Episode 92: Q&A—let’s talk about recessions

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Macan Nia:

Commentary is for general information purposes only. Clients should seek professional advice for their particular situation.

Peter Ward:

Not even going to bring up Manchester United, I don't even want to talk about it this time.

Kevin Headland:

Recession, that simple word can create a sense of fear in the minds of many investors. But what is a recession? While it's defined in economic circles as two consecutive quarters of negative GDP growth, it's not always that simple. Recessions are officially declared by the National Bureau of Economic Research in the US and the C.D. Howe Institute in Canada. These two institutions have a committee that reviews the business cycles of their specific country and will decide on whether all their preset conditions have been met before declaring the official recession.

But what does that mean for investors? Since markets are forward-looking and will often react in anticipation of a slowing economy, investors should not wait until a recession is declared before preparing their portfolio. A slowing economy is often synonymous with slowing earnings growth and therefore, more due diligence is necessary to identify investment opportunities or risks. In this episode of Investments Unplugged, we bring our producer, Peter Ward, out from behind the curtain. He'll facilitate a Q&A about recessions with myself and Macan. Listen on, this is Investments Unplugged.

Peter Ward:

And Kevin, I'm not even going to bring up Manchester United. I don't even want to talk about it this time. You're doing way better.

Kevin Headland:

That FA Cup game yesterday was a classic. What a great game.

Peter Ward:

That was wild. I couldn't believe it. Even from a neutral perspective, I was very impressed. And, of course, I heard from my dad right away about the glory that's coming to Man United this year, so. We'll leave it there.

So today we're going to talk about recessions. We're starting to hear it a lot more in the news and things like that, and economists are starting to predict Q4, Q3. So we want to really just talk about what this means to the average Canadian. So let's maybe start with the technical definition of a recession and what it might mean for the average Canadian.

Kevin Headland:

So the technical definition of recession is two consecutive quarters of negative economic growth or negative GDP. That's what we call a technical recession. It's important though that for a recession to actually hit the headlines, it's typically declared and it's declared by a institute called the C.D. Howe Institute for Canada and the National Bureau of Economic Research for the US. Now, both of those think tanks have members of a council and they look at different indicators and different variables and economic data and whatnot that have to all be flagged before they declare a recession. So you could actually get two consecutive quarters of negative GDP growth without getting necessarily a recession declared quote unquote in the newspapers or the headlines. So it's important to understand that. And there's different levels of recession. It's a word we use often, but there's a lot of different definitions, I would say, different expectations and different results after recession as well.

Macan Nia:

As Kevin mentioned, the definitions or the contributors change throughout time as well as an economy changes through the decade. So example, when you look at GDP, so gross domestic product, as we were talking about before, there's different factors into it. So broad-based, there's inventories, there's government, there's net exports, there's investments, and there's consumptions. And the contributing factor to those prior to a recession and coming out of them, they do change depending on what the flavor of that recession was.

The contributors going into COVID or coming out of it were very different than the great financial crisis or that from the '90s. Over the past couple of decades in the US as an example, manufacturing used to be a much bigger contributor to the economy than services. And as the economy has evolved, manufacturing has become less, services has increased in its importance, so it's evolving. So all of that in a nutshell, I think we like to use these technical definitions because it makes it black and white, but in reality there's a lot of gray in terms of the weakness, the degree of the weakness, what's contributing to it, what's not contributing to it. So it's changing and it's very complex.

Kevin Headland:

Also, how it pertains to the average Canadian, as you mentioned, Peter. The average Canadian could feel that they lost their job or there's layoffs in their company and they're worried and maybe they hold back spending. They might feel that their individual economy, shall we say, or their individual situation, feels recessionary, whereas others don't. So it's also very different in terms of how you feel.

Do you feel really positive about the economy and where you are in a personal situation or you're feeling a little bit more constrained, a little bit more worried? That changes also, but also that tends to permeate through your consumption. And if on aggregate, more Canadians are more fearful about their own individual economic situations, they might consume less, which would then almost be a self-fulfilling prophecy that would create an overall recession because demand slows so much that the economy, the data comes out negative in two consecutive quarters.

