Monday Minute | Global Economic Outlook for 2024 and Beyond

PART ONE

PART TWO

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.

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

Air Date: February 05, 2024 | 12:00 PM, EST

Caroline: Good afternoon, everyone, and thanks for joining us. I'd like to welcome you to part two of our Monday Minute Live Chat series on A Global Economic Outlook for 2024 and Beyond. We have continuing the conversation, Johanna Kyrklund, who's Group CIO and Co-Head of Investment with Schroeders. Of course, moderating the discussion is James Davis, who is Chief Investment Officer with OPTrust. We hope you enjoy this continued discussion with these two amazing CIOs.

Johanna: I probably haven't thought about it as much as you have. I can see that it could lead to much better health outcomes that I guess I would see as a huge opportunity. If you're managing a pension, it becomes a bit of a problem over the long term because of the longevity impact that it has.

Look, I tend to be an optimist. I guess big picture, coming back to the first question you asked me about AI, if we look at all the disruptions we've seen through time, going back even to the agricultural revolutions that happened, people didn't become redundant. It's just that we started to emphasize other roles. Once we got beyond just trying to grow a crop, which when you have to do with basic tools is pretty much what you did all day, suddenly being a scientist became a thing.

Human beings, I think, have a habit of finding stuff to do with the time that's freed up. I think that, yes, health could be significantly impacted. In particular, I think it could have a huge impact on the emerging world. We're used to having huge resources at our fingertips in the developed world. I think that actually, this could be game-changing for emerging economies in terms of the access to health care that this could provide for them. That's one of the positives that I see from AI. Absolutely. Sorry, I could go on and on, but I thought I paused [unintelligible 00:37:00]. [crosstalk]

James: No, this is great. First of all, I'm by no means an expert in the space. As I understand, the way AI is able to process life sciences data is allowing for, I guess, the evolution of genetically based treatments to move much more rapidly, which I think is wonderful. I think that is probably the future of medicine. It's going to be biochemical and genetic more than anything else. I'm pretty excited about that. I don't know where it's going to go. I do believe that technology is going to be really, really forceful in terms of advancing.

Johanna: Again, it comes back to something we were discussing earlier. Technology is still central to everything. I think this technological disruption we're seeing is unrelenting and it will continue and ultimately is a force for good. That's why even when we're thinking about-- again, it's interesting because this is already a trend. I think it got accelerated by the pandemic.

The health challenge of finding vaccines showed us what we were capable of. The fact that vaccines actually were discovered so quickly, it just woke us up to the possibilities here. I think that also more broadly, because of that technological disruption, this comes back to the point about China. Unfortunately, Europe-- I guess we're doing our bit on the life sciences point. Actually, China is a place with a lot of technological innovation. I think that cutting off a major part of the world economy where that innovation is happening is probably not a good idea in this environment.

James: Even how we think about portfolio construction is evolving. I know in the traditional world of SAA, we've always thought about it in terms of what's your allocation to stocks. Maybe we break stocks out into developed markets, emerging markets, bonds. We can break out into government and corporate. I think there is a better way to be thinking about how we structure our portfolio.

It's not just the simple risk factor approach, but the way I've been thinking about it more recently is the technology bucket, if you like. How do I think about the technology theme in the technology bucket? How do I think about energy in the energy bucket? Oftentimes the two of them, they diversify really, really well. Part of that is for macroeconomic reasons. I think those are two major themes that are playing out.

We need to think about them more than just, do I have the same weighting as the S&P 500 to technology in my overall portfolio? Have I tilted one way or the other? I do think it becomes much more structural and much more thematically based on the way that we're thinking about our overall portfolio.

Johanna: I can't agree more. When I think about the portfolios we'd be, managing 10 years ago, we didn't really have thematic allocations, but now we do and they're overwhelmingly allocated to the areas you're talking about. We have technological disruption as a major theme. Then we have energy transition, sustainable food and water, digital infrastructure. These things, basically, technology and I guess commodities in some senses, because even sustainable food and water is a major challenge we face and is also diversifying. Again, I don't want to sound callous, but it is.

I think the point is, the nice thing about that is that by having those two allocations, because historically when you've gone thematic, you get very growth-oriented very quickly, but actually having those two acts as a decent counterweight. It's interesting. One thing we've noted is, and I don't know about how it's been for you in Canada, but certainly in Europe, with the focus on sustainability, a few years ago, I think a number of asset owners did go down an exclusionary path, which has undermined their ability to cope with this environment.

