Strategists: Brace for a Recession, as the Fed May Be Powerless to Prevent It

Peter Berezin, Chief Global Strategist at Canadian investment research firm BCA Research, warns that investors should prepare for a U.S. recession. As economic conditions worsen, the Federal Reserve is unlikely to be able to rescue the situation. The following is the full analysis:

"If you place a cup of lukewarm water in the refrigerator, its temperature will gradually drop. Eventually, the water will freeze, transitioning from a liquid to a solid. Apart from keeping the fridge temperature below zero degrees Celsius, nothing else needs to happen for this 'phase change' to occur.

The Federal Reserve's tight monetary policy

The same logic applies to the impact of the Federal Reserve's tight monetary policy on the economy. As the Fed continues to tighten, the U.S. economy is cooling down, evidenced by falling inflation and slower wage growth. If the Fed allows the economic temperature to keep falling, it will eventually freeze.

At the start of 2022, there were two job openings for every unemployed worker. Anyone who was jobless at that time could easily find new employment, preventing the unemployment rate from rising.

Things are no longer that simple today. Job vacancy rates have returned to pre-pandemic levels, and it’s becoming increasingly difficult for those who lose their jobs to find new ones. While the influx of workers over the past 12 months has contributed to the rising unemployment rate, nearly half of the increase is due to more people becoming unemployed.

A weakening labor market

Signs of stress are also reappearing in the housing market. Homebuilder confidence fell to its lowest level of the year in August. Home sales are sluggish, and new housing starts and permits have been delayed. Since the start of this year, the number of homes under construction has dropped by more than 8%.

A weakening labor market will dampen consumer spending. In July, the personal savings rate was 2.9%, less than half of what it was in 2019. Excess savings accumulated during the pandemic have been depleted, and after adjusting for inflation, the bank deposits of the lowest 20% of earners are now lower than they were in 2019. Additionally, consumer loan delinquency rates have risen to levels last seen in 2010, a year when the unemployment rate was twice what it is now.

Unlike in the past, construction employment hasn't yet fallen. Perhaps builders are holding onto their workforce, but if housing construction continues to weaken, a wave of layoffs in the sector is likely to follow.

Commercial real estate remains in a slump. Office vacancy rates are at record highs and still climbing. Defaults are rising in office buildings, apartments, retail spaces, and hotels. Regional banks, which account for the bulk of commercial real estate loans, are likely to face more losses.

Manufacturing activity has also slowed down again. The new orders component of the ISM Manufacturing Index fell to its lowest level since May 2023 in August. In real terms, core capital goods orders have been trending downward for the past two years. Construction spending has been bolstered by stimulus from the CHIPS Act and the Inflation Reduction Act. Although spending remains high, it has peaked and is expected to decline over the next few quarters.

Markets expect the Fed to cut rates

The Federal Reserve is unlikely to prevent a downturn. After it began cutting rates in January 2001 and September 2007, the economy slipped into a recession just months later.

Markets currently expect the Fed to cut rates by more than two percentage points over the next 12 months. Long-term bond yields will only drop significantly from their current levels if the Fed provides more easing than the market has already priced in. This is unlikely to happen unless a recession occurs.

Even if the Fed’s easing exceeds market expectations, its effects will be delayed. In fact, as low-rate mortgage debt dwindles, the average mortgage rate paid by homeowners is almost certain to rise next year, being replaced by higher-rate mortgages.

In the event of a recession, we expect the S&P 500’s forward price-to-earnings (P/E) ratio to drop from 21x to 16x, with earnings expectations falling 10% from current levels.

This would bring the S&P 500 down to 3,800 points, a decline of nearly one-third from current levels. In contrast, bonds may perform well. We anticipate the 10-year U.S. Treasury yield will fall to 3% by 2025. For the past two years, investors were right to favor stocks over bonds. But now, it's time to reverse that playbook."

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