Transcript: Global Economic Outlook for 2024 and Beyond (Part One)

Air Date: January 29, 2024 | 12:00 PM, EST

Caroline: Good afternoon, everyone, and thanks for joining us. I'd like to welcome you to this week's Monday Minute Live Chat hosted by the Canadian Leadership Congress. Today's topic is A Global Economic Outlook for 2024 and Beyond. Here to talk about it is Johanna Kyrklund, who's Group CIO and Co-head of Investment with Schroders, and moderating this discussion with Johanna, we have James Davis, who is Chief Investment Officer with OPTrust. Welcome to both of you. I'd like to hand things over to you, James, to get us started.

James Davis: Excellent. Thank you, Caroline, and Happy New Year. Great to see you again, Johanna. Happy New Year to you.

Johanna Kyrklund: Great to see you both.

James: I have to say this is the time of year where we always reflect on what happened in the previous year before we look forward to the future. I'm really curious, 2023 for me was a very, very unusual year. Lots of ups and downs obviously in the market, crazy geopolitical environment, no one knew where inflation was going to go or where interest rates were going to go. I'd love to hear from you what you took away. What were some of your key learnings in 2023?

Johanna: Maybe there's two aspects. I think the first thing that really surprised people was the fact that we didn't really get a recession in the first half of 2023. I don't know about you, James, but we certainly were expecting a more significant slowdown in the United States, which we obviously didn't get. I think the thing that we clearly underestimated was the impact of the fiscal stimulus.

I think that one of the things I certainly learned from last years, generally we've been positive on the US market for a long time because of its dominance of technology and many other factors, but in the last two years, US exceptionalism has taken on a new facet, which is really their ability to stimulate beyond what other countries are allowed to do. This is not sour grapes from a UK perspective because clearly, we were punished by the markets when we tried to spend fiscally last year with the gilts crisis.

I'm just saying in general, the US has been able to spend, to expand fiscally, and I think it's benefited from the fact that it has that reserve currency status. That's one thing is we underestimated the power of that fiscal stimulus and how it helped the average person.

I guess the other key surprise of the last year was the dominance of the tech sector. I would've imagined that in a world where rates were going to be a bit higher for longer that actually such long-duration stocks would've underperformed, and clearly, I was completely wrong about that. I guess now with hindsight, what I can see is that they're so cash-generative that they almost became quasi-cash instruments with the added flip of huge growth associated with AR or huge potential. Those are probably the two lessons I learned from 2023.

James: How were you thinking about geopolitics? Schroders, for example, and I know you, Johanna, have had a lot of opportunities to visit China, you have a big emerging market presence in general. I know there have been a lot of concerns about the direction that China has been taking over the past few years. Many pension plans have been looking at potentially excluding or divesting from China. I'm curious how you think about it, and you probably have a better advantage point than many in terms of understanding what's happening in the country there. How do you think about China and emerging markets more broadly?

Johanna: I think the first point, the issue of people getting out of China was somewhat sparked by what happened with Russia. That was the first time where we really as people allocating capital-- Certainly, I've been in this job for 26 years, I'd never been in that position where I was having to assess a sovereign in such a way. I think that that's what then raised the question of, is there a day where we might be getting out of China?

I think China is fundamentally different to Russia. Russia ultimately chose a path of isolation, so that actually in the end, it wasn't that intertwined with global supply chains the way that China is. I don't see how in practical terms people could be excluding China because again, they pursued a very different policy over the last couple of decades, what Russia did, so we're in a completely different situation with China.

I guess the big question would be what happens with Taiwan? Certainly, from our perspective, our expectation is that that China is generally a force for stability actually. Often we think of China as an unstable player, but if you look in recent years, the economies that have been throwing out the war book have been in the West. China generally is interested in stability more than anything else.

From that perspective, impossible to put probabilities on this, we're not expecting an invasion of of Taiwan. I think that would be the trigger event. I think that ultimately they're aiming obviously for closer ties with Taiwan, but I think they're hoping to get that through softer means. It's a medium-term objective, it's not something they're doing in the short term. We certainly wouldn't be excluding China. The question then is do you need to set up frameworks so that, should that day come, you can extricate yourself easily? That's where maybe considering China differently from EM ex-China could make sense.

You probably remember, James, we've spoken over the years, one of my principles is I typically try to do things that maybe cope with political risks, but that I would like to do for other investment reasons as well. I hate making allocation choices just based on politics which are just so binary. There is some benefit to thinking of China separately to EM ex-China because the drivers are so different.

