This article is brought to you by Schroders.

Schroders : Climate change and higher inflation affect 30-year return forecasts

Schroders : Climate change and higher inflation affect 30-year return forecasts

This year, we are expecting higher returns across most asset classes in real and nominal terms, particularly among the fixed income markets.

Each year Schroders’ team of economists helps investors take a truly long-term view with 30-year return forecasts for a range of asset classes around the world. These forecasts are unique because they include the effect of climate change, which is added on top of a set of building blocks to produce our estimates.

Policymakers are likely to keep interest rates higher in response to inflation being more persistent. This has been driven by major shifts in the three areas of decarbonisation, demographics and deglobalisation known as the 3D Reset.

As higher cash returns drive up returns on all fixed income assets, the risk premium for owning equities will be lower. So, equity investors will need to work harder given the challenges of making equities a more attractive prospect than cash and sovereign bonds.

Meanwhile, the impacts of climate change on asset returns are uneven with winners and losers in different geographies. Despite the substantial downgrades in emerging market returns from the incorporation of climate change, they are still expected to deliver higher returns than most of the developed markets.

We adopt a three-step approach to incorporate climate change in our macroeconomic assumptions.

  • Physical impact: We focus on the physical risk of climate change by examining the impact of temperature rises on output and productivity.
  • Transition impact: We consider the transition risk by evaluating the economic impact of actions taken to mitigate climate change and reach net zero targets.
  • Stranded assets: Lastly, we account for the effects of stranded assets - where we factor in losses resulting from the write-off of coal, oil and gas reserves that can no longer be exploited and hence remain in the ground.

Three climate scenarios

Our three climate scenarios then describe how physical risk, transition risk and stranded assets interact to collectively impact productivity, economic growth, and inflation for different economies. These are Current Policies, Delayed Transition and Net Zero with Innovation. They are crucial for estimating long-term asset returns.

We believe that the Delayed Transition scenario is the most likely of the three scenarios presented and forms our central scenario. Under this scenario, policymakers delay climate action until 2030 and then introduce aggressive policies over a short span of time to limit temperature increases to 1.6°C by 2050, resulting in a disorderly transition.

Our Net Zero with Innovation scenario examines the upside to this central scenario – where proactive policies spur greater innovation and productivity, resulting in an orderly transition to limit global warming to 1.4°C with comparatively lower economic pain.

In our scenarios, policymakers induce the transition to a low-carbon economy by raising carbon prices and internalising the cost of emissions. Carbon prices can be considered as a proxy for mitigation policy ambition and effectiveness.

Efforts to mitigate climate change will also have uneven impacts

While we anticipate investors will still be rewarded for taking more risk and investing in equities over the next 30 years, and particularly so for emerging market equities (see table, below), the effects of policies to decarbonise economies will create challenges for the asset class, rewarding those best placed to unpick them.

Due to the costs involved, decarbonising economies will be inflationary. This is because carbon pricing is widely seen as the main policy approach required to incentivise the transition to renewable forms of energy. The impact of climate change will also have more direct economic costs. Some fossil fuel reserves will simply need to be left in the ground, for instance, becoming “stranded assets.”

At asset class level, we expect a delayed transition will generally mean less growth and lower corporate earnings, productivity and so equity returns would be lower than otherwise.

This will offset some of the benefits to equity returns from the higher inflation premium, and prove particularly consequential for emerging market equities, where the potential for losses from stranded assets is also greater (chart 4). Overall, the impact of climate change on asset returns are uneven with both winners and losers.

Further reading : How climate change and higher inflation have affected our 30-year return forecasts