As lawyers and legal staff celebrate the closing of a year characterized by strong demand for services and higher hourly rates, firms are facing headwinds in the form of a slowing economy, increasing energy costs and persistent inflation for the year ahead.
Economists are raising warning flags in the form of subdued forecasts. “We expect real gross domestic product (GDP) will grow at a 1.6% and 1.4% rate in 2022 and 2023, respectively,” says Bernard Yaros Jr., Assistant Director and Economist at Moody’s Analytics. “For comparison, it increased by 5.7% in 2021.” (Growth of GDP, the total of the nation’s goods and services, is the most commonly accepted measure of economic health. “Real” GDP adjusts for inflation).
While a decelerating economy is sure to exert downward pressure on revenue lines, the task of maintaining profitability should be even harder in light of rising operating costs. “Attorneys are traveling again, client entertainment has returned and the cost of associates has gone up fairly substantially,” notes Eric Wangler, President of the North America Division of BigHand.
The part about associates, adds Wrangler, is especially notable. “When things were booming over the past year or so, many law firms hired associates like crazy and had to pay them a lot more than usual. Now that demand is subsiding a bit, they realize they have some ongoing costs for personnel who might not be billing enough hours.”
The results of ALA’s 2022 Compensation and Benefits Survey support the idea that associates have recently become a more expensive resource. Those with more than two years’ experience received increases in base salary from 9.0% to 11.0% in 2021, up substantially from the previous year’s 3.0%. Anecdotal evidence suggests that 2022 has also seen hefty boosts.
Given that human capital is the biggest expense at law firms, some difficult decisions will need to be made when demand softens. Trimming of staff is the least favored solution. “The firms we have talked to aren’t planning to go crazy with layoffs,” says Wangler. “They realize it’s hard to find these folks, so they will ride it out for the next six months or so. At the same time, it means revenues will not cover their costs as much as they would like.”
With the slowing economy and higher revenue costs, firms may also look hard at how much office space they need, says Dan Atcheson, Firm Administrator at Jenkins Wilson Taylor and Hunt, PA, and Chair of ALA’s Professional Development Advisory Committee. “The second largest operating expense for law firms typically is real estate costs, so in light of increasing economic pressures, I expect we’ll continue to see firms reevaluate their overall space needs. The pandemic has certainly been a catalyst for many firms to move to a permanent hybrid work environment, which in theory requires less physical space and saves money on rent,” says Atcheson. “Perhaps a slowing economy will inspire even more firms to consider downsizing their footprint, whether it be by renegotiating their existing lease, subletting a portion of their space or moving to a new — yet smaller — location altogether.”
“I expect we’ll continue to see firms reevaluate their overall space needs. The pandemic has certainly been a catalyst for many firms to move to a permanent hybrid work environment, which in theory requires less physical space and saves money on rent.”
While the prospect of softening revenues and rising costs are daunting for any firm, some practice areas should do better than others, says Wangler. Real estate should continue to enjoy its strong 2022 showing, and litigation is in the midst of a comeback that may see its return to 2019 levels in the months ahead. Also, rising interest rates and the economic slowdown may mean that lawyers will be kept busy with bankruptcy work. “I think a lot of that activity was delayed by government programs intended to prop up businesses during the pandemic,” says Wangler. “Those initiatives won’t be there the next time companies go through tough times.”
Law firms benefit when their corporate clients are profitable. And here the news continues to be good. Moody’s Analytics estimates corporate profits will increase 7.9% and 5.2% in 2022 and 2023, respectively. Those are hefty advances, given the difficult comparisons with a 25% increase in 2021. “Corporate profit margins are about as wide as they’ve been since WWII, as companies have been able to pass on rising material and labor costs to consumers,” says Yaros.
Despite the rosy margins, companies of all sizes face the challenge of managing labor costs that are rising faster than productivity. The culprit, of course, is the tight labor market. “We’re expecting the unemployment rate to be around 4.1% at the end of 2023,” says Scott Hoyt, Senior Director of Consumer Economics for Moody’s Analytics. While that’s an increase from the 3.7% level expected when 2022 numbers are finally tallied, it remains low. “It’s still a great labor market from a consumer perspective.”
Little wonder law firms and their corporate clients will be focused on labor availability as the new year gets underway. But economists suggest that the more immediate concern is inflation.
“In early 2023, an important statistic to follow will be the core consumer price index [CPI],” says Yaros. “As long as core CPI inflation remains stubbornly elevated and is not showing meaningful progress in decelerating, it will be premature for the Fed to declare victory in its battle against inflation.”
If the inflation battle does continue, the central bank will keep monetary policy tighter for longer. Translation: Higher interest rates in 2023.
Aside from economic trends affecting firms, Dan Atcheson of Jenkins Wilson Taylor and Hunt, PA, says there is something else that should be on everyone’s radar: the metaverse. In a recent episode of Legal Management Talk, Atcheson discusses how some firms are already renting space in the virtual world to meet with clients and how the metaverse is becoming more conducive for firm operations. He also offers his thoughts on how government regulation will be required to prevent crimes such as assault and battery from occurring in the metaverse. (Yes, it can happen there, too!) Listen to the episode here.