China's got huge exposure to technology, really the only market part from the US that provides that exposure, dominating electric vehicles now. The nature of the market is very different to what you get from the rest of emerging markets. If you look at the underlying factor exposures of the Chinese market versus the rest of emerging markets, I think there's enough difference that actually from an investment standpoint, there's some benefit from thinking about them somewhat separately.

James: Can I get China though indirectly? Sorry, what I mean is can I not just buy developed market equities that will give me that kind of exposure to China, or is that changed?

Johanna: I think in a time when China was all about the Chinese consumer which was really what we were focused on, in the mid-2000s, it was all about capturing that Chinese consumer, you are right, you get that exposure by buying the luxury names in Europe, for example. I think we're a different phase of development with China now. I think that ultimately, there are, especially with these valuations, different kinds of opportunities in China that you can't access elsewhere.

Particularly if you're going into a more multipolar world where there might be more disconnection, they're making different technological choices, partly because they're managing their own risks as well. In some sense, it's a benefit to being exposed to their technology as well from an investment standpoint, not just the technology of the West.

James: Are you seeing more demand for EM ex-China mandates?

Johanna: We're seeing interest in that out of North America. This is not a trend we see in Europe or in Asia. Asia obviously sees things completely differently. It is something we've picked up in North America in particular.

James: I like the idea because it does allow you to differentiate and then to hold China separately, and to your point, if you needed to exit, you would have an easy exit strategy.

Johanna: Yes, exactly. I think that's the benefit of it. As you said, I do spend quite a bit of time in China, and again, I think that it's been interesting. I actually went there in December, having not been there for a few years because of the pandemic. I think also

the relative isolation of China in recent years hasn't helped because just as the geopolitical environment deteriorating and then with the Russian situation. At the same time, none of us were really traveling to China anymore just because of the pandemic. I think that actually going back there reminded me of the fact that ultimately China is a force that is interested in economic integration and not economic isolation. Ultimately, there's also huge innovation going on there that I think you'd want to be part of.

James: The sustainability of their system, albeit quite different than political systems in the West, does require strong economic growth. Now they've got some challenges from a demographic perspective. How about India though? They don't have those same demographic challenges. How do you think about India?

Johanna: [unintelligible 00:09:51] Maybe going back to the point of the original question which was about the geopolitical environment, ultimately, we're in an environment which is much more multipolar in nature. We have been talking about a trend towards deglobalization, ultimately hugely integrated supply chains, but at the margin, the sort of Adam Smith on steroids world of a totally globalized supply chain, the completely frictionless, I think people have realized that the challenges of that partly for political reasons, but also because the pandemic exposed the vulnerability of global supply chains.

In a more multipolar world, there are regions that are benefiting from that and India would be one, Mexico is another. Again, there are always winners or losers, also the Middle East. Those economies that can straddle both sides are really starting to gain, and of course, India's already seen very strong performance over the last year, I think very much reflected. Again, that was something that was discussed, I heard a lot about that in China, their concern that India was stealing a march on them. As you rightly say, they want to be doing well economically. That is quite a stabilizing force over the medium term.

James: Are you worried about war? Are you worried about what's happening in the Middle East, and how that may actually develop into something broader?

Johanna: I think ultimately, we are in an unstable system. I think that ultimately, we're all spending more on defense. If you want to get really bearish for a minute, before the First World War, you have that kind of remit, that militarization across the board. We're not there yet. We went from a system where Germany, for example, was not spending on defense, it now is, people are realizing they need to build up their defense spending.

I think there are some ingredients-- a more unstable world, certainly. I think from an investment standpoint, it sounds callous, but what we need to think about is whenever there is any kind of conflict, we need to think about first of all, how much GDP is actually impacted by this. Secondly is that transmission mechanism whereby a localized conflict then have disproportionate impacts on our GDP and rate assumptions.

Now, clearly, the conflict in the UK was an example of the latter because we had a very obvious transmission mechanism by our commodity prices, which ended up in stagflationary outcomes around the world. That's something that we need to think about. I think generally, in an unstable system, you do end up with fragile equilibria, like you did during the Cold War, where actually people ultimately don't want a huge escalation.

