently, nearly 10 years after the financial crisis, have we seen major economies begin to very slowly increase interest rates. And they’re still a long way from levels considered normal in good economic times. Moreover, the majority of major developed economies have failed to adequately address national debt problems. In the United States, where economic policy risks becoming increasingly protectionist, this could pose an even bigger issue if China responds aggressively.
But the real problem is that a subsequent recession would require a response too. And if we’re already planted at lower interest rates and staggering national debt levels, central banks and governments will have limited room for manoeuvre. They’ll instead probably – and wrongly – turn to quantitative easing, which is an inflationary and dangerous trap.
It all suggests a potentially more prolonged recessionary period could be in store.
Recession proofing your personal finances
Whatever the severity of the next recession, we need to protect our personal finances and position ourselves to capitalise on opportunities. And of course, we need to do this as best as we can before this recession begins.
#1: Emergency fund
The stark reality of recessions is that there are a lot of economic casualties. There will be job losses, and no matter how secure you think your job might be, you’d be a fool not to prepare for the worst-case scenario.
The general advice is that you should have an emergency fund that would cover 6 months of living expenses. That way, in the event of unemployment, you’ll have the cash to cover costs while you seek new employment. If you’re a long way off that, you ought to think seriously about saving up the cash to protect against this risk during a recession.
#2: Cash reserves to capitalise on opportunities
As the prices of stocks, property and other assets drop during a recession, opportunities to pick up assets on the cheap will be rife. If you’ve got spare cash, this is a great opportunity to capitalise on these low prices.
Take the 2008 financial crisis, for instance. If you’d invested $10,000 in the S&P 500 in December 2008, 10 years later you’d have tripled your money. The key, then, is having the cash reserves or cash equivalents to take advantage at the right time.
#3: Clear debt in good economic times
A high level of debt burdens our net worth growth. It therefore also restricts our ability to protect against economic recessions and capitalise on financial opportunities that downturns bring. That’s why it’s imperative that we focus our attention in economic good times on reducing this drag on our wealth.
We can take a variety of approaches to reduce our debts but a couple of the most common are the debt ladder and debt snowball. With the debt ladder, we focus on reducing debt with the highest interest rate first and then work our way down to clear the balances. With the debt snowball, on the other hand, we start by reducing the lowest debt balance – the quick wins, in other words – and work our way up.
#4: Review lifecycle investment risk
Where you are in your financial lifecycle is a critical consideration for the balance of your wealth. If you’re near retirement, you’d be wise to think about rebalancing your portfolio towards lower risk asset classes to protect against economic downside. If you’ve got many years ahead of you before retirement, you have years after the recession to accumulate wealth as stock markets recover.
Think carefully about the balance of risk in your portfolio, but do so not only in the context of your years until retirement, but also in the context of your personal appetite for risk.
#5: Diversify your wealth
If we want to steadily grow our wealth and spread our potential risk, diversifying investments is of paramount importance. If we spread our wealth across various categories, like stocks and shares, property, cash and bonds, we are more protected against downside risk in any one category.
This clearly isn’t a silver bullet. Many asset classes will take a hit during an economic recession and you’ll likely forego some potential gains in riskier asset classes. But it is the generally accepted best practice for personal finance portfolios.
#6: Generate multiple income streams
Another way to mitigate the potential financial risk of unemployment during a recession is by ensuring you have multiple sources of income. Passive income is a crucial feature in the financial independence journey but it also provides some downside protection during a recession.
Think about how you can start to generate additional income from areas aside from your day job. A couple of the most common strategies for income streams are dividend yields on stocks and rental yields on property, but it’s also possible to generate income streams without a large investment commitment.
What should you prioritise?
The chances are that you’ve read some of these suggestions and realised that they might be mutually exclusive for you. Reducing your debt means sacrificing your cash, and holding more cash means delaying your debt reduction. So what should you prioritise?
The answer to that question depends on personal circumstances, of course. If you’re holding a burdensome and expensive debt balance, clear it as soon as possible. In good or bad economic times, this is a wealth killer.
But do not eat into a basic emergency fund to kill your debt. An emergency fund is – you guessed it – for emergencies. Always endeavour to hold a balance to cover for unforeseen eventualities. It may not be possible to get to the recommended level of 6 months of living expenses right away, but make sure you’re on that path.
The remaining areas require a balance of focus. If your financial situation is more mature, then a focus on diversification and alternative income generation might be top of the agenda to protect your personal finances.
Whatever your focus areas, a recession is coming. Prepare for it and capitalise on it – don’t be an economic casualty.