I think this is example of how good arguments always get taken too far. We used to get given a bit of a hard time in Europe for not excluding energy from our portfolios. I think that what recent challenges have shown, particularly here in Europe where we're sitting with a Ukrainian conflict very much on our doorstep, is highlighted that these things are never linear, that there's always cycles, and that ultimately you always have to provide and ensure there's some flexibility in your portfolio.

James: It's amazing how all these things are interconnected, isn't it?

Johanna: Yes.

James: When you smack and you look at it, there's so many different bits and pieces that are connected, and it's important to understand those connections.

Johanna: Sorry. The fascinating about commodities, it's great to hear you agree with me because I've been talking about it for the last two, three years, but I'm seeing zero flow into our commodity business, or just a little bit out of North America. I think it's because a lot of our clients, certainly in Europe, are excluded from that.

James: I think, as you said, the pendulum sometimes can swing too far one way or the other. It worries me, quite frankly, as to how quickly it is swinging the other way in the United States right now. There's so many things to talk about, Johanna. I think we could just keep going for hours and hours, and I just keep jumping from topic to topic. When I think about climate change and ESG, we know climate change is real. We can see it. We feel it.

We know that there is a transition that's going to have to take place. Whether that takes place in a orderly way or a disruptive way, economy is going to impact our overall portfolio, but we have to be on top of it. I'm curious as to how, for your US clients, if you are able to answer this, do you find that the pressure that is being put on them politically is causing them to rethink how they've been thinking about things like climate change and ESG?

Johanna: I actually think that political pressure in the United States is more on China. Certainly that's what I hear. We're less subjected to it because we're in the UK. I think that is more political pressure point. Ultimately I think in the United States there's always been a focus on the prudent man principle. Then it just comes down to whether you think climate change is happening or not. I think you and I agree on that particular subject and therefore it's a risk you need to take into account. For me, I think that's where I see more political pressure, is the China fund.

James: It's interesting because the whole thing gets muddled up with what is fiduciary duty. I've seen that again and again. I think there are parts of the world that are more progressive in how they think about fiduciary duty. Way I always thought about this though is you need a healthy climate to have a healthy economy. If you don't have a healthy economy, you don't have a healthy asset portfolio. Though there is that systems thinking we need to apply as we are thinking forward in terms of our overall portfolio decisions.

Johanna: I think, as you know, we actually embedded climate risk into everything we did across every single desk a few years ago. Our deadline was then in 2019, which we hit. As part of that effort, for example, we embedded the impact of climate change in our long-term return assumptions because certainly if you're doing a 30-year return forecast, you do need to take into account climate change.

Now, actually, as we did that exercise, which seemed quite radical at the time, we're now thinking, hang on a minute. Do we need to think about it on a 10-year view as well? Actually, some of the work that we did on the 30 is now affecting our 10-year return assumptions as well and so it is something we need to consider. Based on our modeling, it does have real impacts on GDP.

James: It's the transition path that matters most. It's hard. It's hard to know. We've done some analytics on that maybe two years ago, looking at our overall portfolio and what the impacts of climate change would be. Honestly, there wasn't one positive scenario that came out of that. It just didn't look-- based on a traditional portfolio construction anyway. There was nothing optimistic that you could see based on all of the pathways that seem that we're heading down. I think it's something we'll be grappling with sooner than later and it's something that's going to be more difficult to manage than I think people are actually expecting.

Johanna: I think the thing is people are also underestimating the people consequences of it. If we think about Europe, the immigration crisis we're likely to face as a result of climate change in Africa, for example. Again, we could talk hours on this, but the political environment is fractured in many different ways. Interestingly, climate change creates debates about what you should do about climate, but also has consequences for other political consequences like the consequence of mass immigration.

James: It's one of those interesting things where we do have to cooperate as a world. The countries have to cooperate. I don't know if we're seeing enough of that yet, but it's one of those things that goes against some of the things that we've been seeing more

recently geopolitically where we are trying to become more self-sustaining. We're onshoring now, We're trying everything we can to mitigate risks, but this is one of those risks where we're actually going to have to cooperate.

I did want to come back to technology because I had one other question for you. After the demise at FTX, and there was certainly a feeling that crypto was dead and that Bitcoin was going to go to zero and there was no future in the cryptocurrency or shall I better call it token space, I don't know if you invest in that space or not - I'd be curious to know if you do - but how are you thinking about crypto as an investment opportunity going forward?

Johanna: First of all, we look at the cryptocurrency, we didn't make allocations. The reason was because our reason for making allocations of something like crypto would be for diversification reasons. Quite frankly, we didn't have the statistics going back long enough to justify the inclusion of crypto. I think then it becomes a question of whether you want to trade it. We wouldn't say that that is our expertise. We have looked at managers who could do it for us if we wanted to extract the alpha from the crypto markets. Ultimately, again, we just had a lack of understanding of the potential correlations that meant that we didn't make the investment in crypto.