What you'll probably get is the equivalent during the Cold War, the hot wars. I think ultimately, typically, people are incentivized to keep things stable. From a market standpoint, people often ask me, what do you do about this environment? Again, as I said earlier, you can't just do things for political reasons. Ultimately, we need to take risks to generate return. If you're thinking about that geopolitical tension, the obvious thing to own is more commodity-related investments.

In the last decade, commodities were a total waste of time, from an investment standpoint. They were correlated with growth, it didn't provide any diversification. We, for the last three years, have really been seeing commodities and commodity-related risk as a pretty structural diversifier. There are a number of reasons for that. Funny enough, decarbonization also has that consequence. Also, this political environment. Again, we were not only commodities just because of the geopolitical tension. Actually, the hedges against those kinds of scenarios, but also crucially benefit from other trends we're seeing, like decarbonization.

James: I agree with you. I think, from my perspective, one of the things we always try to do is build a resilient portfolio because you never know what's going to happen. One of my key learnings over the years is I cannot predict markets, I have to have a view. Most importantly, I have to manage the risk. That always starts with portfolio diversification.

I think that stagflationary kind of environment is one of the most challenging environments for pension plans, especially defined benefit pension plans like we are. We've been building up our commodities exposure. One of the biggest challenges with commodities is over the long run, they don't tend to generate a very attractive real rate of return. Maybe that's due to technological innovation. At the end of the day, what is the best way for an investor to own commodities? Should they own commodity futures? Should they own the equities that are extracting the commodities? How do you think about that?

Johanna: You're absolutely right. When you look at the long-term risk premium from commodities, it's [unintelligible 00:14:53] best to get the roll yield really over the long term. First of all, we're doing our strategic allocations, it's hard to allocate commodities strategically because of that long-term return challenge, which is why the thinking we've been having is to say allocate to cash as the strategic allocation, which gives you the room to move into commodities when you think the time is appropriate.

You have to manage the exposure. Take account of the roll yield. If the roll yield is not there, then maybe you shouldn't be allocated. That's one of the ways we've thought about strategic challenges; not to try and include commodities from a strategic asset allocation perspective. Make the allocation to cash, which again, has other benefits. Then you can go in and out.

In terms of generating return from the commodity exposure, I think there's a number of ways we can think about it. Commodity futures are helpful, particularly if the curves are inverted. It's a very pure exposure, it can be quite helpful. When we look at commodity stocks, we are focused also on not owning stranded assets, so we are focused on owning those assets, but then engaging very significantly with the companies to make sure that also at the same time managing their transition. I think that's an important thing to think about from a long-term perspective.

There is money to be made there still. Then there's ways about how do you make money out of the new source of energy, renewables, the infrastructure required for electric vehicles, for example. We're thinking about it in a fairly broad perspective. Direct exposure, owning traditional commodity stocks, but with the engagements that goes with it to ensure they don't end up-- that ultimately they're taking a forward-looking approach, and then also trying to make money out of the decarbonization trend, actually seeing it as an investment opportunity.

Interestingly, a few years ago, when we first started talking about this, a lot of our stock pickers were like, we don't want to think about this. Interestingly, so many of them now coming up with thematic ideas, they're increasingly seeing this as an opportunity to generate return because ultimately, it's hugely disruptive. Out of disruption always comes opportunity.

James: It's interesting, too, because I think we have a very similar view on how to play commodities. In the last maybe year and a half, we introduced a new program in our fund, which is a long-only commodities program. Basically, it is starting with cash, and then moving only into commodities, and only those commodities where we see the best opportunities. There is an element of momentum in that as well. Think of traditional CTA-type strategies. We certainly do employ some of those in that overall strategy.

We think over the long run, that helps to overcome some of the challenges with just simply buying and holding commodities, recognizing that it's very easy to get whipsawed in a momentum-type strategy. That's something we introduced in the last couple of years. We're quite pleased with how we're seeing that unfold.

When I think about energy, I think it's broad. We have a lot of exposure to renewables in our portfolio, we have for a long time, we've been early movers in that, since maybe back in 2007. It served us really, really well. Those assets have done particularly well, but they're expensive now. It's harder to earn the returns that we need to pay pensions than it was a few years ago.

We think we need to be in that space as a minimum, just bringing us back to where we were, to mitigate stagflationary risk or geopolitical risk. Being in the commodity space, including more traditional commodities, we think is really important. We think it's thematic. The other thing that we think is really thematic is technology. I'd love to get your thoughts on AI and the evolution of AI. Are you worried about it? Are you using it at Schroders? Do you use AI to help in investment decision-making? How are you investing in it, if at all?

