With recession looming, advisors prepare for the worst

While the most optimistic pundits or devout followers of modern portfolio theory might continue to cling to notions of why things will be different this time, the boring old principles of basic economics still point toward a looming recession.

For most prudent financial advisors, the backdrop of the excessive government spending during the pandemic that fueled runaway inflation, forcing the Federal Reserve into its current rate-hike cycle, looks like a brewing storm from which clients will need to find shelter.

With that in mind, the general consensus appears to highlight three main strategies: raising cash, reducing investment portfolio risk and loading up on fixed income.

“The best way to prepare for a recession is to evaluate your current job and cash position,” said Kyle Simmons, founder and lead financial advisor at Simmons Investment Management.

“Think through ahead of time what you would do if you were laid off and make a list of possible jobs before anything happens, and also take a look at your company’s HR policies to see if they have a standard severance package,” Simmons said. “Finally, you should build your cash position and make sure your emergency fund is adequate. A minimum of six months' expenses is a good place to start.”

It's not uncommon to hear financial advisors tout the benefits of cash reserves during good times and bad, but with an economic slowdown seen as a virtual certainty, advisors are reminding clients to shore up their cash accounts and take advantage of the suddenly higher savings rates.

As the Fed has pushed its short-term rate up to around 4.75% in an effort to tap the brakes on the economy by making borrowing less attractive, the flip side is that savings accounts now yield close to 4% at some online banks.

That scenario, although not ideal from a near-term financial planning perspective, does help to get clients to focus on setting aside some cash for emergencies.

“If your clients are concerned about volatility, you can remind them that they had a good start to the year and it’s time to build up some cash,” said Ken Van Leeuwen, founder and chief executive of Van Leeuwen & Co.

“The initial reaction to a recession pushes the markets down, and people hate selling when markets are down, so put away some money now to get through the expense structure of 2023,” he said.

Jay Zigmont, founder of Childfree Wealth, said getting clients to focus on cash as a backstop can also have psychological benefits.

“A recession, or similar economic downturn, tests your financial foundation,” he said. “To that end, focus on money management, budgeting, getting out of debt, having an emergency fund and skilling up as needed.”

Once the debt is under control, Zigmont is telling clients to “focus on building three to six months’ worth of expenses in an emergency fund.”

Ron Strobel, a financial planner at Retire Sensibly, said 2023 has become a wake-up call for people who have been “freely spending over the last few years and now they are cracking down on their excess spending.”

“We have reminded clients during our annual reviews that surviving a recession has generally meant bridging the gap between the bad economic times and an eventual economic recovery,” Strobel said. “Sometimes that takes a few months and sometimes it could be a few years. We have a survive-to-fight-another-day mentality that means we might cut back on discretionary spending today, such as travel or restaurants, to survive an economic downturn and then we can increase our spending again once things eventually improve.”

Along with restocking the emergency funds, advisors are reducing risk on the investment side.

“If recession was impending, investors would usually want to take a risk-off approach,” said Paul Schatz, president of Heritage Capital. “In equities, that means buying consumer staples, utilities and some health care at the expense of technology, consumer discretionary, industrials and energy.”

Dennis Nolte, vice president of Seacoast Investment Services, has already prepared his clients for a recessionary cycle by moving out of growth stocks last year.

“We look like goofballs this year, but so be it,” Nolte said. “We'd been long the things that do well in recessions, utilities, staples, health care, and that hasn't looked good the first six weeks of the year. We're holding a good amount of cash and short-term Treasuries and imploring our clients to get a good yield on their emergency funds.”

The reduced risk on the equity side is generally being coupled with a shored-up foundation on the fixed-income side.

“Investors should increase their allocation to fixed income,” said Schatz. “We’re buying long-dated Treasury, municipal and investment-grade corporate bonds at the expense of bank loans and high yield. And investors should eliminate exposure to commodities and increase exposure to absolute return funds.”

Van Leeuwen is also taking inventory of his clients’ fixed-income exposure.

“We’re looking favorably at bond investments: investment-grade bonds, corporate bonds, also mortgage-backed securities because they could be good in a rising-rate environment,” he said. “You should look to be a bond investor six months before you think the final rate hike will occur.”

While the Fed is still technically in a tightening cycle, trying to tamp down inflation and hoping to navigate a mild recession, it is important to think a few steps ahead to what Fed policy will be once a recession begins.

“Remember that markets are forward-looking and react in anticipation of a recession months before the bottom of one occurs, and this makes it incredibly difficult to proactively time entering or exiting stocks because a recession is expected,” said Kevin Brady, vice president at Wealthspire Advisors.

“If there is an active decision to take less stock risk and add to fixed income, we discuss how keeping some duration in fixed-income portfolios is prudent, and some duration means in the four-to-five-year range,” he said. “If a recession were to occur, the Federal Reserve would surely act to cut interest rates, which would lead to lower yields but price appreciation within high-quality fixed income. The more duration exposure one has, the larger this price appreciation has been historically.”