FORESIGHTLong read

Examining the benefits of thematic allocations and the impact of higher rates

Schroders Group's CIO shares her views on topics ranging from how tokenization could help democratize private assets to whether the 10-year Treasury yield is at fair value.

22/03/2024

Part two of “The Monday Minute” hosted by the Canadian Leadership Congress continues the conversation, moderated by James Davis, Chief Investment Officer for OPTrust, with Johanna Kyrklund, Co-Head of Investment and Group CIO, as she shares her outlook for 2024 and beyond.

James Davis: How are you thinking about AI and how it may impact healthcare, medicine, biotechnology and longevity?

Johanna Kyrklund: I tend to be an optimist. In terms of understanding the big picture with AI, if we look at all the sort of disruptions we've seen through time, going back even to the agricultural revolution, people didn't become redundant. It's just that we emphasized other roles once we got beyond just trying to grow a crop, which, with only basic tools, is pretty much what you had to do all day. I think we have a habit of finding stuff to do with the time that gets freed up.

Healthcare is one area that will be significantly impacted by AI. I think that could have a huge impact on the emerging world. In the developed world, we're used to having huge resources at our fingertips, but I think AI could be game changing for emerging economies in terms of the access to healthcare it could provide for them.

James: While I’m not an expert on these issues, I understand that the way AI is able to process life sciences data is allowing the evolution of genetically based treatments to move much more rapidly. That is probably the future of medicine. That technology is going to be really forceful in making advancements.

Johanna: Yes, technology is still central to everything. The technological disruption we're seeing is unrelenting. It will continue, and ultimately it is a force for good. This was already a trend, but it got accelerated by the pandemic. The health challenge of finding vaccines quickly showed us what we were capable of. To get back to a point I made earlier [in part one], China is a place where there is a lot of technological innovation. I think that for investors to cut themselves off from a major part of the world economy where that innovation is happening is probably not a good idea in this environment.

James: In the traditional world of strategic asset allocation, we’ve always thought of allocations to the major asset classes, stock and bonds. But now I’ve been thinking about allocations more in terms of themes, like technology and energy.

Johanna: Ten 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, and then we have energy transition, sustainable food and water, and digital infrastructure as themes. Those two allocations – technology and energy – are diversifying. Historically, when you’ve applied thematic approaches, they often were very growth oriented. But technology and energy can act as counterweights to each other.

In Europe, with the focus on sustainability, a number of asset owners went down an exclusionary path on energy, which undermined their ability to cope with the current environment. It’s an example of how good arguments can sometimes get taken too far. We also heard objections in Europe about not excluding traditional energy companies from our portfolios. Recent challenges have shown, especially in Europe with the Ukrainian conflict on our doorstep, that things are never linear. There are always cycles and ultimately you have to maintain enough flexibility in your portfolios to deal with them.

James: It's amazing how many different bits and pieces are interconnected, and it's important to understand those connections.

Johanna: We talked [in part one] about commodities, like oil. We’re seeing very little flow into our commodities strategies from European clients, and I think it’s because many clients are excluded from owning them.

James: As you said, the pendulum sometimes can swing too far one way or the other. Still, we know that there is an energy transition that is going to have to take place. Do you find that, for US clients, the pressure being put on them politically is causing them to rethink how they've been approaching climate change and ESG?

Johanna: I think the political pressure in the US is more on the China front. Still, in the US, there’s always been a focus on the prudent man principle, and then it just comes down to whether you think climate change is happening or not. For those who agree it is, there’s a risk you need to take into account.

James: It's interesting because the whole thing gets muddled up with what is fiduciary duty. There are parts of the world that are more progressive in how they think about fiduciary duty. I've always thought that 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. So, there is that systems thinking we need to apply as we are thinking forward in terms of our overall portfolio decisions.

Johanna: We actually embedded climate risk into everything we did across every single investment desk. Our deadline for this was end of 2019, which we hit. As part of that effort, we also embedded the impact of climate change in our long-term return assumptions. Certainly, if you're doing 30-year return forecasts, you need to take into account climate change. Some of the work that we did on the 30-year return assumptions is now affecting our 10-year return assumptions, as well. Based on our modeling, climate does have real impacts on GDP.

James: We've done some analytics on our overall portfolio, looking at what the impacts of climate change would be. Honestly, there wasn't one positive scenario that came out of that. So, I think it's something we're going to be grappling with sooner rather than later, and it's something that's going to be more difficult to manage than I think people are expecting.

