How prepared are financial advisory firms for the inevitable recession?

It seems like we were just talking about the survival prospects for firms, particularly independent firms, during a severe economic downturn. When the COVID-19 pandemic hit, the economy froze, unemployment spiked and GDP dropped like a stone, as did the markets. Influential folks like Creative Planning’s founder Peter Mallouk said most RIAs could withstand one or two quarters of that environment, but if those conditions lasted longer than that, many would be gone.

That lasted all of two months.

Go back a bit further. It’s hard to remember the pre-plaque days, but worth noting that, even then, many economists and market observers were giving high odds to the probability of a recession and market pullback. At that point, we were already almost 11 years into an economic expansion, the longest the U.S. has ever gone without a recession.  The unwinding of stimulus measures launched in the wake of the Great Financial Crisis, a trade war with China, equity valuations seen as highly frothy and speculative—it felt as if we were due.

The only thing that has changed—fundamentally—between then and now is the massive amounts of money the government has spent. By some measures, we have spent the equivalent of 27% of GDP keeping consumers, businesses and the economy afloat. The pandemic didn’t cause an economic fallout, it just delayed it and potentially increased the severity.

Equity markets already have fallen dramatically, as have valuations across many other assets. Housing is wobbly, the crypto winter is upon us, your portfolio of NFTs is worth a fraction of what it was and no one now believes that inflation is a transitory thing—as of this writing, the Federal Reserve just raised interest rates 75 basis points and has strongly signaled it will do so again next month. No one would have predicted that just six months ago.

No doubt, independent advisory firms have taken a hit. Take Vanguard’s Balanced Index Fund as a proxy for a typical firm’s 60/40 portfolio: It is down over 17% year-to-date. Firms that charge on AUM have either experienced, or will experience, similar drops in revenue, unless they are making up for the slippage with organic growth.

Which is not to say wealth management firms can’t withstand a recession—though this time there will be no Paycheck Protection Program forgivable loans to help out. Good advisory firms run with high margins. A statistic from Dan Seivert at Echelon Partners, referenced in this issue, notes that a 15% market decline reduces an RIA’s valuations by almost 50%. The same thing happened in the previous financial crisis, he said, yet only 2% of firms went out of business.

Let’s hope the worst-case scenarios don’t come to pass, but these market cycles are inevitable, and I’ll argue even good for the industry in the long run. A recession can clean out the speculative fluff (crypto, DeFi, meme stocks, SPACs, a handful of #fintwitterers, etc…) and bring to advisors, and clients sharper clarity over real value—including the value of good financial advice.

Good luck,

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David Armstrong

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