We are interested in the impact of tokenization on financial markets more generally so we are developing a thematic allocation that can help us take advantage of it in the X universe, at the most, very small x universe, but we do have our stock pickers focused on it as another of disruption. I think the final thing is we always know that these technologies are truly disruptive when they interact with other technologies. This is where my mind stopped to boggle because, to be honest, I can't quite think it through, but essentially the combination of AI and tokenization, and the ability that that could--

Particularly for investors or clients who do want to interact directly with financial assets in a different way, the digital native way. I don't know, I think that combination could be quite powerful. Because I think one of the challenges is that in terms of buying assets on blockchain, one of the challenges is engagements. You have people who are digitally native who are obsessed with it, but it doesn't really go beyond that because most of us are too busy doing other things.

If there was a way in which through artificial intelligence people could understand our preferences better and engage with us in a different way to then lead us to those kinds of investments, I think you could see a more widespread adoption. Often in finance, the lack of innovation or the reason why innovations take root is because the fundamental problem we have is that while you and I are fascinated by this, the average person on the street just isn't that interested in portfolios and their pension, and things like that.

James: I've been thinking about private markets these days. Again, we could spend hours on this. Maybe one bridge from our previous topic is you mentioned the tokenization and the impact it might have in the equity markets. I'm curious as to if you've given some thought to how it might impact private equity markets in particular. It's interesting because you linked it in with AI, which I think is quite forward thinking. One of the ways that private equity, for example, in my view, could get disrupted is that there is more tokenization of either bits and pieces of a private equity company, or potentially the whole company in and of itself. I'd be curious as to if you have any thoughts on that.

Johanna: That's exactly what I was thinking about when I was talking about marrying AI with tokenized investment. In some sense, it's increasing the ability, the range of asset classes that retail investors can get exposure to. It's basically the democratization of a whole range of asset classes that so far have been only within the reach of professional investors and asset owners like you. Yes, I think that is a huge potential disruption. Again, it blurs the lines between public and private, which comes back to point you made earlier about when you're thinking thematically, which I completely agree with, is we're seeing those lines getting blurred.

Increasingly our private equity experts are working with our public equity experts, because actually, once you start to increase the-- when you start thinking about the world thematically. One of the things we're looking at is the circular economy. Very hard to get access to that through public markets. That's where we're collaborating with our private equity experts to build the allocation to thematics. Because actually some of these disruptions require both sides. Equally, you don't want to be set into out of stuff when it IPOs. It might actually be worth hanging on to.

That blurring of lines, breaking down of those distinctions, I think, is part of that, and I think would partly be hastened by the democratization of private assets. I imagine a world which I'm sure you would think, because clearly I think you and I see eye to eye. I mentioned the other day, and someone looked at me like I was absolutely crazy, and I thought it was completely uncontroversial. A world where here at Schroders, we'll be managing all assets, public, private, all in one place, just organized really, by what is the problem you're trying to solve for the client? Is it generating income? Is it generating growth? Really, the detail of whether it's accessed by private or public becomes just a question of a technicality to some extent.

James: One of the questions my board asks me almost all the time is what keeps me awake at night? As we look forward to 2024 and beyond, what keeps Johanna Kyrklund awake at night?

Johanna: For me actually, it's the impact of AI on politics. I think we're already in a highly divisive political environment because the pie is not growing fast enough, which always increases political risk. Put climate change on top of that. We're talking about immigration, for example, as an issue. Ultimately, in some sense, the pie is shrinking and we're seeing more division, we're seeing more unstable situation. When we all studied history, we learned the power of propaganda. Back then it was a poster. Now, the fact that people who can't be bothered to read the full political spectrum can be basically fed news items that support their own beliefs, reinforce their beliefs through an algorithm.

I think that is something that worries me, because ultimately, as you said earlier, there's some major challenges here that require some clear thinking and basically getting more and more blinkered. That worries me. That's a kind of nebulous concept. When we first started talking about political division, people weren't thinking, really. People said, how is that going to affect markets?

Thinking about what might happen in the US this year with the election. That's probably the thing that I struggle with the most, because I can't think of how I hedge that. I live in a world of risk. Normally I can think of how I can protect the portfolios, be it through diversification, through having the right processes cope with mistakes. The problem with AI interacting with politics is it creates fragmentation. That is a difficult system to navigate.

