A Look at Factors Driving the Markets: Mid-year Check-in

A Look at Factors Driving the Markets: Mid-year Check-in

Tony Roth, Chief Investment Officer

Johanna Kyrklund, Group Chief Investment Officer, Schroders

Tony Roth: This is Tony Roth, chief investment officer of Wilmington Trust, and you're listening to Capital Considerations. Welcome. It is the end of the first half of the year, and it's time to take stock of what is happening in the economy in the United States, around the world, and how economic events are impacting markets.

I am very excited today that we have a wonderful guest to help us in this endeavor, who is also a chief investment officer. Please welcome Joanna Kyrklund, who is the group chief investment officer of Schroders Investment Management.

She's based in London and she's responsible for investments on behalf of multi-asset-class clients globally, and is the lead portfolio manager of their diversified growth strategy. Prior to joining Schroders in 2007, Johanna specialized in tactical asset allocation strategies at both Insight Investment and Deutsche Asset Management.

Johanna has a deep educational background in economics and politics. So, Johanna, thank you so much for being here today and helping us sort through the world.

Johanna Kyrklund: Thank you. I'm delighted to be here.

Tony Roth: There’s so much happening in the markets that has surprised this year, whether it be the overall pace of growth where the level of the S&P as a whole or specifically those big growth tech names particularly in the American markets that continue to drive returns for investors.

I think none of which was really anticipated nearly to the degree that we're having it. But I think the place to start, perhaps, is to take a step back and to recognize that we are in a world which has not mean-reverted in so many ways to what we had experienced for so long prior to this big pandemic event.

The world does feel different. At least here in the U.S. whether it's different lifestyles, different approaches to work, this onset of inflation, which I know you're experiencing as well in the UK, that we're working through, et cetera. Where is the world in a post-pandemic stage?

What are some of the hallmarks that you see as having come from the pandemic that have changed our world and which ones are going to be the ones that are going to continue to sort of define the environment moving forward?

Johanna Kyrklund: Well, I think when you look at history, typically what happens is there's some sort of long-term trends that are shifting and then you get catalysts that accelerate that change.

And I think that framework is useful for thinking about the current environment as well because even before the pandemic, there was some key trends that were very much in place. I think the first thing was that after years of quantitative easing and globalization, the average person wasn't doing well enough out of the system.

This was true in the US it was true in Europe, it was true around the world. What we were experiencing was a rise in inequality. At the same time we were seeing the geopolitical environment deteriorating a bit, partly because as people feel under pressure, politicians feel under pressure domestically, often they end up then playing a bit tougher on the global stage.

And then generally when the economic pie is not growing fast enough, which was the case in the last decade, questions over how it gets divided get much more fractious, both at domestic level and at global level.

Tony Roth: The wealth inequality that we've had, has been one of the reasons that we've sort of seen this almost tribal nationalism in so many parts of the world, that has looked autocratic in certain ways.

I don't know that I've ever really connected it to quantitative easing per se. But I guess that linear logic would make sense because it is in fact the quantitative easing to a large degree that has allowed those that have capital and asset appreciation. Right? Do so well.

Johanna Kyrklund: Do very well.

Globalization of course helped capital over labor as well, so that was already a preexisting trend exacerbated by the quantitative easing. So you have this increasing in income inequality, and that's why we ended up with Brexit in the UK.

We also had an aging demographic, but basically the pandemic then accelerated these trends. What it exposed was the vulnerability of global supply chains, which again leads to a deglobalization trend.

It was an unprecedented shock to the labor market. I mean, you mentioned the change in lifestyles and obviously I didn't live through the first World War, but I imagine that it must have felt the same. The first World War changed the way people work. People went away to war, came back and to some extent went back to the way they used to live.

But in many cases women had worked for the first time. People didn't want to go and work in service anymore. I don’t know if you watched Downton Abbey. Here in the UK, obviously we watched it.

Tony Roth: Right.

Johanna Kyrklund: But the point is that people get used to different way of existing and that's what happened with the pandemic.

Before this episode, people used to say, well, we're never going to get the kind of inflation we saw in the seventies, because back then you had organized labor. But I would argue that the whole labor market all over the world is exposed to the same shock at the same time. It has the same effect as if it'd been organized.

