Economic recovery is the period following a recession when an economy begins to heal and grow again. This upswing brings welcome relief from job losses, declining wages, and a slump in business activity. This guide will equip you with the knowledge to identify the signs of recovery, explore the different types, and grasp the role it plays in shaping the future of the economy.
What is economic recovery?
An economic recovery is the initial part of the expansion, where the economy gains strength and returns to growth after the recession. Economic growth is showing signs of strengthening. Consumer spending is starting to increase, especially for durable goods. This, in turn, encourages businesses to intensify production. Other terms for economic recovery are an economic upturn, an economic revival, and an initial expansion.
What’s happening: During this period, economic and business activity is improving. Typically, it is characterized by positive economic growth, improved income, and employment prospects.
And as the recovery continues, the economy is headed for expansion. Economic growth is high, inflation is creeping up, the unemployment rate is falling, and consumer and business confidence increase.
Understanding the business cycle
The economy isn’t static – it naturally goes through ups and downs over time, following a predictable pattern known as the business cycle. This cycle has four distinct phases, each with its own characteristics:
- Expansion: This is the golden period of economic growth. Businesses are thriving, production is high, and unemployment is low. Consumer confidence is strong, leading to increased spending, which further fuels economic activity. Investors often see this as a time for growth-oriented investments.
- Peak: The expansion can’t last forever. Eventually, the economy reaches a peak where growth starts to slow down. Inflation may begin to rise, and interest rates might be increased to cool things down. This period can be a sign for investors to adjust their strategies.
- Contraction: This is the dreaded recession. Economic activity shrinks, businesses cut back on production, and unemployment rises. Consumer spending weakens, creating a downward spiral. Investors often experience market volatility during recessions.
- Trough: The recession eventually hits rock bottom, known as the trough. This is the low point of the business cycle where economic decline levels off.
Recession vs. recovery: Key differences
While recessions and recoveries are both turning points in the business cycle, they represent very different economic climates:
- Recession: A recession is defined by a decline in Gross Domestic Product (GDP) for two consecutive quarters. It’s characterized by high unemployment, falling profits, and a general sense of economic malaise. Businesses are hesitant to invest, and consumers tighten their belts.
- Recovery: Recovery, on the other hand, signifies the beginning of a turnaround after a recession. The economy starts to pick up steam again, with GDP growth returning. Businesses gradually increase production and hiring, and consumer confidence begins to rebound. The unemployment rate starts to fall, and the overall economic outlook becomes more positive. Investors may see this as a buying opportunity in anticipation of future growth.
Types of economic recovery
V-shaped recovery: real GDP fell sharply and soon reached the trough. But, the economic stimulus prompted a speedy recovery and soon achieved expansion.
U-shaped recovery: Economic growth fell drastically and into the trough, but slowly. Furthermore, the recovery takes some time before heading towards expansion, longer than the V-shaped one.
W-shaped recovery: The sharp decline in real GDP boosted the economy immediately reached the trough. The economic stimulus stimulated economic recovery, but it was not strong enough to move the economy toward expansion. Finally, the economy fell again and headed for another trough. A second economic stimulus may prevent the economy from a deeper recession and regain momentum for a recovery toward expansion.
L-shaped recovery: The economy fell and immediately reached the phase of the trough. But it is still stagnant and will not recover soon, even when the government launches an economic stimulus. The “lost decade” in Japan is the most common example of restoring an L-shaped recovery.
Signs of economic recovery
Real GDP growth is the main indicator of economic recovery. When it comes out of recession, real GDP grows positively. And, if it lasts for two consecutive quarters, it is a signal of recovery. Of course, the hope is that it will lead to expansion, not fall as in a W-shaped recovery.
Other indicators of economic recovery include interest rates, consumer spending, business spending, industrial production, unemployment rates, inflation rates, and working hours.
Interest rate
Low interest rates usually initiate a recovery. Policymakers start implementing expansionary policies when the economy is slowing down or contracting to prevent a recession.
One option is to lower policy rates. A cut in interest rates increases the money supply in the economy and decreases interest rates in financial markets. Lower interest rates drive consumers and businesses to increase demand for goods and services, especially those financed by loans.
Consumer spending
Consumer demand is starting to increase, especially for durable goods and housing. Consumers benefit from the new loan’s lower costs. They also saw an increase in overtime pay as the company attempted to intensify production.