Peter Ward:

So then it could just maybe start in one sector and no two recessions are the same, and then that snowballs from the people in that, that are affected by it, pulling back and causing a larger spread almost.

Kevin Headland:

For sure. And the other thing I think also is that the last few recessions we've had, especially in the US, but there tends to be when there's a US recession, Canadians tend to feel it, and we often have a Canadian recession as well, although we can have a Canadian recession without a US recession, but the last few recessions we've had have been crisis level recessions, COVID, financial crisis, 2001 tech wreck. These tend to be very big draw down, equity markets as well. And when we say the word recession, for investors, it tends to be a fearful name, a fearful word, and that's not always the case. It's been a very long time since we had just a simple reset of the economic cycle.

Peter Ward:

And I think that's a great segue into the next question. Sometimes recessions aren't as bad or severe as in recent history. I think a lot of people carry the scars of the great financial crisis in the dotcom crash. You know it's bad when they have to name them. But like you just mentioned, Kev, sometimes it's just a simple reset of the economic cycle. So maybe talk us through some of the different types of recession, like a shallow recession versus deep recession, for example.

Macan Nia:

Yeah, I think when you look at shallow recessions, they're typically GDP declines in a shallow recession from anywhere being up to minus 2%. So we've seen that historically where the dotcom for example, and I think we're going to talk about it in a bit, but the difference between markets and economies. So the dotcom crash from a market perspective was severe, but from a recessionary perspective was a very mild recession. You had mild recessions in the early '70s, you had one in 1990, 1960. Typically, and not to make generalities, but in general cases, when you get a recession, you have an increase in the unemployment rate. And you typically have, in mild recessions, that unemployment rate increases, but not to a high degree. You get that mid to maybe mid to high single digits. Those more severe recessions are the ones where you have GDP declines of greater than 3%.

So looking at the great financial crisis, that was a very severe recession, the most severe in modern financial history outside of COVID. You saw a peak decline of roughly 5%. You saw that unemployment rates skyrocket. Putting COVID into perspective, I just talk about great financial crisis being a decline of roughly five. The COVID decline was roughly 20% because we shut down the economy. So how bad could it get this time?

Typically, the ones that are more severe are ones where there's an impact to the financial system. And what I mean by that is credit dries up, banks stop lending to businesses, banks stop lending to individuals and it exacerbates the problem. This time around, if we get a recession or even a slowdown, we don't anticipate it being a strong one because the banks are very well capitalized here in Canada, US as well. The unemployment rate we believe will increase at the margin, but it's unlikely to increase significantly because the employment work continues to be somewhat decent. So I think if we get one this time around, it's more likely to be on the mild side.

Kevin Headland:

And some of the data that Macan just talked about is US-specific and we tend to use US data because it's broader and more deep and we've got a lot more information on it. Going back to the C.D Howe institute, for example, they have five categories of recession. One being mildest and five being the most severe. And one tends to be that broad drop in real GDP, but no decline in quarterly unemployment. Now we've already seen a material increase in unemployment from the low levels after COVID of 5%, in Canada, up to 5.8%. Now people think that's a large move. However, we're just now near the worst period, pre-COVID. So we're almost just back to normal, shall we say, after the impacts of COVID.

So this is by no means one where we would say it's extreme recession where it's unemployment led. Typically, you have that because if you have your job and you're just worried about it, you hold back a little bit, maybe you make cuts here and there. When you lose your job, you have to really make cuts, and this is where it flows through the financial system. This is where you could get much more defaults on your mortgage or much more impacts to the financial system. This is not what we expect. Again, this is not going to be an unemployment recession, but more likely a technical recession we said, two consecutive quarters of slightly negative GDP growth and ideally a reset of the business cycle.

Peter Ward:

So now just to touch on the COVID recession, what are your thoughts on that? It was almost like a man-made recession, I would say. Would we have had that recession had COVID not hit?

Macan Nia:

All the signs, actually interesting enough, as we were going into 2020, the global economy was slowing. Now whether we were going to get a technical recession can be debated, but the global economy was slowing and it seemed like we were at the end of the business cycle. And all that COVID did was make sure it happened because we shut down the economy from Feb to April. So I anticipate from a minimum we would've had a slowdown and we may have likely experienced a recession as well.