In terms of their demand shift. So that's why we're seeing a struggle with labor supply particularly in the service sector. And then the other key thing about the pandemic was it gave us backdrop of inequality. We were ready for new economic orthodoxy anyway because the system wasn't working and we saw a rise in populist policy, but then the pandemic allowed governments to really cross Rubicon in terms of fiscal policy and fiscal intervention. I know we all had different rules in every country. Here in the UK, we got down to the level of being told how many people could come around for dinner in our house.

Tony Roth: Right.

Johanna Kyrklund: That would've been un unthinkable, that level of government intervention in our lives before the pandemic.

Tony Roth: Right, right, right.

Johanna Kyrklund: And once you get used to it, then, you know, suddenly every time there's a problem. We've had an energy crisis in crisis in Europe, for example, since, the Ukraine War. Then the view is, well, the government sort that out now. We're now used to level of fiscal activism that hadn't happened before.

So the seeds were sown before the pandemic, but the pandemic then accelerated these trends.

Tony Roth: Where has this left us then, and what do we see going forward? And one of the trends that you have talked about is, maybe it's an anti-trend in a sense. I think in the U.S. it's a trend, which is to say that participation in the labor force has really shrunk.

With the baby boomer generation and early retirees in the U.S. and that's been one of the key reasons that we haven't had as much labor supply. And that was a trend that existed prior to the pandemic, but the pandemic accelerated that trend. So to what degree do you think that that is both in Europe and in the U.S. potentially an ongoing trend where participation will not mean-revert and we will have continuing labor shortages that will make the inflation that we're experiencing more of a structural phenomenon? Or is that not how you see it?

Johanna Kyrklund: We are in a more inflationary environment compared to the last decade, and the labor supply is really one of the key aspects to that. Part of it is just that everyone just got that bit older, right?

So you can linger in the workforce. Here in the UK we have seen a significant rise in the long-term sick, which I think is just people kind of opting out of the labor force because they've just got to certain age and again, accelerated by the pandemic. So I think there is a labor supply problem, which I think is fairly structural as populations age.

And COVID kind of accelerated that a little bit. There are other things that also deteriorated the trade-off between growth and inflation, aside from the participation rate. And by the way, also people demanding different conditions for working. That has changed.

Tony Roth: People want to be able to work from a mountaintop or the seaside and that has a big impact on productivity because while employees always think that they're maximally productive, we've been at this long enough now that the employers have recognized that while you may be able to turn out as many widgets, in some cases from afar, you can't actually move the enterprise forward with the same level of collaborative creativity and change, and continue to grow and adapt when you don't have people working together face-to-face.

Johanna Kyrklund: Yes. And then I think there's a couple other things that deteriorated that trade off between growth and inflation. One is deglobalization, which is at the margin of course. In economics what happens at the margin is everything. And in the markets even more so, right? Already, things we're sort of cooling a bit geopolitically, but then also what COVID exposed was the vulnerability of global supply chain.

So you're seeing a trend towards nearshoring or reshoring. And a recognition that, endlessly trying to get the cheapest production can sometimes be counterproductive if you then undermine the resilience of your system. So that at the margin is somewhat inflationary. And then we have decarbonization which again, when you're trying to shift your energy source, I mean there really is nothing more fundamental to the global economy than that.

What that means is it's going to result in a bit of a misallocation of capital because, due to a range of pressure's going to be underinvestment in traditional fossil fuels and people trying to develop renewables as fast as possible.

But if you were looking for the most efficient energy source right now, it would be fossil fuels So at the margin again, that deteriorates the trade-off between growth and inflation. So, I think we're in a more inflationary environment.

Tony Roth:  It's so interesting because we wrote our forecast for 2023, which is a structural, economic, thematically based forecast, and we identified three trends that would support inflation moving forward, notwithstanding all the efforts of the Fed. Not to say that we're not going to—

Johanna Kyrklund: Still get cycles.

Tony Roth: Yeah, it'll be cycles. But we identified the inflection in the labor market. We identified the change relationship with China and the change relationship within China. China’s efforts to modernize its economy to become much less of a manufacturing and much more of a service-based economy and much more predicated on domestic consumption.

