Chief Global Strategist Peter Berezin of BCA Research, a Canadian investment research company, warns that investors need to prepare for an economic recession in the United States, as the economic conditions worsen and the Federal Reserve is unlikely to rescue the situation. The full text is as follows.

If you put a cup of warm water in the refrigerator, its temperature will gradually decrease. Eventually, the water will freeze and change from a liquid to a solid. Besides keeping the temperature in the refrigerator below zero degrees Celsius, no new events are needed to generate this "phase transition".

Similarly, the Federal Reserve's tightening monetary policy has an impact on the economy. As the Federal Reserve tightens monetary policy, the US economy is cooling down, with a decline in inflation and wage growth as evidence. If the Federal Reserve allows the economic temperature to continue to drop, it will freeze.

In early 2022, there were two job vacancies for every unemployed worker. It was easy for anyone who was unemployed at that time to find a new job. This prevented the unemployment rate from rising.

Things are no longer that simple now. The job vacancy rate has fallen back to pre-COVID-19 levels. Those who have lost their jobs are finding it increasingly difficult to find new ones. Although the influx of labor into the labor market over the past 12 months has led to an increase in the unemployment rate, nearly half of the growth is still due to an increase in the number of unemployed people.

Weakness in the labor market will weaken consumer spending. The personal savings rate in July was 2.9%, less than half of 2019. The excess savings during the pandemic have been depleted. Adjusted for inflation, the bank deposits of the lowest 20% of income earners are lower than in 2019. The consumer loan delinquency rate has risen to the level of 2010, when the unemployment rate was twice what it is now.

There are signs of pressure on the real estate market again. Residential builders' confidence fell to the lowest level of the year in August. Home sales are weak. New home starts and permits have been delayed. The number of homes under construction has decreased by more than 8% since the beginning of this year.

Unlike the past, the employment in the construction industry has not decreased. Perhaps construction companies are hoarding labor, but if residential construction continues to be weak, a wave of layoffs in the industry will follow.

Commercial real estate is still in a slump. The office vacancy rate is at historically high levels and still rising. Default rates in the office, apartment, retail, and hotel sectors are on the rise. Regional banks that account for a majority of commercial property loans will suffer more losses.

Manufacturing activity is slowing down again. The new orders sub-index of the ISM manufacturing index fell to the lowest level since May 2023 in August. Core capital goods orders have been on a downward trend over the past two years in real value terms. Construction spending has been subsidized by the "Chip Act" and the "Inflation Reduction Act." Although the absolute value is still high, this spending has peaked and will decline in the coming quarters.

The Federal Reserve is unlikely to rescue the situation. The economy has previously entered a recession shortly after the Fed started cutting rates in January 2001 and September 2007.

The market currently expects the Fed to cut rates by over 2 percentage points in the next 12 months. Only if the Fed's level of easing exceeds the level already priced in by the market will long-term bond yields drop significantly from their current levels. This is unlikely to happen unless there is an economic recession.

Even if the Fed's easing policy does indeed exceed market expectations, its impact is lagging. In fact, with the reduction of low-interest mortgage debt, the average mortgage interest rates paid by homeowners are almost certain to rise next year and be replaced by high-interest mortgages.

In the case of an economic recession, we expect the forward price-to-earnings ratio of the S&P 500 index to drop from 21 times to 16 times, and earnings expectations to decline by 10% from current levels.

This would cause the S&P 500 index to fall to 3800 points, nearly a third lower than the current level. In comparison, bonds may perform well. We expect the 10-year U.S. Treasury yield to fall to 3% by 2025. Over the past two years, it was correct for investors to be bullish on stocks rather than bonds. But now, it's time to reverse the script.