How Advisors Can 'Recession-Proof' Portfolios in 2023

As we enter 2023, a consensus has yet to emerge on whether we’re due for a recession. Although the market suffered no shortage of contractions and tumult this past year, the unusual terrain of the current economic landscape has made it difficult to precisely define exactly what’s been unfolding and what may be lying ahead.

While 2022 saw the GDP undergo consecutive quarters of negative growth, the job market remained robust, and consumer spending did not decline as it traditionally has in recessionary environments.

Given the very nature of recessions and the backward-looking methods used to diagnose them, they’re often already underway by the time economists feel comfortable sounding any alarms. Even with the market’s present volatility and the pervasive fears surrounding a downturn, it’s hard to declare with unambiguous certainty that a recession is waiting in the wings for 2023.

By many metrics, we are not on track for a recession. However, as the Federal Reserve continues increasing interest rates to combat inflation, consumer spending is declining in turn. While nothing is guaranteed in an economic atmosphere as mercurial as this one, the longer these conditions grip the market, the more likely it is that 2023 will produce recession-like conditions.

Regardless of scale and whether the economy endures a full-blown recession or a more manageable series of contractions, advisors should be taking steps to recession-proof client portfolios for 2023. The instability of 2022’s market may only be a prelude to more pain ahead, meaning it’s imperative to take proactive, rather than reactive, measures at the earliest possible opportunity.

Will There Be a Recession?

Although the market’s current climate somewhat deviates from the conventional expectations around what the run-up to a recession looks like, there are multiple factors at play that should be spurring financial advisors to act sooner rather than later.

The S&P 500 index recently fell 25%. Economists erring on the side of optimism might point out that the decline for bear markets has been about 33% on average since the 1950s.

The drop for proper recessions has been even more severe, averaging about 40%. What’s more, previous declines at 2022 levels have traditionally ended in fourth-quarter rallies once assets were determined to be oversold.

However, the stats for these preceding market dips obscure the array of unique variables fueling this particular bout of upheaval. The interplay between rising interest rates, inflation, and the war in Ukraine — to say nothing of prolonged ripple effects from the COVID-19 pandemic — is without parallel in modern history, diminishing any would-be points of comparison.

Further compounding concerns, the inverted yield curve — one of the most historically reliable indicators of a forthcoming recession — has appeared several times over the past year. This occurs when interest rates on long-term bonds fall lower than those of short-term bonds.

What Advisors Should Do

The economic situation heading into 2023 will likely force many advisors to break from established recession procedures. Preserving investor assets amid this potentially adverse environment could result in a wider reorientation of portfolio constructions.

For example, while traditional wisdom might call for investors to increase their bond exposure going into a recession in order to be protected on the downside through lowered interest rates, the Fed’s ongoing fight against inflation means interest rates are likely to remain high for the foreseeable future.

When it comes to areas of investment, advisors and investors should be seeking out high-quality stocks. In this case, that means entities that can operate and turn a profit agnostic of economic conditions. The priority should be essential businesses as well as companies that provide consumer staples and can pass costs on to customers without facing a decrease in consumption.

Examples include the health care, utility and telecom industries, all of which provide necessary services that consumers rely on regardless of whether they’re in a boom or bust cycle. Even though stocks in these fields may generate smaller returns in a market downturn, their necessity in day-to-day functions ensures a certain degree of quality control and reduced exposure to the sensitivity of the economy.

While assessing stock options, advisors should be looking for companies that have increased their dividends across an extended period of time and maintained their market position even amid lean phases; even if they decline, they’ll be faster to rise back than their less resilient competitors.

Additionally, advisors should be wary of overweighting portfolios toward fixed income assets — arrangements of roughly 80% in stocks and 20% in bonds might want to be modified to a 70-30 stocks-to-bonds ratio. Concerning bonds themselves, advisors should consider short-dated bonds along with municipal bonds such as corporate bonds, all of which have become increasingly attractive from an investment perspective.

Stay Calm and Plan Ahead

Above all else, the most critical part of recession-proofing a portfolio is remaining calm and formulating a plan alongside investors. Though it’s going to require some major recalibration, all changes should be made with careful consideration and deliberation: If an investor is looking to reorient entirely by going strictly into cash, moving completely out of equity or hedging their fortunes on timing the market, urge them to reconsider.

Advisors are looked to for sage financial insights, and in a year as potentially consequential as 2023, now is as opportune a time as ever to reinforce the value they bring to clients.

(Image: Shutterstock)

Virag Shah, CFA, is a portfolio strategist at Van Leeuwen & Co.