And then thirdly, the tenuous transition, as we called it, from hydrocarbons to green energy. And so, we look at the environment today and what we see is a China that's coming out of recession much more slowly and with a weaker renminbi, stronger dollar, somewhat disinflationary into the U.S. at least.

We also see energy prices much lower than we might have expected. Probably the one area that we're not seeing the abatement, if you will, as quickly is the wage pressures here in the U.S. What do you think the near-term outlook is going to be in the U.S. from an inflationary standpoint?

I know I have a U.S. bias, and I do want to get to Europe later in the conversation, but if you focus on the U.S., it seems like the CPI/PCE metrics are coming down pretty considerably, but we have that core stickiness in wage inflation, particularly in services. How do you think it'll play out?

Johanna Kyrklund: What's happening in the U.S. is happening in all the major economies. So if you just look at the last month, all the major central banks have sounded more hawkish than investors were expecting, be it Australia, the RBA, Canada, the Bank of England, the E C B, they’re all facing the same problem as the states. Generally, the inflation's coming down, the sickness is in the wage side of things, and it is very much associated with the service sector. Now we are seeing signs that those wage pressure is cresting a little bit.

I think that it will be sort of alleviated in the next few months, but ultimately, whether we're able to get inflation down to target, I doubt. I think we're going to end up with higher inflation than what the target will be telling us to. And I think that central banks will have to find a way of communicating why they think that's okay.

Tony Roth: And so why haven't the markets received the memo? We started the conversation with your really fascinating, I think, observation on the connection between the monetary easing that we've had for so long up until recently and inequality, the transmission mechanism being asset inflation in financial markets. Yet even though we have higher inflation, we’re still seeing that asset inflation, particularly in the U.S. equity market.

And that's been surprising to many of us. It's been surprising to me. We've been underweight risk here at Wilmington Trust this year. Not a lot underweight but we've had a minor underweight to risk, which is really significant for us because our mutual point is to be overweight risk. This is the only time we've been underweight risk in nine years because we did feel that the markets would receive the memo, if you will, on the structural inflation. They haven’t. So what's your take on that?

Johanna Kyrklund: So by the way, we've been in the same position as you. We all underestimated the resilience of the U.S. economy this year. So I don’t know about you, but the reason why we turn a bit more cautious is because we expected things to slow down quite markedly for rates to bite.

As we move into this new regime, the sort of maps that we were using in the last decade just aren't working as well. And a lot of the maps that we were using were focused very much on the good side of the economy and probably not enough on the service side.

We've underestimated the fact that this sort of post-pandemic recovery continues. I started traveling the second I could. But many people waited and are only starting to travel now. So that sort of pent-up demand still exists.

That's been one of the challenges is that we've been using models that, as I said, are very much based on the last 10, 20 years and this has been a much more service sector-dominated environment. So underestimated the resilience of the U.S. economy. That's been the mistake we made.

Now, the thing that puzzles me a little bit though is that I would've thought if someone told me at the beginning of the year, you know, what's going to happen is the economy's going to be more resilient than expected, and actually the Fed is going to end up having to hike rates by a bit more than people are expecting.

And if you remember earlier this year, there was this pivot priced for the Fed. This idea there'd be cutting rates in the summer. Now we never agreed with that. We always thought that was too optimistic, but we weren't necessarily expecting them to have to keep tightening as it now looks likely over the summer.

Tony Roth: They’ve come out now and they said that they're going to hold rates for two years at this higher level, which seems crazy.

Johanna Kyrklund:  Yes. Against that backdrop, I'm surprised that there isn't more valuation pressure with the rise in real yields we've seen on the

Tony Roth: That's right.

Johanna Kyrklund: On the U.S. market. So that's the bit that's puzzling me. Now, obviously when you look at the performance of the U.S. market under the surface, of course small caps have lagged consistent with this idea that we're getting a more difficult environment. And what's dragged the market up is the big tech names and AI. That doesn't feel to me like a new bull market.

It's like good news on the economy is good for the market, slightly less good news on the economy is good it seems no matter what happens, the market goes up and, and that I find, I think we're underestimating the valuation consequences of high real yields.

