A stock market graph. (For illustration purposes only.) Ominous signs are piling up that more turmoil is still coming, as key indicators point toward a potential recession. Image Credit: File photo

New York: Even after one of the worst starts to an equity trading year in history, the market upheaval might just be getting started.

Ominous signs are piling up that more turmoil is still coming, as key indicators point toward a potential recession. That could deepen the market rout triggered by the Federal Reserve leading a hawkish shift among central banks and war in Ukraine.

The US Treasury yield curve has collapsed to near inversion - a situation when short-term rates exceed those with longer tenors, which has often preceded a downturn. In Europe, energy costs have climbed to unprecedented levels, as sanctions against Russia exacerbate a global commodity crunch.

“Over time, the three biggest factors that tend to drive the US economy into a recession are an inverted yield curve, some kind of commodity price shock or Fed tightening,” said Ed Clissold, chief U.S. strategist at Ned Davis Research. “Right now, there appears to be potential for all three to happen at the same time.”

Food prices are already past levels that contributed to uprisings in the past, and the outbreak of a war between Russia and Ukraine - which combined account for 28 per cent of global wheat exports and 16 per cent of corn, according to UBS Global Wealth Management - only adds to risks.

Supply shock

Meanwhile, the Fed is unlikely to intervene to prevent sell-offs, according to George Saravelos, Deutsche Bank’s global head of currency research. That’s because the root cause of the current spike in inflation is a supply shock, rendering the playbook used to fight downturns for the past 30 years all but useless.

The probability of a US recession in the next year may be as high as 35 per cent, according to economists at Goldman Sachs Group Inc., who cut the bank’s growth forecasts due to the soaring oil prices and the fallout from the war in Ukraine. Bank of America Corp. said the risk of an economic downturn is low for now, but higher next year.

With a sharp and widespread economic slowdown looming over the horizon, here’s a guide on how to prepare based on conversations and notes by fund managers and strategists.

Europe exodus

While the year started with bullish bets on European stocks, that’s ancient history now. Record inflation, a surprisingly hawkish pivot by the European Central Bank and Vladimir Putin’s attack on Ukraine have changed everything, and a mass exodus from the region’s stocks is in full swing.

Strategists across asset classes see the Old Continent as the most exposed to risks stemming from the war, not least due its geographical proximity and its energy dependence on Russia.

“For euro zone, there is a high probability of recession if the situation doesn’t normalize quickly,” said Christophe Barraud, chief economist at Market Securities LLP in Paris. The risks include the confidence shock from the war, the hit to household consumption from higher food and energy prices, and the amplified supply chain disruptions caused by the conflict, he said.

Even enthusiastic bulls, like UBS Global Wealth Management, have downgraded euro-area equities. Amundi SA, Europe’s largest asset manager, said Friday that a temporary economic and earnings recession on the continent is now possible.

Commodity havens

Miners and energy are the only sectors that have weathered the rout in European equities so far, and that’s likely to continue - unless price rises destroy demand in the process.

“The energy sector in equities is one of the areas that provides shelter,” Nannette Hechler-Fayd’herbe, global head for economics and research at Credit Suisse Group AG told Bloomberg TV. “In the best case, growth is picking up and energy is supported by that. In the worst case, it is prices that continue to increase and energy sector continues to be supported as well.”

In the emerging landscape, the U.K. has been touted as a potential haven because of an abundance of commodity stocks in the FTSE 100 index. While MSCI’s benchmark of global stocks has slumped 11 per cent this year, Britain’s large-cap gauge has lost a mere 3 per cent.

Energy and materials firms, along with the traditionally-defensive sectors of health care and utilities, account for a combined 58 per cent of the FTSE 100 - index members like Shell Plc and Glencore Plc have risen amid fears of a supply squeeze. The figure drops to about 31 per cent for MSCI’s world benchmark.

Opaque industries such as agricultural chemicals are also doing well, and the ongoing tightness in fertilizer markets due to the war in Ukraine could bode well for companies like Yara International ASA, OCI NV, Mosaic Co. and Nutrien Ltd.

Food staples and retailing in the U.S. have also historically outperformed during stagflationary periods, UBS strategists Nicolas Le Roux and Bhanu Baweja wrote in a note.