Clients will need a hero in the coming recession

The new economic reality of elevated interest rates will require preparation, acceptance and a generous dose of patience as financial advisors embrace a shifting economic paradigm. But change does not come without stress. As carefully considered borrowing decisions and interest payment strategies replace the easy flow of funds we once relished, we often find ourselves entangled in debates about when rates might return to the levels we were comfortable with and accustomed to.  

When the pressure mounts, we instinctively seek a narrative to simplify the complex — a tale with a villain, a victim and a hero who can guide us through the turbulent market waters. 

As advisors, it's imperative that we assume the role of the hero, safeguarding clients from market distress and steering them toward eventual prosperity. Achieving this requires rethinking some of the tools advisors have long relied on.

Markets change, boomers stay the same
One constant remains, however, remains — American investors' desire to preserve purchasing power. With the S&P's average return of 14% a year since 2009, the baby boom generation, in particular, became accustomed to significant equity gains, and they are resolute in their commitment to preserving their wealth. Years of low mortgage rates enabled them to enhance their living standard by upgrading their homes, even as the globalization of manufacturing facilitated the affordability of their possessions.

But the shift to onshoring and nearshoring may spur further price increases in consumer goods, even as mortgage rates surge. It remains to be seen whether the resurgence of domestic manufacturing will lead consumers to accept higher prices. What's clear is that elevated mortgage rates have placed "golden handcuffs" on consumers by keeping prices high, supply low and demand strong. The prospect of having to downsize while maintaining the same or similar monthly payments discourages many from selling their homes. Reduced supply contributes to the perpetuation of high property prices. 

Meanwhile, boomers have been exposed to the mantra that bonds are the safe part of the portfolio for decades. Investors were once willing to give up higher returns for lower drawdown by using bonds, but now stocks and bonds have become correlated, resulting in aggregate bonds facing significant declines last year and a continuing struggle this year. While investors previously tolerated the drag on performance from bonds, the current environment suggests that bonds may not fulfill their traditional role, creating an environment where fixed income needs to be smarter.

Accepting the coming recession  
In a recession, which sectors win and which ones lose is intricately tied to the Federal Reserve's role in shaping the business cycle. Small-cap companies have already been impacted as they have less cash on hand and rely more on borrowing at higher rates. This economic shift is underscored by the escalating rates of corporate bankruptcy filings, which are up 30% in the year ended Sept. 30 over the previous year, according to Reuters. As corporations face the imminent challenge of refinancing trillions of dollars in existing debt at substantially higher interest rates, the specter of heightened bankruptcy rates looms.

READ MORE: These unconventional strategies may help inflation-besieged clients in the retirement zone

I have heard it said that the money supply acts as an economic lubricant, like oil in an engine. An engine can continue to run for some time after running out of oil, but it will eventually seize up. The same applies to the economy, which, without a steady money supply, will eventually grind to a stop. More than half the dollars ever created in the history of the United States came into existence in the last three years. We borrowed money from the future to support people in the present. Now, we have to pay back that loan with much higher rates. 

Another facet of this evolving economic landscape is the upward trajectory of labor costs. This trend reflects a growing belief that potentially corporate record profits should be shared more equitably with the workforce responsible for generating them. The shift to labor is upon us, and until there is a recession and unemployment rises, this will continue.

A recession is not binary in nature, where every sector or business is either suffering or not. Which sectors win and which lose is intricately tied to the Federal Reserve's role in shaping the business cycle. We understand that attempting to predict the market is a fool's errand, which is why patience and preparation become an advisor's most valuable assets. The impact of rising interest rates hasn't been fully felt yet, and the potential for a market decline is ever-present, in spite of the soft-landing narrative that is having its moment.

Toews

Past is prologue
Portfolio preparation for the future entails accounting for past experience and understanding potential outcomes. Since no advisor can tell the future, we must, rather, use past market disruption as a guide for how to combat challenges. Our method takes into consideration the unpredictable nature of financial markets while considering the predictable behavior of investors. Most investors prefer not having big losses even if it means not fully participating in up markets. However, the days of cheap equities and fixed income being good enough may be over for a while. Our method accepts a small reduction in upside (shifting the right tail of the classic bell curve of returns slightly left) attempting to limit losses significantly (shifting the left tail to the right). 

Changing one's perspective can be difficult, often leading us to dwell on past fears long after they've ceased to be a threat and to fight the last battle rather than adapting to the present situation. Aggregate bonds are down about 30% in real terms from the peak, and stocks have fluctuated significantly since rates started to rise last year. Flexibility and hedging should be considered essential elements of a portfolio for those in or near retirement, or for those who just don't have the stomach for the rollercoaster. 

We are getting closer to the next equity market decline every day, and though we have the financial resources to lower rates and stimulate the economy during a recession, we understand that this approach may reignite inflation, which would bring us right back to where we are now. We need to be prepared to adjust to the new paradigm of higher interest rates, which may stretch out in front of us for longer than we expect or hope.