Tony Roth: We have a new hypothesis that has not led us to change our positioning yet. But our latest thinking around the economy, again here in the U.S., is that perhaps while companies are still hiring, the labor markets strong, and we're seeing this wage growth, when we actually adjust for things like overtime, which has been significantly cut back, et cetera, what we're seeing is that the total wages paid in the U.S. are starting to actually level off. Of course, GDP continues to grow. We're significantly higher here in the U.S. than the pre-COVID high. And so maybe productivity is actually stronger than we realize. You're looking at productivity as a quotient, if you will, where you put on the top, the total is paid and you put on the bottom of that fraction the GDP and maybe that will provide the ability for companies to keep their margins higher than we realize and put less pressure on valuations.

And maybe that's what's going on in the markets since markets always know best, right?

Johanna Kyrklund: Yes, they do. We have brought back a bit of exposure for two reasons. One is generally, certainly over the last 26 years, I've learned that it's usually better to sort of cut my positions if they're not working.

I think that we have a failure budget. You know the number of times you can get it wrong—

Tony Roth: Right.

Johanna Kyrklund: and still come in and take risk. And you need to use it wisely. And have it over your whole career.

Tony Roth: Mm-hmm.

Johanna Kyrklund: And the way I'm trying to slow my burn rate through that failure budget is by cutting my losses once in a while.

So partly it's just the discipline we have in our process, but also because if I'm honest, again, I was having this discussion with my team the other day. They go, you know, there's all these technical factors and liquidity. I'm like, look, we just got the call on the economy wrong. We thought we would be hitting recession by the summer and that’s not happening.

And just to your point, the consumer's proving to be more resilient. And right now there's no evidence. We're just not used to seeing wages holding up. In the last decade, people were on zero contract, zero hours. I just think we're in an environment where consumers doing a bit better.

So given that we're not expecting a recession now until early 2024. And, of course now we're going into the electoral cycle in the United States. We can wait and wait and wait for a recession to come. But the point is if it's at least six months out, you're wrong. So we're having to reduce the extent of our underweight position in equities.

And I think the other thing that we need to be alert to is that in the rest of the world, particularly in develop markets. An environment of higher rates is quite helpful, for example, to Europe. The banks that have really struggled with the negative yield environment we were in, that wasn't healthy for them, and people still cautioning onto the consequences of positive yields for the European banking system, for example. Europe has been a chronic underperformer, if you think about, it over the last decade, and is perking up this year. Japan is another one. again, the banks potentially do well there. We have reduced the extent of our caution, partly recognizing that we were wrong on the economy and as I said things outside the U.S. are looking interesting as well.

Tony Roth: On a relative basis are you looking forward more optimistic on Europe than the U.S.? Because right now we maintain our underweight on Europe relative to U.S., partly because of the proximity of the war, partly because Europe seems to be further behind in the economic cycle than the U.S. on the inflation fighting front.

So we haven't made that pivot yet. Interestingly, we came into the year with that position. We felt badly about it a couple months ago because Europe had performed better. But now with the, with this massive rally in the tech stocks, led partly by Nvidia and AI. Now the U.S. is outperforming Europe year to date.

Johanna Kyrklund: In the UK we have a game called date, marry, and avoid. The way I think about it is, the U.S. is a market, you marry because ultimately, the pace of innovation and the dynamism of your economy is to some extent unmatched everywhere else in the world.

And we're seeing this again. We haven't talked about this today, but we’re also in a highly disrupted environment. One answer to the lack of labor supply is greater use of technology to replace labor. There's all kinds of disruption going on. Generally, I'd marry the U.S., I'd say I’d date Europe and Japan, they're markets that you buy when you've got a bit of a sort of strong economy, so more tactical. And right now I think there's tactical opportunity in Europe. I don't like betting against the states long term.

Tony Roth: Thank you for that.

I'd be really fascinated to spend a moment on the conversation of technology, AI specifically, on this inflation issue. We see so much talk about it from the tech sector. So much so that I even think that they, maybe they're over their skis and they talk about displacing 30% of the workforce.

I don't think AI is going to take my job over anytime soon because I think that there's so many multifaceted inputs to what we do, you and I Joanna as investors, that the artfulness of it is critical.

Computers have been doing this for hedge funds for years. That progression will continue. I see certain applications, diagnostics in health care, but, 30% of the labor force, boy, that seems like a big number and it'll take decades to happen. How impactful do you think really AI will be on this structural inflation problem as a counterweight the next 12–24 months?