Peter Ward:

So there's a big focus on calling the recession. The joke goes, economists have predicted 15 of the last 10 recessions, but the market's on the economy. So can we expand on the differences there between the markets and the economy?

Macan Nia:

Well, the market can be... It depends actually on the market and the country. Canada's a great example where our index, the TSX, is heavily focused on a few themes. One is financials, and then we always lump in energy materials in the same, but that's very different than the Canadian economy. You can actually get sell-offs in the markets without actually having a recession either, and that happens quite often.

Let's talk about bear markets. So that's a financial term of sell-offs from the peak to the trough of roughly 20% and you get quite a bit of those outside of recession. So we had one in 2018, we had one during the European financial crisis. There was one with the Asian currency crisis. So you can get sell-offs that are material outside of recessions. Typically though, when you get a recession, you get a material sell-off leading into it. I don't think we've seen one where you get a recession without market selling off because at the same time the market is an indication of profits and if the economy is slowing down, as Kevin alluded to, people are spending less, it's likely going to have an impact on company profits and then expectations or forward returns for markets.

Kevin Headland:

It's also important, especially in Canada, TSX tends to be more focused on global economic demand and recession or slowdown, given that we are a large exporting country. So that's important to understand from that perspective in terms of what our expectation of TSX is. Also, where we are coming into it from a valuation perspective, have we had a material jump and valuation is expensive, needs to be a pullback or a readjustment. There's a lot of multiple factors there.

And as Peter, you alluded to earlier, in terms of sectors, when we look at the TSX, not even from a sector perspective, but maybe individual companies and say, even without a recession, we're talking about a perhaps economic slowdown. And Mac and I have talked about this ad nauseam over the last, call it six months or so, is this notion of when we think there's an economic slowdown, we want to be more specific in the types of companies we want to be invested in. So it becomes more of, not a binary decision, equities, no equities, it's more about let's identify the good businesses versus the potential poor businesses that might be more impacted by an economic slowdown. So even in a market pullback during recession, that also could be taken as an opportunity rather than a reason to be fearful.

Peter Ward:

So you're saying that even in a recession, some companies may still do well, granted that we'll see an overall market pullback, but some individual companies may not be affected by the cause of the recession or may have certain attributes that allow them to stay profitable?

Macan Nia:

Yeah, and it's about changing the style or type of investments you may want to own or the type of companies you may want to own. During a recessionary period, Peter, the market takes all these companies down together from a price perspective, but that doesn't necessarily mean their underlying businesses have changed. So they could continue to be growing their earnings, their margins, but the market has just discounted the entire, really the entire market because of recession.

What we care about is during those recessionary periods, is there going to be a fundamental change to their business model? So if there is a fundamental change, that's a different discussion than if their market price goes down, but the actual business hasn't gone away. And if anything, it's getting stronger, because it's those companies that are more likely to be able to recover coming out of that recession.

We've talked a lot about inflation over the past couple of years, talking with our portfolio managers and the companies that they invest in, I was talking with one of our portfolio managers and they were talking about the individual securities that they own and the type of businesses they're in, and they've been able to pass on a lot of that inflation costs. So yeah, inflation has been tough for businesses, but not all businesses. If I'm investing in a product that I want regardless of the inflationary environment, if they add whatever 5% increase, I'm going to pay that 5% increase. I may not pay for another product. So in any given market environment, there's always opportunity to invest. And even in a recessionary period, there's opportunities to add value.

Kevin Headland:

Benjamin Graham said many years ago, in the short-term, markets are voting machine, long-term, a weighing machine. And when we talk about price sensitivity and the market pulling down things overall price, it tends to be that voting machine, right? Just sentiment, sentiment moves the price down. It's not always an indication of the value of those businesses. And again, as active managers and our portfolio managers can take advantage of these short-term dislocations of negative sentiment towards the broad market to take advantage of better valuation in good businesses that will do well over time.

