The Federal Reserve may not be able to save the economy, investors should adjust their strategies!

Peter Berezin, Chief Global Strategist at BCA Research, recently wrote that investors need to prepare for a potential recession in the US, as the Federal Reserve 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 in the freezer, its temperature will gradually decrease. Eventually, the water will freeze, transitioning from liquid to solid. This "phase change" does not require new factors, only that the temperature in the freezer remains below zero degrees Celsius.

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

In early 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 an increase in the unemployment rate.

Now the situation is not so simple anymore. The job vacancy rate has fallen back to pre-pandemic levels, and those who have lost their jobs are finding it increasingly difficult to find new ones. Although the influx of the labor market in the past 12 months has led to an increase in the unemployment rate, close to half of the growth is due to job losses.

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

The real estate market is showing new signs of pressure. Homebuilders' confidence hit the lowest level so far this year in August, with soft home sales, and new housing starts and permits have peaked and fallen back. The number of housing units under construction has dropped by over 8% since the beginning of this year. Unlike in the past, employment in the construction industry has not declined—perhaps due to builders hoarding labor—but if residential construction continues to weaken, we will see layoffs in that sector.

Commercial real estate continues to face challenges. Office vacancy rates are at historically high levels and still rising. Default rates in office, apartment, retail, and hotel sectors are climbing. Regional banks that hold the majority of 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 in real terms. Construction spending has been supported by the "Chip Act" and "Inflation Reduction Act," and while the absolute value remains high, this spending has peaked and will decline in the coming quarters.

The Federal Reserve may not be able to rescue the economy. Previously, following interest rate cuts by the central bank in January 2001 and September 2007, the economy fell into recession within a few months 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 Treasury yields are unlikely to drop significantly from current levels unless the Federal Reserve is more accommodative than the market has already anticipated, or if an economic recession occurs.

Even if the Federal Reserve does provide more accommodative policies than currently priced in, the impact will lag behind. In fact, the average mortgage rates paid by homeowners are almost certain to rise next year as low-rate mortgages mature and are replaced by higher-rate debt.

In the event of an economic recession, BCA Research expects the forward price-to-earnings ratio of the S&P 500 to decrease from 21 times to 16 times, with earnings expectations declining by 10% from current levels. This would lead to the S&P 500 index falling to 3800 points, a drop of nearly one-third from current levels. In contrast, US Treasuries may perform well. BCA Research expects the yield on the 10-year US Treasury to decline to 3% by 2025.

Over the past two years, favoring US stocks over US Treasuries has been the right move, but now is the time to change strategies.