Johanna Kyrklund: I don't think it's going to help with the inflation problems. I think we're kind of in a slightly more inflation regime. We've already been in it for a couple of years.

I think we probably have another two or three years more at least. Beyond that, who knows? And there will be cycles. But ultimately, as I said, there's a deterioration in the trade-off between growth and inflation.

The replacement of labor with technology has been going on for a long time, will continue, will act as a bit of an offset. But as you say, a lot of the strength is in the service sector, which is actually the bit that's harder to replace.

Medium term. I mean, we are taking the trend very seriously, not just AI but general. We're in a world of technological disruption. So that's something that thematically we've been looking to exploit.

Company level, we're seeing opportunity. So, I wouldn't discount it as a trend, but I think we're still at the phase now where we need to work out what the true use cases are.

So if you remember when the internet first came in in the nineties, you know, we did things like we now can buy books on Amazon and it's a little bit more convenient than buying books from, from the bookstore. And you can only go so far with that kind of displacement.

I mean, the fundamental shift was when the internet was combined with the smartphone and suddenly you can do stuff when you're waiting for a bus. And I think it's the same thing with AI. At the moment, we’re still trying to think what do I do today that can be replaced by AI?

That's not really where the magic happens with this kind of technology. It'll be a different way of operating. I tend to be optimistic in the sense that for example, standards of customer service are going to go through the roof now, because a lot of information you'll be able to have about your customers, and that's been a trend that's been on, will accelerate and then we'll demand more. So, what tends to happen, I find with human beings, is that once something has become easier, we then ask for more.

Tony Roth: With technology advancement, there's always also an element that's not really captured by the economists. At least not from the sort of the orthodoxy classic model. There’s also, at least arguably, an improvement in quality of living.

Johanna Kyrklund: Yes.

Tony Roth: That’s an intangible. One might argue either perspective, but you know, you look at this device, the smartphone, and I think about the longevity problem. We talked earlier about earlier retirees. Isn’t that a massive longevity problem?

In fact, we have an episode coming up on the longevity problem. But the question being, what are people going to do if they retire at 65 or 67? What are they going to do for the next 50 years? Well, if they could just watch TV on their phone all day, they could just be a anesthetized by their phone.

They're happy. Is that a better quality of life or is that a tragic outcome? I don't know. But, people feel themselves to be more well off as a result of many of these technologies. And that's not always captured in the economic equation of inequality as an example.

Johanna Kyrklund: The fundamental problem with economics is it's not a science because there's a rather inconvenient truth is that it's based on human behavior. And human behavior adapts to new realities, and human demands change.

Tony Roth: Let’s take it down a level to the actual investment portfolio. One of the things that I think is increasingly popular, we've been doing it for many years now, is the disruption that happens from technology, and it's not just that we have the tech sector. Every company is a technology company now.

Everyone has to be a consumer of technology as enterprise in order to be successful. So we have a technology economy really. And so those disruptions happen very early in the enterprise cycle. And the way to get access to that is through private investing. And so we have incorporated, for clients that can take the illiquidity on, you know, up to 30%, 40% of portfolios in private investment opportunities, because the multiples, the prices today in the public markets are so unattractive it would look like from a long-term standpoint, the equity risk premium is very compressed.

And so, the opportunity set seems to be just earlier in, in the business life cycle. And you have to invest in the private markets to, to access that. So that's a big part of our, our going forward portfolio for the next decade. When you think about the portfolio for the next decade, does that resonate with you or are there other things that you think are really prominent, long-term investors should be focused on?

Johanna Kyrklund: I would agree that a lot of opportunities exist in the private markets. You don't have as much of a challenge with the S&P 500, but we've certainly seen this phenomenon in the UK where a lot of the good companies in the UK index have been bought by private equity buyers.

So we've definitely seen this as a decline in public markets and I think allocations to private assets make sense from that perspective. If I look across public markets in terms of the opportunities that we see there, one thing that I'm quite into at the moment is that the distinction between developed markets and emerging markets is shifting.

We used to think of sovereign risk as residing overwhelmingly in the emerging economies. But actually, through this pandemic, they have actually many cases pursued much more orthodox policies than we've done in the west. And of course, last year, the country that had the worst sovereign problem was the UK.

