This is adapted from a longer version of an article published earlier. Please read at oureconomist.com.
Economic boom and downturn are natural to any country’s economic cycle. An economic boom is a period where a country’s economic indicators such as Gross Domestic Product (GDP), credit rating, employment rate, inflation rate, market indexes, and asset prices experience an expansion.
Economy and stock market are not one but are closely related to each other. A stock market is volatile which depends on the emotions of investors. High volatility in a stock market may not necessarily mean a disruptive economy but mostly the two end up in the same direction in the long term. To put things in perspective, stock markets are usually weighed daily but economy quarterly.
A downturn, is, however, a phase where economic activities slow down reflecting plummeting market indexes. A downturn may not necessarily end up as a recession. A downturn of more than 10% of a major market index is known as a correction. An economy can still be rescued at this point with new monetary and fiscal policies from Federal Reserve and government respectively. A bear market is when market indexes have dropped more than 20% of its recent peak. An uncontrolled bear market can lead to a recession. A recession is a period where GDP contracts for at least two consecutive quarters. If growth is further curbed, a recession can turn into a depression.
The National Bureau of Economic Research (NBER) defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
A depression is an extreme recession that lasts three or more years or which leads to a decline in real GDP of at least 10 percent. Usually, recessions are common that occur every 6-8 years whereas depressions are rare that occur once in 75-100 years. The Great Depression of 1929 is a great example of major depression. Depressions are more likely to show up when a country is overleveraged on a long term, government is extremely corrupt, country is involved in a major war.
A downturn, recession, and depression can be caused by various reasons. Well known reasons are higher debt burden, market bubble, faulty management, and pandemics.
High debt burden is a natural way for an economy to end up in a downturn. On its course in an economic boom, borrowing increases resulting in a lot of debt being accumulated. Investors borrow money to achieve financial leverage. During the process, the Federal Reserve gradually increases interest rate which makes it harder for investors to invest. When lenders lend money easily to investors, debt grows faster than income. At some point in time, debt turns colossal compared to income. High debt is corrosive to an economy. That’s why increasing interest rates is vital to any economy to protect it from a colossal collapse. When interest rates are high, investors stash their assets because they feel it’s safer compared to investing and begin to deleverage. More and more investors begin to deleverage resulting in a domino effect and eventually economy slows down. Downturn leading to a recession, or a depression depends on how bad the debt burden, monetary and fiscal policies are.
Market bubbles are common where in market scrambles it’s way to peak more than its intrinsic value resulting in a high Price-to-Earnings ratio. A high PE ratio is a good indicator that a given market is overvalued and will most likely result in a crash. The Dot-com bubble is a great example.
Poor management is also a leading factor to trigger an economic slowdown. Corruption and greed can result in massive losses to a company. If a major company that is linked to many fails, the event will have a domino effect and the market will eventually crash. The infamous Global Financial Crisis of 2007-09 is a great example.
Pandemic, in addition to carnage, causes fear among people all over the world resulting in shutting down the global economy for months. This can have a lethal impact on the global economy. Both demand and supply shrink, resulting in an economic shock. COVID -19 is one such example. This is also the first of it’s kind and the impact is uncertain as it depends on development and distribution of vaccine.
Notwithstanding economic stimulus by the Federal Reserve, bear markets are painful. Fear, unemployment, losses, uncertainty dwell for long. The silver lining is that every downturn eventually ends with an increased confidence among investors. Companies with significant cash pile and the ones that gets bailed out survives. Some strong companies buy undervalued potential companies. Eventually, best companies in every industry come out stronger and weaker players don’t survive. When bear market finds a new low equilibrium, confidence among investors gets slowly instilled. As more and more investors invest, an economy heals. There have been seventeen recessions in the last 100 years. On an average, recessions lasts for one and a half years and needs five years to recover. A good foresight of the economy will mitigate the ominous effects of bear markets.
Picture source: economist.com