How Recession Happens? 8 Tips to Prepare for it!

Introduction

An economic recession is simply defined as a significant decline in the economic activity spread across the economy that usually lasts more than a few months. More economically speaking, a recession is a decline in a country’s Gross Domestic Product or a negative real economic growth for two or more successive quarters in a year. The latter is a widely known definition of recessions as well as a widely-accepted one.

A severe or long recession is referred to as an economic depression. A devastating breakdown of an economy (essentially, a severe depression, or a hyperinflation, depending on the circumstances) is called an economic collapse.

Is Malaysia heading towards a recession? We’ll never know until it happens.

What causes recession?

The reasons behind economic downturns remain largely unsolved. However, there are several traditional explanations to the phenomenon.

The traditional explanation – Economy-wide changes

The traditional explanations postulate that recessions are caused by events that have an economy-wide impact, such as an

  • increase in interest rates
  • decline in consumer confidence.
  • Firms reduce output and lay off workers, which further decreases demand, and the economy slows even more.

Caused by events that hurt particular firms or industries

Economic recessions can be caused by events that would have an impact on specific companies or industries. For instance, a major innovation can adversely affect some firms, causing them to reduce production. This would in turn lead to a retrenchment of workers. On the other hands, positively impacted companies would need extra hands and seek additional workers.

It naturally takes time for the displaced workers to find new means of employment. During this phase of “reallocation” a situation of recession may occur.

Recession Cartoon

What happens during recession?

Rise of Unemployment rate

During a recession, there is a general trend of rising unemployment rates and decreasing overall output. With fewer people contributing to the economy, the overall economy is bound to be affected. Income growth would be stalled. While there would be more people in the market looking for employment, the demand for recruiting people is far lesser.

When people are earning lower incomes, their spending power decreases. As such, there is a reduction in spending. Businesses are limited in their ability to pass along any increases in expenses in the form of higher prices. In order to move goods off the shelves, businesses are more likely to reduce prices. This eventually causes deflation.

With prices drifting downward and commodities becoming more affordable, consumer spending will once again kick off and increase. The increase in consumer spending, over time, leads to an increase in industrial production. This in turn improves corporate profits leading to increased employment and improved earnings, etc. This is how the economic cycle takes place.

That’s why people say economy won’t growth continuously without recession.

Stock market plummet


Photo by alexthecat

People are generally conservative during recession. Those who lose their jobs because of recession start selling off their investments because they need money to sustain while they get another job. The increased number of people selling their stocks causes the stock market to fall sharply


Real Estate plummet

During a recession, people turn to fiscal conservatism. This affects the real estate industry as well, as there is lesser demand in the real estate market. People put off buying and selling of property during the periods of economic recession. Another scenario is where the increasing levels of unemployment during a recession cause affected homeowners to sell their home to accommodate changing job demands.

On the other hand, because of the higher supply of houses on sale as compared to the low demand, an economic recession will forcefully reduce the selling prices of homes. As such, the economic recession has a positive impact on potential homebuyers. This is also because there are lower mortgage rates that are caused by changes in interest rates.

How A Recession Impacts Your Daily Life?

1. Lose your job

Newspaper columnist Sidney J. Harris distinguished terms this way:

“a recession is when you lose your job; a depression is when I lose mine.”

2. Can’t afford to pay back your mortgage

A sudden loss of job can cause retrenched employees to experience a negative monthly cash flow. A similar situation can also happen if your employers go bankrupt suddenly. Arrears on mortgage can also causes homes to be auctioned. In a worst-case scenario, sometimes, even after the homes are sold forcefully, people still owe the bank, money.

3. Watch your investment portfolio shrink in value

High exposure in equity will result in a sharp fall in the stock market. When people are Investing too aggressively in a bubble economy, it is extremely risky that one day your stock portfolio just shrink 50% within a few days.

How to prepare for recession?

1. Create a worst-case scenario

Create a worst-case cash flow forecast. Predict how bad it could be if you lost your job or if your business dropped in sales by about 50%.

2. Build up an Emergency fund

Prepare an emergency fund with enough money to cover at least 6 months of expenses.

3. Have a consistently rebalanced investment portfolio

This ensures that you lock the capital gain of certain asset classes when it is booming.

4. No matter what field of your profession, always strike to be the best

Always strive to be the best. Avoid becoming redundant or “fat” in your company. If you do not prove your worth, you will be the first to be led to the exit door during a recession.

5. Diversify your income source

Please beware if you are in a business that serves just 1-2 major customers. You will be at a great risk during a recession. For employees, work out some forms of alternative income besides the main employment.

6. Know your funding sources and manage the relationship properly

Another way to prepare yourself for a slowdown is to know your funding sources and manage the relationship properly. Remember, when funding sources tighten they do so selectively and this applies to their sources of business as well as the credits.

7. Learn to live on less than your income

You may see pay cuts in your job during an economic recession, so look now for ways to trim your budget as much as possible.

8. Last resort – compromise on your lifestyle

When everything doesn’t seem to work out for you, go for the last resort: try reducing your lifestyle dramatically. Sell that luxury car. Move to a smaller house. Cut down on expensive dining.

Cash is King

Cash is king during recession. It is only in your best financial interest to acquire assets (stocks, real estate) during a recession.


