Why the US avoided a recession in 2023 and a gameplan for investing in China

Schroders Group CIO shares her views on topics ranging from investing amid geopolitical turmoil to harnessing the power of AI.


Johanna Kyrklund, Schroders’ Co-Head of Investment and Group Chief Investment Officer, was recently featured on The Monday Minute, a series presented by the Canadian Leadership Congress, which sponsors events and research for leaders at Canada’s top pension funds. In a discussion moderated by James Davis, Chief Investment Officer of OPTrust, one of Canada’s largest pension funds, Johanna discussed the global economic outlook for 2024 and beyond.

Following are highlights from part one of the conversation, which covered topics ranging from China and India to the impact artificial intelligence (AI) could have on portfolio management.

James Davis: 2023 was a very unusual year. What were some of your key learnings?

Johanna Kyrklund: The first thing that surprised people was the fact that we didn't get a recession in the first half of 2023. We certainly were expecting a more significant slowdown in the United States, which we didn't get. Collectively, we underestimated the power and impact of the fiscal stimulus and how much it helped the average person. Generally, we've been positive on the US market for a long time because of its dominance in technology and many other factors. Over the last two years, US exceptionalism has taken on a new facet, which is its ability to stimulate beyond what other countries are allowed to do. The US has been able to spend to expand its economy, and I think it's benefited from its reserve currency status.

The other key surprise of last year was the dominance of the technology sector. I would have imagined that, in a world where rates were going to be a bit higher for longer, such long-duration stocks might have underperformed. Now, with hindsight, I can see that the tech companies are so cash generative they almost became quasi cash instruments with the added benefit of the huge growth associated with AI.

James: 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. What is Schroders’ view of China and emerging markets more broadly?

Johanna: I think the concerns about China were somewhat sparked by what happened with Russia, but China is fundamentally different from Russia. Over the past several decades, Russia has chosen a path of isolation and hasn’t been intertwined with global supply chains in the way that China is.

The big, looming question is what happens with Taiwan? China is generally interested in stability. We're not expecting an invasion of Taiwan in the near term, so we are not currently excluding China. They obviously want closer ties with Taiwan, but I think they're looking to achieve that through a softer means. The question is, can you set up a framework, if that day comes, that will enable you to extricate your investments easily.

It also may be worth considering China differently from EM [emerging markets] – ex China. I resist making allocation choices simply based on politics. While we aim to manage political risks, we strive to have investment reasons primarily guide our decisions. Looking at China and EM ex China also make sense because the drivers of investment are so different.

China has huge exposure to technology and is the only market, apart from the US, that provides that level of exposure. China is also dominating electric vehicles now. So, the nature of its market, and the sector-level exposures it provides, make China very different from the rest of emerging markets.

James: Do you think you could get sufficient exposure to China indirectly, through developed market equities, for example?

Johanna: In a time when investing in China was all about the Chinese consumer, which was probably true in the mid-2000s, you could gain the exposure to Chinese buyers by investing in companies like the European luxury brands. But today there are exposures you can get only in China. They’re making different technological choices, for example. From an investment standpoint, I think there is some benefit to being exposed to their technology as well, and not just to the technology of the West.

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

Johanna: We're seeing interest in that in North America. It is not a trend we see in Europe or in Asia. Asia, obviously, sees things completely differently.

James: I like the idea of having a China portfolio and a separate EM ex China portfolio. To your point, that also provides an exit strategy from China, if geopolitical events eventually require that.

Johanna: Yes, that is one benefit of having separate China and EM ex China strategies. Over the course of my career, I have spent a lot of time in China. I recently went there in December [2023]. It was my first time there in several years because of the pandemic. I think the relative isolation of China in recent years hasn’t helped. But my trip reinforced that China is interested in economic integration, not isolation. There is also considerable innovation going on there that I think, as an investor, you want to be a part of.

James: How are you thinking about India?

Johanna: We have been talking about deglobalization because the pandemic exposed the vulnerability of global supply chains. There are regions that are benefiting from this. India is one, Mexico is another, and, so too, is the Middle East, given all these regions’ ability to straddle both sides [the East and West and developing and emerging markets]. China is already concerned about the inroads India is making. India wants to be doing well economically, and that is quite a stabilizing force over the medium term.

James: Are you worried that what is happening in the Middle East might develop into a broader-scale conflict?

