Peter Berezin, Chief Global Strategist at BCA Research, recently pointed out in his article that investors need to prepare for a potential recession in the US economy, as the Fed may not be able to rescue the economy and investors' strategies need to change accordingly. Here are his views.

If you put a glass of warm water into the freezer, its temperature will gradually decrease. Eventually, the water will freeze, changing from liquid to solid. This 'phase change' does not require new factors, only the temperature inside the freezer to remain below zero degrees Celsius.

Now, replace 'temperature inside the freezer' with 'interest rate level.' The US economy is responding to tight monetary policy, manifested in the decline of inflation and wage growth. The economy has not cooled down yet because it was very hot two years ago. But if the 'temperature' of the economy continues to drop, it will freeze.

At the beginning of 2022, there were two job vacancies for every unemployed worker. At that time, anyone who lost their job could easily find a new one, preventing the rise in unemployment.

Now the situation is no longer that simple. The vacancy rate has fallen back to the pre-epidemic level, and those who have lost their jobs are finding it increasingly difficult to find new ones. Although the inflow into the labor market over the past 12 months has led to an increase in the unemployment rate, close to half of the growth is due to unemployment.

The weakness in the labor market will weaken consumer spending. The personal saving rate in July was 2.9%, less than half of 2019. The excess savings during the epidemic have been depleted. Adjusted for inflation, the bank deposits of the lowest 20% income group are lower than in 2019. The default rate for consumer loans has risen to the level of 2010, when unemployment was twice today's rate.

The real estate market is showing new signs of pressure. Housing builders' confidence dropped to the lowest level so far this year in August, with soft home sales, and the number of new housing starts and permits issued has peaked and is now declining. Since the beginning of this year, the number of housing units under construction has decreased by more than 8%. Unlike in the past, employment in the construction industry has not declined—perhaps builders are stockpiling labor—but if residential construction continues to be weak, we will see layoffs in the sector.

Commercial real estate is still facing difficulties. The vacancy rate of office buildings is at its highest level in history and is still rising. Default rates in the office, apartment, retail, and hotel sectors are climbing. Regional banks that hold most of the commercial real estate loans will face more losses.

Manufacturing activity is slowing down again. The new orders component of the ISM Manufacturing Index fell to the lowest level since May 2023 in August. Core capital goods orders have been declining over the past two years when adjusted for inflation. Construction spending has been supported by the Chip Act and the Inflation Reduction Act, but this expenditure has peaked and will decline in the coming quarters.

The Federal Reserve may not be able to rescue the economy. In the months following the central bank's rate cuts in January 2001 and September 2007, the economy slipped into a recession.

Currently, the market expects the Federal Reserve to cut interest rates by more than two percentage points in the next 12 months. Long-term US bond yields will not decrease significantly from current levels unless the Federal Reserve is more accommodative than the market already expects or an economic recession occurs.

Even if the Federal Reserve does provide more accommodative policies than currently priced, their impact will be lagged. In fact, the average mortgage loan rate paid by homeowners will almost certainly rise next year as low-rate mortgage debt matures and is replaced by higher-rate debt.

In the event of an economic recession, BCA Research expects the PE ratio of the S&P 500 to decrease 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 drop to 3800 points, a decrease of nearly one-third from current levels. In contrast, US bonds may perform well. BCA Research expects the 10-year US Treasury yield to decline to 3% by 2025.

In the past two years, it was right for investors to favor US stocks over US bonds, but now it's time to change strategies.