Recession: What It Is and Its Impact on Small Businesses

As a small business owner, you may hear economists warn businesses of a "looming recession". But what exactly does a recession mean and why should you care about it? In this article, we'll explain what a recession is and its potential impact on your small business.

What is a recession?

A recession is an economic phenomenon in which the economy experiences a decline in output, employment, and income. There have been four recessions in the United States in the last 30 years. From 1945 to 2009, the average length of a recession was 11 months. However, it is important to highlight that recessions are a normal part of what we call the “business cycle”—a cycle of contraction and expansion in a country’s economy. Don’t worry, we’ll discuss the business cycle later in this article. For now, a recession happens when a country’s economy is contracting.

The National Bureau of Economic Research (NBER) is responsible for declaring a recession. However, it only declares recessions after they have ended. This is because they must review all data before all members of the Business Cycle Dating Committee come to an agreement on whether a recession has occurred. Only then can they make the declaration.

This results in situations where we could be in a recession and not even know it. As a business owner, you need to be keen on picking up on the signs that we’re in or entering a recession and should be looking for ways to prepare for an economic downturn.

Recessions and the business cycle

As mentioned, a recession is a normal, although unpleasant, part of the business cycle. So what exactly is the business cycle?

The business cycle is a concept that explains how an economy continues to swing between expanding and deflating phases. When expanding, growth is experienced by the country’s economy. During this phase, the country’s output, income, employment, and retail sales are all increasing. When this is happening, lenders in the country will encourage consumers and businesses to take on more debt by gradually making borrowing money less difficult and expensive.

As debt becomes more easily accessible, the prices of assets start to increase. This may create an illusion of growth through “asset bubbles”—rapidly increasing value that’s unsustainable. As this continues to happen, economic expansion eventually stalls. As things start to slow, loans and credit become less affordable, business slows, and the stock market takes a hit. This is when a recession hits the economy.

How to know if we are in a recession?

Given that the NBER only officially declares a recession once it ends, it’s hard to gauge whether we’re in or approaching a recession. Unfortunately, there is no single method or metric that predicts when and how a recession will begin. Thus, economists track multiple variables that are widely recognized predictors of a potential recession when they occur simultaneously.

Real GDP is the general metric for identifying a recession. This is because real GDP measures the total output of American companies and people making it a great metric to assess the country’s overall business activity. Also, the impacts of inflation are adjusted for when calculating real GDP, hence the term “real.”

Traditionally, the rule of thumb is a recession starts when the real GDP growth rate is negative for two consecutive quarters or longer. However, it does have two main limitations. It takes a long time for real GDP numbers to be confirmed meaning a recession is predicted too late for business owners to prepare for. Additionally, the metric is an estimate and an adjustment to that estimate can change the prediction from it being a recession to being business as usual.

Due to the limitations of real GDP, the NBER uses monthly statistics to be able to predict a recession in a timelier manner as the statistics below provide a more up-to-date estimate of economic growth.

Key indicators of a recession

If you want to know whether the economy is in a recession, keep an eye on these indicators:

  • Real income: A measurement showing personal income in the country that has been adjusted for inflation and social security and welfare payments. This is a good metric to watch out for as the decline in real income will eventually translate into a decline in consumer purchases and demand. Typically, this results in economic contraction. To keep track of personal income, you can refer to the Bureau of economic analysis report.
  • Employment: Employment statistics directly tie in with personal income in the country. The fewer people are employed, the lower personal income will be. A low employment rate can indicate low purchasing power and demand, which can point to economic contraction. You can monitor employment conditions by following the Nonfarm payrolls report by the Bureau of Labor Statistics (BLS), which surveys private and government entities throughout the U.S. about their payrolls.
  • Manufacturing: The manufacturing sector produces according to the predicted demand. This means that if manufacturing declines, demand is predicted to be low. As mentioned above, low demand points to economic contraction. You can look at the manufacturing sector’s health measured by the Industrial Production Report.

In addition to the metrics above tracked by the NBER, the following warning signs can give you more time to figure out how to prepare for a recession before it happens:

  • The Leading Economic Index (LEI): The LEI, a publication of the Conference Board, aims to forecast future economic trends. It takes into account things like stock market activity, new manufacturing orders, and applications for unemployment insurance. An economy that is having problems could be indicated by a falling LEI.
  • Consumer confidence: If consumer confidence, one of the main drivers of the U.S economy, shows a decline it could signal that the country is approaching economic problems. This is because if consumers’ confidence is low, it indicates their lack of confidence in making purchases and lesser spending slows the economy.
  • Inverted yield curve: A graph called the yield curve shows the market value, or yield, of various U.S. government bonds, from four-month notes to 30-year bonds. Longer-term bond yields should be higher when the economy is running normally—otherwise, everyone would cash in on their investments. An inverted yield curve is when the exact opposite is happening: long-term yields are lower than short-term yields. When this happens, it could signal that investors are concerned about a recession. An inverted yield curve has previously been used to forecast recessions.

Normal vs Inverted Yield Curve Image courtesy of Corporate Finance Institute

Most common impacts of recession on small businesses

One of the most common effects of a recession for all businesses is reduced cash flow. However, unlike bigger corporations, small businesses have less access to cash resources, making managing cash flow extremely important during an economic downturn.

During a recession, customers may frequently put off payments longer than usual due to their personal cash constraints. Small businesses are more likely to spend money as it is received which makes the timeliness of customer payments pivotal in keeping the business afloat. This creates a domino effect of late payments to vendors or manufacturers, which slows down all operations of the business. Because there is even less financing available during a recession, it is difficult for small businesses to borrow their way out of this.

Another universal experience for businesses during an economic downturn is a decline in sales. When customers experience cash constraints, they’re more likely to put that money towards essential items and save elsewhere. Lesser customer spending directly translates to a decline in revenue for businesses.

Both reduced revenue and access to financing mean that businesses will have less cash available to keep their doors open. This leads to a domino effect on other aspects of the business such as less marketing spending and reduced employee budget. Marketing is typically one of the first expenses to be eliminated when a company has budgeting challenges because it is frequently viewed as a luxury, especially by small businesses. Without marketing, the possibility of attracting new customers to offset client loss is low, which could have a negative effect in the long run. To prevent this, successful small businesses come up with innovative strategies that are less expensive like social media campaigns or using employees as brand ambassadors.

Suggested resources

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

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