I think that redefinition of risk between developed markets and emerging markets is also an interesting trend. For example, we've been making allocations to local emerging market debt, which has been an asset class, that has been out of favor for so long. But I actually think it's quite interesting.

They're actually getting their inflation under control already. In general, the spirit I’m adopting is, think of what I did in the last decade and do the opposite. And I know that sounds silly, but my point is to say that we are in a different kind of regime. In the last decade, emerging markets typically did very badly.

But I think there are interesting opportunities there. Now, I wouldn't necessarily focus on China, by the way. I'm thinking beyond China.

Tony Roth: China seems to be just a real enigma still because now that President Xi has been reseeded for his next term or for life or however he wants to define it, perhaps he won't be as tough on the economy, but he's been so focused on the common good.

It has been so much at the sacrifice of the rule of law that it makes it hard to get comfortable with any kind of overweight, certainly relative to global market cap as an allocator in China. And so, a lot of these other emerging market areas, in Indonesia, Malaysia, Korea of course is no longer emerging really, are attractive.

What about India? I mean India I think is an area that has really suffered from a lot of corruption, frankly, under the current government. Do you see opportunities there in the public markets?

Johanna Kyrklund: Yes, we do. I mean, across Asia we see a lot of opportunity and even China. The problem is for a top-down allocator like me, I think the risks have got so idiosyncratic there at company level because of government intervention that you need to stop.

I find it difficult market to allocate too, in terms of going overweight or underweight, but actually as a stock picker there are interesting opportunities even in China. So China, India, across Asia. There’s aging issues as well in Asia, but when you, when you spend time in Asia, you see the sheer wealth creation, the innovation that's going on.

Even Latin America, again, much more orthodox policies than what we've seen historically, inflation under control, wealth creation. We're in a maturing phase, obviously the developed markets, and I feel like some of these things are sort tipping over.

Tony Roth: Let me just tap into your background in politics for a moment. Do you think that there's any hope around immigration? In other words, we've all moved to these very nationalist closed type of attitudes towards the world. It’s just so ironic because there's so many people in Asia and in Africa and in Latin America that want to come to the developed world or the overdeveloped world that could really help to tame these inflation problems over time.

Yet the solution is there but it's not politically compelling. Will that sort itself out? Will there be an equilibrium that will be reached over time where the pressure will build up and it will just make so much economic sense that it will become politically attractive to open the doors to more immigrants?

Johanna Kyrklund: There's no question that immigration helps with an aging demographic. And that's why, for example, America actually is in a better demographic state than Europe or Asia. It is because of the immigration. It does help sort of sort your demographic destiny. The question is whether the system is set up to cope with the sort of political consequences of immigration.

the challenge we have in Europe is we have generous welfare systems and it's sort of working out how that plays out in the context of increased immigration. This is the kind of thing that's going to be debated heavily, I think, in places like Europe.

So the welfare systems we have here, were created at the time and we are very homogeneous societies and everyone felt they were benefiting. So the political consequence of that I think is something that might, might be an issue in Europe.

And again, in Europe you are seeing the rise of more extremist parties. I don't think there is an easy answer to this particular issue. I see it less of an issue in the U.S. I think it's a problem for Europe.

To the extent that it feeds into a sense of political division, That has a long-term impact on markets.

Cultural divides make it harder to cope with crises when you have a divided system. For many years we had very centrist politics where we used to say, well actually doesn't matter if the government doesn't do anything.

You know, often people like to have that sort of stalemate between Congress and the house and the presidency in the U.S., for example. But that's because ultimately they weren't dealing with big crises. If you have increased divisions as a result of immigration or in general global challenges, it can make some crises look more difficult to resolve.

Debt ceiling was an example of that recently. It got resolved in the end, but there was a scenario where things could have been taken even more to the brink than what we experienced last time this happened. That's where potentially there’s a risk of miscalculation in a divided political system.

Tony Roth: Let’s talk about, just real briefly, because I think it’s an uncomfortable omission if we don't talk about it. The war. It's one of the factors that has caused us to underweight Europe. That's just one factor, but are we being overly reductionist?

