Reflections on uncertainty

All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• With rates likely to be higher for longer and trade tariffs such a hot topic, this could be a tough year for investors to navigate.
• US economic uncertainty might be closing on a forty-year high, but uncertainty is part and parcel of investing.  
• However, the global economy, and financial markets, have a record of growth over the long term, as companies adapt to changes in the world.
• Having solid financial foundations with a well-diversified portfolio, targeted at long-term performance, is one way for investors to rest more easily at night.

With a barrage of President Trump headlines and US trade tariffs seemingly on their way, and fewer rate cuts expected than just a few months ago, uncertainty is the buzzword for investors. 

Geopolitical tensions dominate the airwaves, and multiple complex crises paint a picture of a world which is more uncertain than ever. Naturally, this can make investors hesitate. 

The impact that news flow can have on investor psychology and physiology, and the importance of understanding how it can affect and exacerbate behavioural biases, was covered in February, in our article Investing: how does it feel?. This month, we examine the central thread which ties much of this together – uncertainty – and reflect on how investors might navigate it. 

Ambiguity and risk aversion

During periods of uncertainty, taking less risk can appeal. Investors may hold higher allocations of cash and fixed income within portfolios.

There is another factor to be conscious of. One of the key reasons why investors struggle with uncertainty, is ambiguity aversion – the tendency to avoid situations where probabilities are unknown.

Whilst risk aversion implies making more cautious investments, ambiguity aversion can manifest itself in a reluctance to participate in markets altogether. Investors take a seat on the sidelines, preferring the comfort of cash over risk assets.

Is uncertainty really at an all-time high?

Whilst policy uncertainty is indeed high (see chart), we would argue that the world is becoming more predictable, in many ways. Economic cycles, inflation dynamics and central bank policies, along with their transmission through the economy, are better understood than before. 

US economic uncertainty soars

After spiking to fresh highs around the COVID-19 pandemic, the US economic policy uncertainty index has surged in recent months, as the new US president took office

This, of course, does mean that when shocks occur, they can shake markets, at least in the short term (remember that markets can and do overreact to events in the short term). But far from highlighting that the world is more uncertain, they actually highlight that uncertainty is always present. 

The one certainty when investing is that there will always be uncertainty. History shows us that companies and economies adapt and innovate, and the world continues to grow, however uncertain it might be. Global growth has averaged 4.7% a year since 1990, reflecting the resilience and predictability of economic progress.  

Companies keep innovating

The threat of higher tariffs, and the possible ramifications for global trade, is one area of concern. However, as shown by events during the COVID-19 pandemic, companies adapt their supply chains and business models to meet the pressing challenges. 

The “nearshoring” trend of late, to bring more of the supply chain closer to key markets, shows how Chinese companies have successfully responded to US tariffs of late (see chart), relocating much of their manufacturing operations to Mexico and Southeast Asia before exporting into the US, with lower tariffs.

Mexico overtakes China as a US exporter 

After strong growth in US imports from China for much of this century, trade tensions have seen the US importing more goods from Mexico on a rolling 12-month basis

Adapting to trade restrictions 

More recently, developments in artificial intelligence (AI) show how China has been able to very successfully make technological progress in the space, despite increased US trade restrictions on exporting AI infrastructure to China. 

The MSCI World Index has grown at an annualised rate of approximately 7% over the past 50 years, reflecting the ability of businesses to show resilience and adaptability to drive continued economic progress. By remaining invested, investors benefit from the wealth creation that accompanies innovation. 

The real risks 

Nonetheless, risks do loom on the horizon. It may seem counterintuitive, but perhaps investors should pay less attention to market risks. 

Risk is often framed in terms of market volatility. However, the key risk for investors is that of not achieving their individual financial goals. 

It is also important for investors to remember the distinction between trading and investing. Those investing over a long period might turn down the noise on short-term news flow, and short-term market gyrations, because much of this affects those with very different goals. 

Investors should filter out risks that do not have a predictable and significant impact on the time horizon for which they are investing.  

Scenario analysis 

Applying probabilities to different scenarios, and then positioning portfolios for the most likely outcome and perhaps hedging for the less likely ones, is a possible antidote to an uncertain world. The problem with this approach, though, is the difficulty of assigning these probabilities. Positioning portfolios for specific outcomes can also be costly. 

So, what can investors do? Having a robust investment process while creating a well-diversified investment portfolio across asset classes, sectors and geographies is one approach. By holding a wide selection of quality companies, investors can have exposure to companies that have a record in delivering value to shareholders by producing sustained profits in the face of whichever world they face. 

Good diversification is about holding a broad range of assets in a portfolio that can perform well in many scenarios, however unexpected some of them might be. By having solid financial foundations in place, investors can take a step back from the complexities of having to try and make sense of an uncertain world, and instead focus on finding those companies able to tap into the global economy’s record of sustained wealth creation over the long term.