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17th November 2022
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Market update

I am writing this on the eve of the much-anticipated Autumn Statement, during which UK Prime Minister, Rishi Sunak, has promised that the Government will deliver the budget that the financial markets expect. The issue is that a “market friendly” budget is likely to place even more pressure on the beleaguered UK consumer.

UK inflation, as measured by the Consumer Price Index (CPI), rose by 11.1% year-on-year in October, the highest reading since October 1981 and a big jump from 10.1% in September. Worryingly, prices of food and non-alcoholic beverages rose at the fastest pace since 1977, according to the Office for National Statistics, having a deeply negative impact on those with the lowest incomes who spend a greater proportion of their income on food and shelter.

With the Chancellor, Jeremy Hunt, repeatedly stating that “tough but necessary” decisions need to be made, most expect a combination of higher taxes and less public sector spending to be announced. So, high (and rising) inflation combined with lower take home pay because of higher taxes, plus higher mortgage costs and lower house prices all add up to a rather bleak outlook for the UK economy. The Bank of England has been warned of a recession and there is now a decent chance that we are already in one.

Have markets already discounted recession risk?

It’s prudent to bear in mind that financial markets are inherently forward-looking and so one needs to consider whether equity and bond markets have already “priced in” a recession.

There’s a commonly held belief in investing circles that bond markets are better at pricing future economic risk than equities. There is some evidence of this in that the government bond markets have predicted almost every recession for the past 50 years by way of an inverted yield curve (this is explained in my market update from the end of March).

Since the extreme and unprecedented moves in the UK government bond (Gilt) markets of September, bonds have enjoyed rather better returns, which will be a relief to more cautious investors who tend to have higher allocations. In fact, the most interest rate sensitive areas of the bond markets, Inflation Linked Gilts have risen in value by almost 30% since their lowest point in early October. Gilts and Corporate Bonds have also enjoyed total returns of circa 12.50% and 11.50% respectively.

As I have mentioned in my last couple of updates, we think that bonds probably have priced recession risk in the UK and now see an abundance of opportunities in the asset class.

The folly of market timing

Last Thursday (10th November) US CPI came in lower than expected, but only by 0.20%. This, arguably rather small, reduction in the pace of price rises set off an extraordinary rally in US equity markets. The S&P 500 ended Thursday some 5.54% up and the Nasdaq almost 7.50% up.

To put this into some context, an article by Forbes suggested that this was the 14th biggest one day rally in the past 50 years.

But is such a big one-day rally based on just one data point rational? Well, no.

With apologies for getting into mathematics (the details of which I won’t describe), the same Forbes article stated that the standard deviation (the variation of dispersion of movements) of daily movement for the S&P 500 since 1950 is 1%. Therefore, last week’s move represents roughly 5 standard deviations (otherwise known as a 5-sigma event) and should only occur once in 14 million trading days. That’s once every 56,300 years!

There is also evidence that markets have been making bigger one day moves more frequently over the past 20 years or so. In fact, a 2006 article on the popular investing website, The Motley Fool, stated that since 1950 the S&P 500 had seen 52 days with 5-sigma or greater movements and three since 1987 that were 10-sigma or greater! I would argue that anyone who thinks they can accurately time when to be in or out of markets is perhaps kidding themselves, based on these numbers.

The reason for these more extreme market moves could be anything from meme stock culture (think the Game Stop saga of last year), the rise of algorithmic trading, sheer short-termism from market participants, or a combination of these and other factors.

The point I am making is that markets have been making bigger moves, more frequently and on the back of less robust data. This is probably exacerbated by the regime change from low interest rates and inflation that we have been trying to navigate over the past 2 years.

Evidence would, therefore, suggest that investors are exhibiting more herd-like behaviour at a time of increased market and economic stress. Therefore, in my opinion, it is brave (or even foolhardy) to make any large bets in portfolios at the moment. The chances of being on the wrong side of a 5%+ move are increasing and so staying invested, in a diversified portfolio, matters now more than ever.

Until next time, stay well.


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