So again, these dislocations can often be a very opportunistic time to look at investing in assets. And we shouldn't be fearing just in case the market pulls back, don't just run for the hills, right? This is not the time to be doing that. At the same time, to use an overused baseball analogy, this is not the time to be swinging for the fences. It's not the time to be swinging for home runs. This is time to be trying to hit those singles and doubles and win the long game versus trying to get the big runs quick.

Peter Ward:

The headlines during COVID about a manufacturing recession, are sector-based struggles actually defined as recessions or is that more of a buzzword for a part of the economy that maybe isn't doing so well now because of certain circumstances. And I think we touched on this with the severity of a recession, sometimes a sector is doing really bad and it can be recessionary, but it might not affect the overall economy as much.

Macan Nia:

Is this idea of global synchronization where the global economy would all move together then global desynchronization, and we're getting some of that today where just because there may be a slowdown or recession in Canada and the US doesn't mean that's going to be the case in Europe or in Asia. In Asia, when we talk about this, purely China. We're going through one right now where Europe manufacturing, one could describe it as being in a recession, but when you look at economies like India, Brazil, Russia, even the US, I would not characterize them as being in a manufacturing recession.

We're also getting these things called rolling recessions. So we've heard this over the past couple of years where coming out of COVID, we saw manufacturing experience a slowdown or recession. Manufacturing in aggregate seems to have basically bottomed, there's early signs that it could be picking up, very early, but services are now moving into a recession.

So yes, sectors can be in and out. To your point of the question, there's not a way of looking at sectors and saying two consecutive quarters of negative GDP growth, but you would look at it from a profit perspective. And then that idea also goes along with, okay, manufacturing seems to maybe be recovering now, it's rolling into an expansion, while services is declining and even from the global perspective as well. Whereas with Canada and US, we're pretty much the same because they're our largest trading partner, we actually import roughly 80% of their central bank policy. So that's rarer for Canada and the US, there might be nuances, but there's definitely cases. China versus US today is a perfect example, is where they're struggling, US seems to be resilient as of today.

Kevin Headland:

And just taking a step back, when we talk about manufacturing recession, I think the term recession is often used in multiple different ways and I think that's one of the things because we hear manufacturing recession, what does that mean? The word recession is really supposed to just be about the economy, but we're using recession in terms of this idea of slowdown in different indicators. So manufacturing recession is, the manufacturing data has been weak or negative for a prolonged period of time. We often hear earnings recessions meaning earnings growth has been negative for a prolonged period of time, usually two plus consecutive quarters. So the reward recession tends to denote just weakness in certain indicators or data that we receive from either an economic perspective or market perspective.

Peter Ward:

Now, a recessionary environment may not be the worst time for an investor. These environments may create favorable conditions in the markets. Can you elaborate on some of those conditions that may favor people with money to invest?

Macan Nia:

It's counterintuitive and investors do the exact opposite, but I always say if there's something you wanted to buy, a house, a car, whatever it may be, and it was at a, let's just use that bear market definition of 20% discount, would you wait? Would you wait for a 25% discount or 30%? More often than not, most of us wouldn't. We take advantage of that 20% discount and buy because we don't think that it might get to 30. Markets seem to have a different view on, and we all know why because of emotion and then it's money, but when markets are down 20%, how many times have we heard, okay, I'm going to wait for it to be 25% and then it's down 25%, and you say, I'm going to wait for 30.

And then more often than not when markets recover, especially from these big sell-offs, it's a quick move upwards leaving investors behind. So just using the past, I'm going to use the past eight recessions going back to the fifties, if you would've bought when the market was down 20% from its peak, your average two-year return was roughly 20%. So in these times of sell-offs during recessions, historically, not every single recession, but the majority of them, investors are better served investing when the markets are down 20% because it's factoring in a lot of that negativity.

Markets are forward-looking. When those returns are down 20%, they've already factored in that recession and that's why you get often those strong forward returns. Look at COVID example, when markets were down 20%, your two-year forward return was roughly 70%. Unique case, but there's more often those signs than the ones that you get a recession and market returns are negative five years later. And I always use the example, Kev, before you want to jump in, is people want to time these things and it's impossible. But for a medium to long-term investor, I always use the example of the great financial crisis. The peak was on October 9th, 2007.