James: Most divisive certainly in my lifetime, but probably going back many, many, many decades, that I've ever seen the world in, and certainly the US. It's so disturbing to see and hear some of the things that are happening in the US, whether it's alignments or polarization around geopolitical events like what's happening in Gaza, or just domestically. It's the domestic division that I find so disturbing. You talked about the world. The pie isn't growing at the same pace. You have another challenge too, which is governments don't have the fiscal capacity that they used to have, especially with higher levels of interest rates.

Do you think that's going to be more constraining from a policy perspective? I think where I'm going there is, at least for the past couple of decades, you can almost always count on monetary, and then more recently, fiscal policy coming to the aid of a weakening economy or financial market turmoil. Can we count on that going forward to the same extent as we've been able to in the last few decades?

Johanna: No. Basically, I think that we're in a world, we are in the midst of a regime shift; decarbonization, an aging demographic, peaking of the working age, population de-globalization. All of that leads to deterioration, inflation growth tradeoff, which makes things more challenging. Then the next phase, which I think everyone's been talking

about for the last few years, everyone accepts now, we're in a different regime now. Then the next question is with that, what does that do to-- basically, how do policymakers react to that set of cards?

What you're now seeing is that really from the '90s onwards, there was an economic orthodoxy, which of course was established also in Canada, when you guys got your fiscal deficit under control and flattened the yield curve in the '90s with Martin. Essentially this idea of fiscal rectitude and loose monetary policy, which is then what we impose on emerging market economies. During the Asian crises, we implemented again. Even after the financial crisis, we were tightening fiscally here in the UK. This idea of you keep your finances in order, then you can keep monetary policy as loose as you like.

All of that's been challenged. During the pandemic, we got used to a level of fiscal intervention that was unthinkable before. Once you get that genie out of the bottle, it's hard to put it back in. Ultimately, people didn't do well enough out of that system, which is why you've got the rise of more populist policies. Basically you see more fiscal spending, government debt now very high, and really you're going to see more divergence because not everybody's created equal. I mentioned right at the beginning of this call, the UK tried to do a little bit what the US did last year in terms of fiscal expansion.

UK can't get away with it because we're so reliant on the kindness of strangers and we don't have the benefit of being a reserve currency. We got slapped down. Rightly so. The US so far has gotten away with it. Depends, I think, what happens though with the election. I think if Trump is elected and he goes down the path of more fiscal profligacy, I think that's where investors might lose patience with the US.

I think this whole debate about what is your combination of fiscal policy and monetary policy, where we have such consensus for so long, is now we're seeing huge divergence. In the other corner, of course we have a number of emerging economies that never had the luxury of throwing out the war book, who've actually run very orthodox policies, are now looking pretty strong, which redefines where political risk lies between developed markets and emerging markets. This point you've made about fiscal policy, I think it's all about what is your willingness to use fiscal policy, and what is your ability to use fiscal policy, and that will drive the fortunes of markets around the world.

James: There are more strains on it too, right, because you have to spend militarily now?

Johanna: Yes.

James: So much more on defense spending, given what's going on around the world. Then there's the climate transition, which is going to put even more pressure on governments to-- [crosstalk]

Johanna: An aging demographic, of course. Hopefully AI can help us. If you see here in Europe, there's quite a lot of tension in number of countries like Sweden. What it comes down to is we've made promises with the welfare state, but are hard to keep with this level of aging and the complexity of the health demands that that creates.

James: Where is fair value as you see it now for 10-year US treasury yields? I'm just curious, given we were talking about fiscal, we were talking about inflation, do you think we're close to fair value now? If you were thinking over the next five years, what would you say?

Johanna: I think that we're going to be in a system of sort of lower highs on the yield as time goes on. Who knows what we get on a five-year view, but ultimately I think having had many years of yield just getting lower and lower every single time, I think it's going to be the opposite now. I think right now on a one-year view, I think we're close to fair value at these levels.

I wouldn't be surprised if the US 10-year ends up being at the same place by the end of this year through a combination of maybe the front-end rallying, but ultimately concerns about the long-term fiscal path of the US coming into force at the end of the year. Right now, tactically, I'd say we're at fair value on the US 10-year, around 4%. Crucially, it's not the fair value we were used to in the last decade. We're not going back to that world. The question is, where does it settle over the medium term? I think it could be higher.

James: You have, I'm sure, some views as to how the world will unfold and how financial markets will unfold over the next year or two. Do you have a model portfolio that you put together a shortage for, say, a typical pension plan? I'm sure for many of your clients, it's very customized, but when you think about it in a way that you would communicate to a broader pension investment community, how would your model portfolio change given what you've seen over the last year and what you expect to see over the next year or two?