Johanna: We are using it. First of all, maybe just to pick it-- first, from an investment process perspective, we are quite medium-term investors. AI as an information processing advantage is less useful to us, in that sense. We are using AI, from a productivity enhancement perspective. We have our own version here at Schroders that we all use extensively. I think just that productivity-enhancing perspective is always useful. When I think about the power of AI for medium-term investors like us, as opposed to short-term traders, when you look at any investment process, you're really looking to see whether you can get an information advantage, an analytical advantage, or a behavioral advantage. For me, actually, the really interesting thing would be the behavioral because where you really get an advantage from AI is where you're training it on data that not everybody else has.

At the moment, we're training our AI tools on data sets that everybody else has. We're not getting much of an information advantage, maybe a bit of an analytical advantage. I think if we could train those AI tools on our own behavior, this in some sense would make my job as CIO redundant. If you think about what do we do all day, we watch our investment desk, we know the people, we understand their behaviors, we know their tendencies, we've watched them through time.

When strategies go wrong, we're able to help them because of our artisanal approach of understanding the investor. I think that is something that could be disrupted by AI, as in- - and again, approaches like this exist already, but they're quite clunky compared to what could be done if we're able to train the--

I imagine a world where essentially we'd have two fund managers plus an AI entity essentially managing portfolio. The AI guy providing the nudges, essentially being the annoying person on the desk pointing out, "Well, look, we always-- we don't size our trades appropriately, we should go in big at the beginning and then scale back." There's portfolio sizing decisions, how you trade the position. There's a lot of alpha in that, which I think could be enhanced through the use of AI.

James: What's the data you would use though? You have your own data at Schroder's, a fairly rich set of data. I've always thought, at least in the last several years, that we have to think about data differently. Data is like the brand new commodity. If you treat it that way and recognize that it's scarce, then it can be very, very powerful. When you were thinking about this, if you like this third AI trader sitting on your desk, what kind of data would that AI trader be analyzing?

Johanna: Basically, data analyzing all of our own trading behavior. It's specifically about-- if you look at the alpha signals we generate, if you're doing a good job, maybe you've got a hit rate. If you're doing a good job, hit rate of 60%, say, right? That's important, but the sizing of the positions and how you trade them is just as important. I think we know it, understand it qualitatively, but I think we could do a better job of analyzing that aspect to improve the skew of returns around that hit rate. You can do it simply through stock losses, but there's more that could be done in the sizing of the position.

James: Yes. See, I find the exits often get ignored. It's the exit strategy that's actually, in my view and in my experience, more important than the actual entry.

Johanna: Exactly.

James: The advantage of risk. That's how you take profits when the time comes as well. I spend a lot of time thinking about that. It's interesting because, in my mind, that's where you get the asymmetries in markets because it is behavioral. It is a fact that many investors don't want to consider the exit. They're good with buying something and then they'll ride it out. If it goes against you, they take the long haul a minute for the long term and they'll ride it out. It's that kind of behavioral bias, I think, where AI machine learning can be so powerful. That's one of the ways that we've been thinking a lot about it as well. I agree with you on the behavioral side.

Johanna: Have you seen a lot of pickup on that side in terms of the managers, and are you seeing a lot of change yet?

James: We are seeing more talk about it. I don't know if we're really seeing it. There's a lot of talk about using these kinds of tools. Sure, everybody is looking at it in terms of

productivity improvements, which I think actually has a big implication for GDP growth going forward and probably is, thinking about it in a more broader sense, disinflationary, which is probably good as well.

In a micro sense, I think that there's going to be a ton more applications, but it's going to come down to that data. As you say, your traders are going to have their own behavioral biases. You also want to try to pick up the behavioral biases that are broader in the market and see if there's a way that you can exploit them. That's where we are now. We're not picking up our own trader biases because a lot of our assets are outsourced and we may not have that direct information as to how the trades are being executed on.

I think that there's a ton of opportunity there from an investment perspective. I truly hope it doesn't replace you and I. I don't think we're at risk in the near term, but I am mindful, so I have to stay sharp and on my game. Just exploring the world of technology further, how are you thinking about AI and how it may impact health care, medicine, biotechnology, longevity, which is so important for a pension plan?

Caroline: That wraps part one of our terrific discussion on A Global Economic Outlook for 2024 and Beyond. Stay tuned for part two coming soon.