You saw a corresponding drop of more than 50, think it was at 56, 57%. If you would've bought at the peak and just had that long-term time horizon, that $1 would've been up 321% as of the end of last year, or you would've been compounding your money at 9% per year. That's buying at the peak of the great financial crisis, seeing a 56% drop. Think of all the shenanigans that have happened. That's not a technical term, shenanigans, but since the great financial crisis, you had the European financial crisis, you've had US elections, oil prices at 145, negative oil prices, wars across the world.

So long answer to your short question is when you get these sell-offs, and it goes against human nature, we have all the data that's suggested is when investors should be buying, they're selling and when investors should be selling, they're buying. So I always look at these recessions as golden nuggets. They happen once a decade. You got to take advantage of these golden nuggets because the forward return for a medium to long-term investor is quite attractive.

Kevin Headland:

Yeah, I'll give a much quicker answer. Just going back is this is actually a really good time for this because this is the four-year anniversary of COVID. Think about that. March 16th 2020 was the Friday where we were told, hey, take your stuff home just in case.

Macan Nia:

Oh yeah, that is crazy. It is during the time... It is March. Yeah, I didn't even think of it that way, Kev, you're right.

Peter Ward:

Yeah, what a time, man.

Kevin Headland:

Right? So think about that. And so I think March 23rd was the bottom of the market that period, the US equity market was down roughly 35% peak to trough. At that time, some people were like, I got to get out. I don't know, I'm worried, what is this COVID thing? Got to get out.

Macan Nia:

This time is different. It's a virus.

Kevin Headland:

Yeah, it could go down to minus 50% like it was in the financial crisis or it goes down to the twenties, the Great Depression, we didn't know. So let's say you panic, you took money out, then you say, I'll wait to get a better time to get back in. Going to 2022, which is the next time we had a bear market scenario, the bottom of the bear market in October of 2022, the S&P 500 was still up 50% since the bottom of March 2020. So if you got out and waited for a better time to get in, there was no better time to get in and hasn't been yet. So that is one where you would've been ideally sitting on the sidelines because I'm still waiting. And that's important to make sure those emotions don't rule the day. As Macan said, make sure we're looking at our longer term goals. And these are golden nuggets, when markets sell off, these are great opportunities for longer term investors to take action.

Peter Ward:

So we have to treat the markets like the Canadian Tire flyer, just buy it when it's on sale. Just buy it when it's on sale.

Macan Nia:

Exactly.

Peter Ward:

But I think that's really interesting. I think, I don't know if it was Warren Buffett, I might get corrected on this one, but didn't he say the worst thing about a bull market is that it doesn't let you in? Those people that might've been waiting to get back in, sometimes it just doesn't come back down. It just keeps going and it is going to be more expensive to get in.

Macan Nia:

The great financial crisis was a perfect example, right? Markets are down 56%, March of '09, basically bottomed, and investors were very slow to get back in. They're waiting for each one and it left a lot of investors behind. And then there's a European financial crisis. Well, I'm going to wait. I'm going to wait. And that was the longest bull market in US history. So the flavors for each recession are different, but historically, the results typically are the same. Is if you take advantage of when markets are down, there's no guarantee, but when markets are up 80% of the time through history, if you're buying at these lows, the odds are in your favor.

Peter Ward:

Now, I know Macan, you're a fan of saying this, but there's always a reason to sell, you say that quite a bit and as we know, headlines move markets. So if a recession is declared, we can assume it would be a market moving event. What would you be telling investors that are watching their portfolios decline or thinking about how to navigate these conditions?

Macan Nia:

So maybe I'll start, Kev, I think going into a, and let's not even say recession, let's just say a material or a slowdown. Is that within your portfolio, I think you want to have a focus on quality, quality companies that can navigate a slowing growth environment. What does that mean? Companies that sell in simplistic way, companies that sell something that regardless of the economic environment you're going to buy. While you're in it, I think a big part is if you have a diversified portfolio that is high in quality, the market's still going to take down those stock prices. The important thing is, and I always say this, is you have two hands. One hand is going to naturally want to sell. Sit on that hand, don't let that hand sell because more often than not investors that do that, it's at really the detriment of the returns.