Photo by johncohen

Changes in interest rate levels are made by the central bank regulator (Bank Negara, Federal Reserve etc) as a way to regulate the economy. In a period of economic downturn, interest rates are reduced in an attempt to revive the economy. This is because reduced interest rates are usually attractive to businesses and for people who want to borrow money or refinance existing loans at a reduced level. Consequently, lower interest rates will result in lower mortgage rates, which produce monthly mortgage payments that are advantageous for home buyers.

Conclusion

There is a possible recession looming. Some people will be harmed and subsequently, the economy will be blamed. They are probably right now maintaining the status quo and simply hoping it doesn’t happen.

Prepare now and you will find that you will not be affected very dramatically. This will leave you in a better edge. Preparation for a recession will enable you to react to changing times and take advantage of select opportunities.

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30 Comments

  • Irwan.biz

    Reply Reply February 19, 2008

    Other than cash, it’s advisable to invest in precious metal such as gold/silver. The values for these metal are usually unaffected if not going up during recession.

    • KCLau

      Reply Reply February 19, 2008

      @ Irwan,

      Why don’t you share your opinion about investment in precious metal? I would like to hear about it.

  • thewild1

    Reply Reply February 19, 2008

    Really great break down of what a recession really means. Lot of people are screaming that it is come, but they don’t really know what it all means.

  • eric

    Reply Reply February 19, 2008

    Thanks for this article – it’s very concise and informative.

    Would like to know, what is your thoughts on the BLR rate this year, with recession looming on the horizon, brought on by US’s decline?

    Some say the BLR’s going to balloon; others opine that since it’s a cost-push inflation, we’ll see the rates reduced to encourage local spendings.

    • KCLau

      Reply Reply February 19, 2008

      @ Eric,

      In fact, we never know the future, but can only predict. However, I don’t predict because it is pointless.
      If you are concerning about BLR rate fluctuation because you are taking up housing loan and some other form of loans that is tied to BLR, I think you don’t have to worry much.
      There are more banking institution giving loans and the competition is heating up. When there is competition, every banks will provide the best rate for their clients, and still make money. It also depends on the banks’ efficiency.

      Consider 4 years ago, housing loan interest rate is BLR+0 (last time BLR = 6%). Recently, banks offer BLR – 1% (BLR = 6.75%). Can you see the difference?

      In fact, I never bother about BLR fluctuation for this year.

  • money chaser

    Reply Reply February 20, 2008

    The easy way to invest in commodities are ETFs There are many ETFs out there that track the spot price of everything from gold to various grades of petroleum.

    I believe this approach is less risky because you are holding the assets indirectly. These instruments are also very liquid because they are cash-settled.

    Check out
    http://finance.google.com/finance?q=GLD
    http://finance.google.com/finance?q=USO

  • sg

    Reply Reply February 20, 2008

    Here’s my take based on some internet reading…hehe

    In Austrian economics, recession happens after a false boom caused by increased money supply (low interest rates, printing money). This inflation causes bubbles throughout the economy.

    This inflation isn’t felt instantly, because when new credit is created or new money is printed, certain folks see it first. So, what will happen is these folks will release the credit, buying stocks, houses. This will cause stock market to rise, house price to rise.

    This ‘heroin dose’ from the central banks can’t last forever, because if they keep printing money real inflation (food, energy, household items…) will occur, exchange rates will drop, and the government might lose election.

    So, they pull the plug. Without the heroin, the artificial demand drops, house prices drop, stock market drops, and anything dependent on it fails.

    That’s recession for you.

    ps. governments think that printing more money will solve it (lower interest rates). But it’s just another shot of drugs. It just delays the judgment day. in fact, don’t you see inflation being very bad now?

    pps. since they’re always inflating money, invest in real things that have intrinsic value to protect from inflation: commodities (gold, silver, palm oil, soy beans….)

  • InvestorBlogger

    Reply Reply February 24, 2008

    This is really great advice. I liked the section on how to prepare. Could it be that this upcoming recession in the US will affect many countries?

    Kenneth

  • BT Khoo

    Reply Reply March 1, 2008

    Do you think that our country is going to be affected by what is going on now in the US, the subprime crisis

  • Joh Wifggins

    Reply Reply June 11, 2008

    You must understand that for a healthyu economy, a recession will be caused every 10-15 years.

  • maridula

    Reply Reply April 5, 2009

    i m ab.tech student and this site was really enriched with information i wanted in my report abt.recession nd i will b taking its advantages in future too

  • Sarah Johnson

    Reply Reply June 2, 2009

    Hi, Thanks heaps, this information was very informative and interesting. I thought reading about what a recession wasetc was going to be boring but this wasn’t
    thanks again and well done

    Sarah

    • KCLau

      Reply Reply June 4, 2009

      @ Sarah Johnson,

      Welcome to my blog and thanks for your kind words.

  • ChampDog

    Reply Reply June 6, 2009

    Great article! I like the prevention or preparation section as well. : )

  • sleek

    Reply Reply June 11, 2010

    Hello,
    Really great work, I’m working towards a research on recession. It helped me with some details.
    Thankyou very much and thumbs up.
    sleek

  • ben

    Reply Reply September 19, 2010

    one way to earn during recession >>> short the future market !

  • Jeremy

    Reply Reply June 1, 2011

    Very well written lau but i dont really agree with cash is king durng recession. Perhaps cash or currency is actually devaluing frome time to time. What w are holding now is not similar to years later.

    Just my thoughts.
    jeremy

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