Johanna: Across the globe, collectively, we are in an unstable system, and many countries are spending more on defense. Apart from recognizing the humanitarian considerations, as investors it’s our job to assess the impact any conflict will have on global GDP [gross domestic product]. We have to determine when there is a triggering mechanism that will lead any localized conflict to have a disproportionate impact globally on GDP and interest rates. Clearly, the conflict in Ukraine was an example of when there was a triggering mechanism – commodity prices – that led to stagflationary outcomes around the world.

From an investment standpoint, people often ask me, what do you do in this environment? As I said earlier, you can't do things for just political reasons, and ultimately, we need to take risks to generate return. But I think if you're expecting heightened geopolitical tensions, the obvious thing to own is more commodity-related investments. In the past decade, commodities were a total waste of time from an investment standpoint. They were correlated with growth and didn't provide any diversification. In contrast to that, for the past two or three years, we’ve seen commodities and commodities-related risk as a significant structural diversifier. There are a number of reasons for that, including, oddly enough, decarbonization. So again, we are not owning commodities simply because of the heightened geopolitical tension. They do provide a hedge against those scenarios, but they are also benefitting from other trends we're seeing, like decarbonization.

James: What do you think is the best way for an investor to own commodities? Should they own commodity futures or own the equities that are extracting the commodities?

Johanna: When you look at the long-term risk premium from commodities, at best you get the roll yield over the long term. When deciding on asset class allocations, it's hard to allocate to commodities strategically because of that long-term return challenge. One might allocate to cash as the strategic allocation, which then gives you the room to move into commodities when you think the time is appropriate. So, you’d have to manage the exposure and take account of the roll yield. If the roll yield is not there, then maybe you shouldn't be allocated. But that's one of the ways we have thought about the strategic challenges, which is to not try to include commodities from a strategic asset allocation perspective. Instead, make the allocation to cash, which again has other benefits, and then you can go in and out. In terms of generating returns from the commodity exposure, I think there are a number of ways we can think about it. Commodity futures are helpful, particularly if the curves are inverted, and that is a very pure exposure that can be quite helpful.

When we look at commodity stocks, we also focus on not owning stranded assets. So, we are engaging very significantly with the companies to make sure they're also managing their transition. It’s important to think about this from a long-term perspective. There is money to be made there still, and there are also ways to make money out of the new sources of energy, the renewables and also the infrastructure required for electric vehicles, as examples.

So, we're thinking about commodities with a fairly broad perspective, including direct exposure and owning traditional commodity stocks, but with the engagement that goes with it to ensure they don't end up as stranded assets. Ultimately, you’re asking if companies are taking a forward-looking approach and trying to make money out of the decarbonization trend. What’s happening now is hugely disruptive, and out of disruption always comes opportunity.

James: What are your thoughts on the evolution of AI? Are you using it for help with investment decision-making and how are you investing in it?

Johanna: From an investment-process perspective, we are quite medium-term investors. So, AI as an information-processing advantage is less useful to us in that sense. But we are using AI from a productivity-enhancement perspective. We have our own version of AI here at Schroders that we all use extensively.

When you look at any kind of investment process, you're looking to see whether you can get an informational advantage, an analytical advantage, or a behavioral advantage. For me, the really interesting thing would be the behavioral because where you really get an advantage from AI is when 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. So, we're not getting much of an information advantage, although there is maybe a bit of an analytical advantage. But I think we could train those AI tools on our own behavior.

If you think about what we do all day as managers of investment teams, we watch our staff on the investment desks. 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 we have sort of an artisanal approach of understanding the investor. That is something that could be disrupted by AI. Approaches like this exist already, but they're quite clunky compared to what could be done if we're able to train the art of it. I imagine a world where essentially we'd have two to four managers plus an AI entity managing a portfolio. The AI would provide the nudges, essentially being like that person at the desk now who will say, “Hey, we don't size the trades appropriately. We should go in big at the beginning and then scale back.” All these decisions about sizing and how you trade the position can create alpha, and that process could be enhanced through the use of AI.

James: When you look at it this way, that AI could be like the additional trader sitting at your desk, what kind of data would that AI trader be analyzing?

Johanna: Basically analyzing all of our own trading behavior. If you look at the alpha signals we generate, if you're doing a good job you have a hit rate of say 60%. That's important, but the sizing of the positions and how you trade them is just as important. We already know that and 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. So, you could do it simply through stop losses. But there's more that could be done in the sizing of the position, with the help of AI tools.

Read part two of this discussion to hear Johanna Kyrklund’s views on the benefits of thematic allocations and the impact of higher interest rates.

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

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