I mean, it's hard to see good conclusions from that conflict. It is a drain GDP for the US equal to Europe. But nonetheless it's a lot closer to Europe. And if the Russians become more desperate and decide that they want to take the war elsewhere, then things could change. What do you think?

Johanna Kyrklund:  There's always the tail risk that Putin goes nuclear or something like that, a bit like what we've been dealing with North Korea, or China invading Taiwan. Those kinds of risks are impossible to price, in my view. The main transmission mechanism for Europe is by the energy. So, then you have to think about to what extent is this conflict creating transmission mechanisms to real economy.

And obviously we do have very clear transmission mechanism by the energy price. Now we averted that challenge over the winter. We had a mild winter in the end. Turns out that we had sorted ourselves out, so we ended up not getting the recession expected in Europe. But that is probably the thing to watch. Now, right now there doesn't seem to be pressure on energy prices.

Generally energy prices have been sinking this year. And so for now, I wouldn't see it as something to be worried about in the context of Europe tactically.

To the extent that we are facing higher political risk than we have, you know, in the previous 20 years, people often say, what's the hedge against that? And hedging tail risk is punitively expensive.

Your only weapon is diversification. So I always say, look, after the core risk, and I guess the tail risks will take care of themselves. Then if you get into the tail, hopefully you haven't blown up to a point where you can't take risk again.

So diversification is your main source of protection. In the last decade, I didn't touch any kind of commodities with a barge pole because actually in a deflation environment, they really didn't help. No negative carry, just didn’t find their place in their portfolio.

But structurally, I do think commodities and commodity-related investments are good diversifiers now, in a way, that fixed income was in the last decade. And the reason is because, if you get into difficult geopolitical environment, commodity prices typically will do well. Be it gold, be it energy.

If people are deglobalizing, if people are thinking about these strategic risks, Elise is stockpiling. There's a lot of work right now going on across the world. People trying to secure resources. So in a less collaborative world, and also with the fact that we also face inflation risk, commodities, I think, are very useful to diversify in the portfolio in the way that they weren't historically.

Tony Roth: Yeah, we’re equal weight commodities right now. Are you overweight commodities?

Johanna Kyrklund: We're not overweight. We would be equal weight right now. But what I find interesting is a lot of people don't own them at all.

Tony Roth: Yes. Right.

Johanna Kyrklund: I think they need to be part of your strategic mix. I wouldn’t be tactically overweight right now.

Tony Roth: Yeah.

Johann Kyrklund: But you should own some. What's interesting to me is that because the focus on net zero, particularly in Europe, you know, many investors have just completely forgotten about the asset class and kind of don't want to go there. So it's under-owned as well.

Tony Roth: To wrap things up, do you have a favorite investment right now? Not a company per se, but a type of company or an area of the world? and is there one thing that keeps you up at night?

And I'll tell you that the one thing that keeps me up at night, which is totally irrational, is the constant and irrepressible rise of the small group of American tech companies that we are ultimately underweight in our portfolios today because there's no rational belief set, I think, that justifies given their valuations and the law of large numbers and their size, their continual rise from these price levels. Yet it continues to happen and result in under performance.

What do you think about that? What keeps you up at night and what do you like today in your portfolios?

Johanna Kyrklund: I think from my side, I do like local emerging markets debt. I find it interesting., I think that inflation is falling there. If actually we do move into recession soon, it has rate risk, which should help. Emerging economies are in a better state.

Equally if we see global growth continuous surprise on the upside, that could mean a weaker dollar, which is very helpful to the asset class. And again, it's very under-owned. So I like it. In terms of what keeps me up at night,

I share your concern on valuations, on the tech names. But, I think the other thing is when I look across the whole platform that we have here at Schroders is making sure that we are adapting to new this new regime that we're not using the old maps.

But I think that is one of the challenges we face is just so much change all at once, coming from every direction, geopolitical, economic, technological, climate, all of it, immigration, I mean, all these things coming together.

Tony Roth: Joanna Kyrklund, thank you so much for being here. What a great conversation and wish you the best with your portfolios over the rest of the year.

Johanna Kyrklund: Yeah, same to you. Thank you so much.

Tony Roth: Thank you all for listening today. Please visit wilmington trust.com for our latest thought leadership in the investment planning and banking areas.

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Johanna Kyrklund    
Group Chief Investment Officer
Schroders