Johanna: I think we need to get used to the fact that, we talked about commodities. They were a waste of time in the last decade. They're now a structural diversifier. Fixed income used to be a structural diversifier. It's not a structural diversifier anymore. What it is, a source of income at the right yield, which is helpful. Income as a payoff is attractive. I think that the key thing we need to think about is, again, we need to recalibrate the ranges within which we use fixed income. Right now, we just had a very strong rally, so we're backing off.

Also, if I saw a sell-off in bonds, we'd be buying them to get-- no, I think trading those ranges as fixed income is what I expect to do in the next year or two. Then actually, there's still a very important role for equities. It's interesting. I'm quite surprised by how, and maybe it's very [unintelligible 01:02:22] surprised by how much is being pressed into the US curve right now in terms of rate cuts. I think to some extent, it feels to me like the fed, maybe, its reaction function is becoming somewhat more stimulative now. For a given set of circumstances, inflation coming down, if I were them, but I of course live in a world where I don't worry about my future, if I were them--

I'll explain by that in a minute, but I feel like if the economy can take 4.5% cash rates, as long as we're at full employment, keep it there, even as inflation is falling. Don't take the risk of cutting too quickly. I think that they are quite politically motivated this year, because I think if Trump gets elected, there's questions over the independence of the Federal Reserve over the medium term. We're dealing with things that are unthinkable right now. I used to take central bank independence as an absolute given. On that perspective, ultimately, in a world where I think policy will be stimulative, I still think that equities could do quite well.

What I'd like to see is a broadening out so that we're not buying the same seven stocks for another year. I think there could be an opportunity there. These are my personal views. We're going into asset allocation meetings. The trading fixed income in a range, I think we're all agreed on. There's a huge debate right now about what we do with equity way over the next year. My tendency is to think that there's still opportunity in equities. Valuations are not stretched outside the super seven. Ultimately, I think that with 40 elections around the world this year, nobody's planning on tightening policy.

Caroline: Thanks so much, Johanna and James. What an insightful discussion. I think we've got some great points to get us started thinking about 2024. It's fantastic. That wraps this week's Monday Minute. Don't forget to send us your questions and we'll get right back to you with our speaker's response. We've got lots of exciting content and great interviews lined up for our future Monday Minutes that you won't want to miss. Be sure to go to our website, leadershipcongress.ca to sign up for our informative and timely CLC newsletter. Thank you all for joining us, and see you next time.

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FEATURED SPEAKERS

JOHANNA KYRKLUND
Group Chief Investment Officer | Schroders

Johanna Kyrklund is Co-Head of Investment & Group Chief Investment Officer at Schroders, she oversees investment performance, philosophy and process for all asset classes (excluding private assets). She is responsible for investments on behalf of Multi-Asset clients globally and is the lead portfolio manager of the Schroder Diversified Growth Strategy. She joined Schroders in 2007 and is based in London.

Johanna was Fund Manager at Insight Investment from 2005 to 2007, which involved managing an unconstrained global macro absolute return fund.

She was Head of Asset Allocation at Deutsche Asset Management from 1997 to 2005, which involved managing asset allocation in the UK and fund manager of the Deutsche tactical asset allocation fund.

Johanna is a member of the Schroders Group Management Committee which oversees the development and delivery of Schroders’ overall business strategy. Johanna chairs the Global Asset Allocation Committee and is a member of the Christ Church Investment Committee and Railpen Investment Board.

Qualifications: CFA Charterholder; BA in Philosophy, Politics & Economics from Oxford University.

JAMES DAVIS
Chief Investment Officer | OPTrust

James C. Davis is Chief Investment Officer of OPTrust, one of Canada’s largest pension funds with net assets of almost $25 billion and investment professionals in Toronto, London and Sydney.

James joined OPTrust in 2015. He leads the organization’s investment strategy and oversees its diversified portfolio spanning the globe with capital market, private equity, infrastructure, and real estate assets in North America, Europe, Developed Asia and emerging markets.

James has more than 30 years of strategic investment planning, risk management and leadership experience. Prior to joining OPTrust, he held the role of Vice President, Strategy & Asset Mix and Chief Economist at Ontario Teachers’ Pension Plan.

James’ is passionate about retirement income security and his areas of interest include investment strategy and portfolio design, global macro and systematic investing, private market value creation, liability-driven investing, responsible investing and investment team culture.

James has also served as the President of FuturesTrend Capital Corporation in Prince Edward Island and Vice President & Head, Global Fixed Income & Currencies at RBC Global Investment Management in Toronto. Before embarking on a career in investments, he worked as a Meteorologist with Environment Canada.

In addition to degrees in Mathematics and Meteorology, James holds an MBA in Finance from Dalhousie University and is a CFA charterholder.

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