Donald Rumsfeld famously called them ‘known-unknowns’ – things we sense are important but don’t fully understand and cannot predict. Bob Dylan put it well, too, when he sneered ‘there’s something going on here, but you don’t know what it is, do you, Mr Jones’. Both point to the investor’s greatest challenge, the absence of a crystal ball.
It is sometimes said that markets hate uncertainty. This is not strictly true. Uncertainty is a key feature of markets – it creates the tension between buyers and sellers that sets prices. Without uncertainty there is no market. What we can say is that rising uncertainty tends to depress prices and vice versa. Whether you love or hate uncertainty depends, therefore, on whether you are a buyer or a seller.
There is no shortage of uncertainty at the moment. This is one reason why, ten years after the financial crisis, markets remain relatively inexpensive and volatile and why investor sentiment is subdued. The animal spirits that you might have expected to re-emerge after such a long, unbroken period of economic growth are notably absent. Last week, the monthly Bank of America fund manager survey showed the highest preference for cash since January 2009 when, you may remember, plenty of people thought the world was coming to an end.
There are three types of uncertainty today. The first of these, short-term unknowns, are dominating the headlines and souring investment sentiment. Here in Britain, we look in vain for any clarity about what will happen on 29 March. It is quite easy to get rather cross about this piece of self-inflicted uncertainty. Plenty of business people are spitting tacks and who can blame them? Business investment has fallen for four quarters in a row and the Bank of England has slashed its growth forecasts. The absence of leadership on both sides of the House is depressing.
More important from an investor’s perspective, and on an even shorter fuse, is whether or not the US and China can find any common ground before tariffs on $200bn of Chinese exports are hiked from 10pc to 25pc on 2 March. Talks broke up on Friday with no sign of agreement, kicking away one of the principal supports for the New Year market rally. The hope remains that Donald Trump will put higher tariffs on hold to facilitate a meeting with his opposite number Xi Jinping but, as with Brexit, the default position if nothing happens is not good.
The second type of uncertainty is slightly longer-term but well within the time horizon of most investors. The outlook for both corporate earnings and interest rates is not only crucially important for the direction of markets this year but also unpredictable. Jerome Powell’s recent U-turn on the pace and scale of monetary tightening has given investors a short-term boost but the unreliability of his forward guidance argues for more cautious valuations. As for profits, it is clear that the sugar rush of last year’s tax cuts is ebbing away. The latest fragile retail sales figures are at odds with the apparent strength of the US jobs market.
Investors tend to focus on the short and medium terms but a couple of stories this week have shone a spotlight on the longer-term uncertainties that make investing so challenging. The first of these was Airbus’s decision to end production of the A380 super-jumbo only 12 years after the supposed successor to Boeing’s 747 first carried passengers. The 550-seat double-decker was obsolete almost as soon as it entered service, as airlines switched their allegiance to smaller, more fuel-efficient two-engine planes like Boeing’s 787 Dreamliner. Airbus and Boeing were forced to place their bets long ago, knowing that the winner would not be announced for a couple of decades.
Designing airliners is a long-term game. So, too, is the energy business, as BP made clear with last week’s publication of its annual energy outlook. The most striking number in this report was the prediction that demand for crude oil would drop by only 20pc in the next 20 years even if the industry faces a ‘rapid transition’ to renewables. Oil and gas will still meet half the world’s energy needs in 2040, even if wind and solar account for a third of demand and coal use drops off sharply in a bid to meet the Paris agreement climate goals. Whatever happened to ‘peak oil’, the prediction that fossil fuel production would never rise above its 1970 level? Another long-term bet that’s been overtaken by events.
So, uncertainty is unavoidable on every time-scale and in all aspects of our lives. Only in hindsight is there any clarity. The question is not how to avoid uncertainty but how to adapt to it.
The first thing to do is to accept the limitations of our knowledge. As Yogi Berra said, ‘predictions are difficult especially about the future’. Over-confidence is one of the most damaging of the psychological biases that undermine our investments. It shows up in many different ways: overestimating the chance of good things happening (the lottery ticket effect); believing that more information means better forecasts (it doesn’t); and thinking we are smarter than we are (93pc of Americans famously said they were better than average drivers).
Once we accept that we know less than we think, we can adjust our approach accordingly. We can make sure we are well-diversified, so our mistakes don’t sink us. We can remove emotion from our investment decisions, resisting the temptation to time the market, for example. And we can put our faith in the few near-certainties there are for investors: the long-term reward for risk (shares outperform bonds and cash) and the tendency for things to revert to the mean (which is why prudent investors buy cheap and avoid chasing growth).
As Bob Dylan also said: ‘I accept chaos. I’m not sure whether it accepts me.’
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Published by Tom Stevenson, Investment Director, Fidelity