If you have that hand that wants to buy, during a recession, typically let that hand buy. You'll feel that little knot in your stomach. You'll feel sick of buying these companies at a 20% discount. That's typically a good sign. Warren Buffett, we've been talking about Warren Buffett, he always has that saying, when others are fearful, I get greedy when others are greedy, I get fearful. And history suggests the numbers suggest, when others are fearful and they're selling, those are good opportunities to buy quality businesses at much more attractive prices.

Kevin Headland:

The other thing also is that markets are very forward-looking and it's important that markets tend to price in the economic slowdowns before they happen. So I talked about recessions being declared and actually hitting headlines. Recessions are always, always, always declared retroactively, meaning they are announced, we're in recession, and by the way, it started X months ago, sometimes even a year after they actually started officially. So if we wait for that headline, we're in recession, to make a change or prepare a portfolio or get a bit more conservative, that's too late.

And this is why it's important for us, and one of our jobs is to look at the signs of that slowing economy or that slowdown, and that's how we want to create better asset allocation portfolios. This is where you want to change your asset mix, perhaps, this is when you want to look at the types of companies you're investing in, and I think that's what you want to look at. You don't want to wait for the declaration to happen, but if you prepare in advance, if the market does decline, then you're much better prepared to add or take advantage of those declines to add to portfolios. So you want to make sure you're looking not just at when the recession declared, but in advance of that to make sure we're well-prepared for the potential risk that recessions might have.

Macan Nia:

And Kev, the 2009, the great financial crisis is a perfect example. So the bottom of the S&P 500, so the broad base index for high quality companies in the US bottomed in roughly March of that year. The recession ended or that call ended in August. So if you're waiting for the recession call to be ended, markets were up almost 50% from that March to the end of August. So as Kevin said, markets are forward-looking. You have to take an educated guess. If you're waiting for certainty, of course we would all invest in the markets if there was certainty, but when it comes to market, you have to, there's not a leap of faith, but there's an educated guess. And historically when you're buying at these lows, when all that negativity has been priced in, then those are typically good signs to buy.

Kevin Headland:

Another interesting fact as well, if you look at the previous recessions, Macan talked about 2019, economic data was already slowing. Going back to the financial crisis, in 2006, 2007, there was already indications that the economy was slowing. The financial crisis was the proverbial straw that broke the camel's back, but we were already seeing the weakness in the economy. Even going back to the tech wreck, going back into the dotcom in the late '90s, we were already seeing, and funny enough, data that was showing the economy of slowing, yet the markets were still euphoric about the environment. So you see these indicators they're coming and it's just good times to just be aware of the situations and not be chasing markets if you see signs of weaker economic data.

Peter Ward:

And I think that's sort of, you mentioned euphoric markets, I think that's sort of a warning sign for maybe some of the more shrewd investors out there. You see these big, the dotcom is a perfect example, you see these bubbles start to take shape, but I think everyone wants to get in at that point when really you should be thinking what's the underlying fundamentals here?

Kevin Headland:

And that's key as well. A lot of people are trying to equate this environment to the dotcoms because of the magnificent seven and the types of companies. However, these companies are vastly different, and not all of them, but vastly different in terms of the types of companies of dotcom. For those that are around, I remember the names, everything with a .com at the end of it was seeing valuation jump. They weren't all good businesses, and that's key. Understanding what the good business is, not necessarily what their name is or the specific sector they're in, understanding what they do. I would argue again, the winner of perhaps the internet started off as an online book company.

Peter Ward:

That's excellent. Well, I think that's a great place to leave it. Thank you so much Kevin and Macan for having me on and letting me be the host for today. It was nice to come out from behind the keyboard and do some of the real work, I guess you could say. And now I'm going to insert the standard Investments Unplugged plug, which is, if you like this content, please like and subscribe wherever you get your podcasts. If you feel like leaving a positive review, that would be great. More positive reviews help like-minded listeners find our content. And now over to Kevin to read our incredibly long disclaimer.

Kevin Headland:

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