The second term of US president Donald Trump has thrown markets into chaos – but chaos is just the feeling of living in history, according to Helen Xiong, FE fundinfo Alpha Manager of the Monks Investment Trust.
“Just in my lifetime, I have lived through the collapse of the Soviet Union, the Asian financial crisis, the dot-com boom and bust, 9/11, the extraordinary transformation of the Chinese economy, the global financial crisis, the rise of the internet, social media and smartphones, the pandemic and now artificial intelligence,” she said.
“Every decade brings about change that once seemed unimaginable. If there is one thing I have learned it is that living through history never feels like living through history, it feels more like chaos.”
The same can be said for today’s market environment, she said, as no one can know what Trump might do next. “I have no idea what Donald Trump might do next and I think neither does he,” Xiong noted, suggesting we live in “unprecedented times”.
She used an analogy of two popular games – chess and poker – to make clear the difficulties investors face when trying to make decisions during unprecedented times.
“In chess, grandmasters can often plan 10 moves in advance, but chess is a game of perfect information where everything you need to know is on the board,” she said.
“Investing is more like poker, where you don’t know what card you are going to get next and don’t know how the other players are going to react to it. You are constantly assessing the current information and making the best move based on the information that you have in the moment.
“So you think in bets. You manage risk, you adapt your thinking as new opportunities come along and, when you see an opportunity, you go for it.”
However, there is a key distinction between risk and uncertainty, something she took from the words of economist Frank Knight. He used the term ‘risk’ to denote situations where the outcomes are either known or can be reliably estimated, while ‘uncertainty’ was used for situations where the outcome and probabilities cannot be reliably forecast.
They are “situations where we do not have enough historical precedent to draw reliable conclusions,” said Xiong. While risk can be priced, hedged and insured against, uncertainty cannot.
This is the case for those hoping to invest around short-term noise, particularly relating to the economy, which is not possible to do reliably as there is too much uncertainty, she argued.
“It is perhaps what [John Maynard] Keynes meant when he said ‘there is no mechanical basis for calculating future events when you deal with the real economy’ and ‘decision making in the real world involves irreducible uncertainty’,” she said.
Part of the issue is that human beings tend to oversimplify issues that are much more complex, suggesting we “dumb things down” as part of a “primal need to make sense of the world”.
This is baked in from school and university, she said, where economics students are taught ‘Centrus Paribus’ – the Latin term for holding all things equal.
“It is an admission that we cannot understand the outcomes of the world as it is, so we have to simplify and only move one variable and assume nothing else changes. That is unrealistic, but almost all economic theories are based on that,” she said.
This simplification “renders the conclusion irrelevant” and “doesn’t really work” because the economy is a “complex web of lots of different actors”.
An example of this was in the 2010s, when huge efforts from central banks through quantitative easing initiatives following the great financial crisis should have led to inflation according to economic theory, but did not.
Similarly, a rise in wages at that time should have caused a rise in unemployment, but again this failed to materialise.
The best way to deal with such uncertainty, therefore, is to “build resilience” into portfolios, which Monks does through diversification. Here she said a portfolio should be thought of as an ecosystem.
“We know that more biodiverse ecosystems in nature are more resilient. So while a single crop variety on a field can produce the highest yields in very idealised conditions, it is fragile when nature throws a curveball,” she said.
“By contrast, more diverse ecosystems that contain a lot of different types of plants and animals, all with different resilience to temperature levels, rainfall and diseases, are more resilient. When a disease hits, some crop varieties may suffer but the ecosystem as a whole continues.”
Monks does this by investing in three types of stocks. First are disruptors – companies that are using technological innovation to drive change in industries.
Next are the compounders, or those where investors will get rich slowly. “They are the franchise companies that compound over a long period of time,” she said, such as long-term holding Mastercard.
Last is the capital allocators, which are the more economically sensitive companies in the portfolio. “Growth is not delivered as evenly as the compounders but therein lies the opportunity. We look for management teams that can allocate capital countercyclically and turn that volatility into an opportunity,” she concluded.