The recovery pace depends partly on how quickly consumer spending starts to pick up after the economic downturn. When spending increases fast and robustly, it will encourage businesses to increase output.
Household consumption plays a vital role in stimulating the economy. Understandably, it accounts for more than half of the gross domestic product (GDP) in most countries.
Business investments
Businesses are starting to order light equipment, such as technology software, systems, and hardware, to increase efficiencies. Due to an improving economy, they see an improvement in income and free cash flow.
But, in the early stages of recovery, the business has not ordered heavy machinery to increase capacity. They are unconfident enough to do so, fearing that the recovery will be temporary or of a weak scale.
Industrial production
Manufacturing output rose from its lowest level. Still, the increase is at a slow pace. Businesses want to confirm that the recession has really ended.
Also, after downsizing during a recession, it will take time for businesses to recover production to normal levels. Only when it comes to the expansion phase, where consumer demand is getting stronger, companies will start adding new workers.
Unemployment rate
In the initial phase of recovery, employment conditions improved despite the high unemployment rate. Layoffs are slowing down, but new recruits have not yet arrived. Businesses prefer to increase overtime and use temporary workers to meet the increasing demand for products.
That way, their profitability will be better. Businesses will recruit new workers if they are more confident that recovery is underway to expand, and available resources are fully utilized. Only when the recovery is strong will the unemployment rate slowly fall.
Working hours
Companies are more intensively using the existing employees. They will increase over time to meet the increasing demand.
Businesses will fully utilize their resources before deciding to add a new worker. That is to maintain operating expenses and anticipate the possibility of temporary recovery.
Inflation
The inflation rate remains moderate and may continue to fall in the early parts of the recovery. And, it slowly rises as the demand grows strong.
Durable goods may see a rise in prices. Their demand outlook improves as the recovery is underway. Previously, consumers tended to put off purchasing durable products during a recession. And, because interest rates are still low during this period, consumers will buy durable goods, anticipating a possible increase in interest rates when the economy is headed for expansion.
Government policies for economic recovery
Expansionary economic policies are one way of moving the economy out of recession. It can take the form:
- Expansionary fiscal policies with options to lower taxes and increase government spending
- Expansionary monetary policies by cutting policy rates policy, purchasing government securities, and reducing the reserve requirement ratio.
Both policies seek to stimulate the economy by increasing aggregate demand. But, if the recession is caused by supply-side shocks, policies to increase aggregate demand are ineffective. Take the case of stagflation.
Stagflation occurs due to increased costs, for example, due to a surge in oil prices. That results in an increase in the production cost and can result in a shrinking of economic output and a sharp spike in inflation.
Expansionary economic policies will only increase inflation. As aggregate demand rises, it will only cause inflation to increase further.
Conversely, a contractionary policy will result in a shrinking economy. Aggregate demand will weaken, forcing businesses to cut output.
Both policies are ineffective because the problem’s source is from the cost side (aggregate supply), not from the demand side. Fiscal and monetary policy are both demand-side policies.
Investing during the economic recovery
Economic recovery presents a unique window of opportunity for investors. As the economy rebounds, different asset classes can offer attractive returns. Here’s a closer look at how economic recovery impacts investments:
Asset class performance
Stocks: During a recovery, stock prices typically rise as corporate profits increase with growing consumer demand and production. Investors may favor cyclical stocks in sectors like industrials, materials, and financials that benefit directly from economic expansion.
Bonds: Bond yields, which are inversely related to bond prices, may initially fall as interest rates remain low to support the recovery. However, as the economy strengthens, central banks might raise interest rates to curb inflation, potentially leading to a rise in bond yields.
Real estate: The real estate market can also benefit from economic recovery. Increased consumer confidence and job growth can translate to higher demand for housing, potentially leading to rising property values. However, rising interest rates could dampen the real estate market in the later stages of recovery.
Stock selection during recovery
While the overall stock market may trend upward during a recovery, not all companies will perform equally. Here are some factors to consider when selecting stocks:
- Company fundamentals: Focus on companies with strong balance sheets, healthy profits, and a track record of growth. These companies are better positioned to capitalize on the improving economic climate.
- Growth potential: Look for companies in industries poised for significant growth during the recovery phase. Sectors like technology, healthcare, and consumer discretionary might offer higher growth prospects.
- Valuation: Be mindful of valuation. While some stock price increases are justified by improving company performance, be cautious of overvalued stocks that may experience a correction as the recovery matures.
