Schroders Economics Group produces 30-year return forecasts on an annual basis, which incorporates the impact of climate change.
In Part1 of our paper we outline the methodology used to incorporate climate change into our return assumptions.
How we've incorporated the impact of climate change
In 2020, our assumption started to incorporate the impact of climate change and the energy transition. Given the high degree of uncertainty around policy intervention to tackle global warming, scenario analysis is a key framework to assess the implications of climate-related risks and opportunities for financial institutions. For this year’s update, our central case has moved to the Delayed Transition scenario following a change in modelling partner to Oxford Economics.
Our new scenarios are consistent with the those published by the NGFS (Network for Greening the Financial System), a group of 116 central banks and supervisors, working together to enhance the role of the financial system to manage risks and to mobilise capital for green and low-carbon investments. In particular, our assumptions on carbon pricing and temperature projections are consistent with those used by the NGFS under the corresponding scenarios. Among the scenarios we considered, we think Delayed Transition is the most realistic scenario where there is a disorderly transition to net-zero as carbon pricing only starts to rise from 2030.
Higher returns expected
This year, we are expecting higher returns across the different asset classes in real and nominal terms. The Delayed Transition is more inflationary compared to last year’s Partial Mitigation scenario, which has pushed up our nominal return forecasts.
In terms of our cash return forecasts, particularly for the developed economies, the rise in expected returns has been driven by upward adjustments to our central bank policy rate forecasts. In the near-term, central banks are assumed to normalise monetary policy faster given the elevated levels of inflation.
Given upgrades to our cash return forecasts, this means higher long-run return forecasts for the sovereign and credit bond markets. For instance, our US and eurozone sovereign and credit bond forecasts are higher primarily because of the increase in the real rate and inflation assumptions.
On equities, our global return forecast has moved higher this year thanks to stronger expected returns in the developed region and emerging markets. For the US, nominal equity returns have been lifted by the increase in inflation and dividend yield. For emerging market countries, such as China and Taiwan, the increase in return forecasts were largely due to the rise in dividend yields. For India, an upgrade to productivity growth (which feeds into the growth rate of earnings and dividends) was the main driver for the upward revision to returns.
Overall, accounting for climate change, equities are still expected to outperform other asset classes over the next 30 years. On a regional basis, emerging equities are expected to outperform most developed equity markets. Our forecasts also suggest that credit and property will still deliver better returns than sovereign bonds. At the same time, the return gap/ risk premium between equities and sovereign bonds has also narrowed slightly from 3.8% to 3.6% led by greater upward revisions to our bond forecasts. That said, investors are still incentivised to move up the risk curve in search of higher returns over the next 30 years. So, it is important to invest actively given the challenges of harvesting returns, particularly with climate change considerations.
Clear direction of travel
Throughout our analysis, we have had to make several assumptions. There is little agreement as yet in the literature about the quantitative impact of climate change on economic activity for a given quantity of warming. There is also debate on the costs of transition and the form mitigation efforts will take. Consequently, the variability in asset return forecasts depends on the models used and assumptions made.
Nonetheless, the direction of travel is clear, and these estimates provide a consistent framework for assessing the potential effects of a development which will have profound effects on the world economy and financial system.
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