Johanna: People are also underestimating the people consequences of it, such as the immigration crisis Europe is likely to face as a result of climate change in Africa.

James: It’s one of those interesting issues where we do have to cooperate as a world. That means countries will have to cooperate with each other. I don't know if we're seeing enough of that yet, the need to cooperate goes against some of the things that we've been seeing more recently geopolitically, as countries are trying to become more self-sustaining and onshoring supply chains. Coming back to technology, I wanted to ask, after the demise of FTX, there was a feeling that crypto was dead and that Bitcoin would go to zero and that there was no future in the token space. Do you invest in cryptocurrency and how are you thinking about crypto as an investment opportunity?

Kyklund: We have looked at cryptocurrency, but we didn't make allocations. Our primary reason for making allocations in something like crypto would be for diversification purposes. Quite frankly, we don’t have the statistics going back long enough to justify the inclusion of crypto. There is also the question of whether you want to trade it, and we wouldn’t say that is our expertise. We have looked at managers who could trade it for us, if we wanted to extract the alpha from the crypto markets, but, ultimately, again, we didn’t have an understanding of the potential correlations, and that meant that we didn't make the investment in crypto.

We are interested in the impact of tokenization on financial markets more generally. Technologies are truly disruptive when they interact with other technologies. Essentially the combination of AI and tokenization and the ability that could create, particularly for investors who want to interact directly with financial assets in a digitally native way, could be quite powerful. One of the challenges in terms of buying assets on a blockchain is engagement. So, you have people who are digitally native who are obsessed with it, but it doesn't really go beyond that. If there was a way, through artificial intelligence, to understand our preferences better and engage with us in a different way, and then lead us to those kinds of investments, I think you could see a more widespread adoption. Often a reason why a particular innovation doesn't take root is that you have a small subset who are fascinated by it, but the average person on the street just isn't that interested.

James: Have you given some thought to how tokenization might impact private equity markets? For example, private equity could get disrupted if there is tokenization of either bits and pieces of a private equity company or potentially the whole company.

Johanna: Yes, that’s exactly what I was thinking about when I was talking about marrying AI with tokenized investment. In some sense, it will help increase 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. That is a huge potential disruption.

That would also blur the line between public and private, and it comes back to the point you were making earlier about thematic allocations. Increasingly, our private equity experts are working with our public equity experts. When you start thinking about the world thematically, like making investments in the circular economy, it’s very hard to get access to these themes through public markets only. So, our public equity teams are collaborating with our private equity experts to build some of our allocation themes. Some of the disruptive innovations lead to investments on both sides because you might not want to sell out of a disruptor on the private equity side after its initial public offering. The investment in that company might be worth hanging on to.

The line of those distinctions is breaking down, and it’s being hastened partly by the democratization of private assets. I imagine a day when, here at Schroders, we will be managing all assets, public and private, in one place, just organized by what is the problem you're trying to solve for the client. Is it generating income? Is it generating growth? The details of whether those opportunities are accessed by private or public markets will become just a technicality.

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

Johanna: It's the impact of AI on politics. So, I think we're already in a highly divisive political environment because the economic pie is not growing fast enough, which always increases political risk. Plus, you have climate change on top of that. Immigration, as we talked about, is another issue. The pie is shrinking, and we're seeing more division between people, and we're seeing more unstable situations.

When we all studied history, we learned the power of propaganda. But in the past, that was often just a poster. Now, people often don’t read news across the full political spectrum, and they can be basically fed, through an algorithm, news items that support and reinforce their own beliefs. That is something that worries me, because ultimately, as you said earlier, there are some major challenges that require some clear thinking. That’s a nebulous concept, and when people first starting talking about political division, they weren't thinking about how that would affect markets. But consider how markets in the US might be affected this year by the election.

That’s the thing that I perhaps struggle with the most because I can't think of how to hedge it. I live in the world of risk management normally. I can think about how to protect portfolios, be it through diversification or having the right investment processes in place to address mistakes. The problem with AI interacting with politics is that it creates fragmentation, and that is a difficult system to navigate.

James: Another challenge is that countries 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? At least for the past couple of decades, you could 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?

Johanna: No. We are in the midst of a regime shift with decarbonization, deglobalization, and an aging demographic and peaking of the working age population. All of that leads to deterioration of the inflation/growth tradeoff. Everyone accepts that we're in a different regime now. The next question is how do policymakers react to this set of cards? From the 1990s onwards, there was an economic orthodoxy. We saw it applied in countries like China, and Canada in the 1990s when [then Minister of Finance and later Canada’s Prime Minister Paul] Martin led efforts that got Canada’s fiscal deficit under control and flattened its yield curve. Essentially, this idea of fiscal rectitude and loose monetary policy, which we then imposed on emerging market economies during the Asian financial crises. The idea was that if you keep your finances in order, then you can keep monetary policy as loose as you like.

Now all that’s been challenged. During the pandemic, we got used to a level of fiscal intervention that was unthinkable before. Once you let 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, and that why there was the rise of more populist policies. So, basically, you're seeing more fiscal spending. Government debt now is very high.

The UK tried to do a bit of what the US did last year in terms of fiscal expansion, but the UK can't get away with it because we're so reliant on the kindness of strangers [foreign investors to drive the demand for UK government debt], and we don't have the benefit of being a reserve currency. The US has gotten away with it so far, but it will ultimately depend on what happens with the election. If Trump is elected and he goes down the path of more fiscal profligacy, that’s when foreign investors might lose patience with the US. But I think this whole debate about what is your ideal combination of fiscal and monetary policy, an issue where there had been consensus for so long, now has huge divergence

Of course, we have a number of emerging economies that never had the luxury of throwing out the rulebook, who actually ran very orthodox policies and now are looking pretty strong, and that is redefining where political risk lies relative to developed and emerging markets. For each country, it’s all about what is your willingness and ability to use fiscal policy to stimulate your economy, and that will drive the fortunes of markets around the world.

James: And there are more strains on it because countries have to spend 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

Johanna: Plus, the aging demographic. Hopefully, AI can help us. In Europe now, there's quite a lot of tension in a number of countries over the issues the aging population creates. What it comes down to is we've made promises with the welfare state that are hard to keep with this level of aging and the complexity of the health demands that creates.

James: Given what we’ve been talking with fiscal policy and inflation, do you think we're close to fair value now for 10-year Treasury yields? 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 lower highs on the yield as time goes on. Who knows where we get to on a five-year view. Ultimately, I think after having had many years of yield getting lower and lower every single time, I think it's going to be the opposite now.

Right now, on a one-year view, I think we're close to fair value. I wouldn't be surprised if the US 10-year ends up being at the same place by the end of 2024, maybe through a combination of the front end of the yield curve rallying and concerns about the long-term fiscal path of the US coming into force at the end of the year. Right now [in early February], I say we're at fair value on the US 10-year, with the yield around 4%. It’s not the fair value we were used to in the last decade, but we're not going back to that world. The question is, when does it settle over the medium term, and I think it could be higher.

James: I'm sure you have a view on how the world and financial markets will unfold over the next year or two. Do you have a model portfolio for 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 facts that we talked about regarding commodities [in part one]. They were a waste of time for diversification in the last decade. They're now a structural diversifier. Fixed income used to be the structural diversifier. It's not a structural diversifier anymore, but it is a source of income at the right yield, which is helpful. Income as a payoff is attractive. We need to recalibrate the ranges within which we use fixed income. So right now, we've just had a very strong rally, so we're backing off. But ultimately, if I saw a selloff in bonds, we'd be buying them again. I think trading those ranges is what I expect to do in the next year or two with fixed income.

There is still a very important role for equities. I'm surprised by how much rate cuts is being priced into the US curve right now. Maybe the Fed’s reaction function is becoming somewhat more stimulative now. I feel that if the economy can take 4.5% cash rates, as long as we're at full employment, then keep it there, even as inflation is falling, and don't take the risk of cutting too quickly. But I think that the Fed governors are quite politically motivated this year because , if Trump gets elected, there will be questions about the independence of the Federal Reserve over the medium term.

So, we're dealing with things that are sort of unthinkable right now. I used to take central bank independence as an absolute given. On that perspective, 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 of the markets and investors not buying the same seven stocks for another year. I think there could be an opportunity there.

There's a huge debate right now about what we do with the equity weighting over the next year, but my tendency is to think that there are still opportunities in equities. Valuations are not stretched outside the super seven stocks. With 40 elections around the world this year, nobody's planning on tightening policies.

Read part one of this discussion to learn Johanna Kyrklund’s views on how the United States avoided a recession in 2023 and what gameplan institutions might use for investing in China.

(This article is an abridged and edited transcript of the full interview.)

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