Executive Summary
The materialization of physical climate risks is driving up disaster-related costs, which will ultimately translate into increased economic volatility, higher average inflation and lower real growth. What will this mean for investors? In this report, we try to answer the three biggest questions by looking at US markets. First, through which channels will climate change affect your portfolio? Second, what will it mean for expected returns in different asset classes? Third, how do correlations and volatility expectations affect the optimal composition of your portfolio? The inputs for our financial analysis are drawn from the “Below 2°C” and “Current Policies” scenarios from NGFS1, with the latter “Hot House” scenario having more severe outcomes on the economy and financial markets. Both scenarios also take into account other structural trends in particular the demographic slow-down.
Interest rates are set to fall and even become negative in real terms in the 2040s. Long-term interest rates are projected to decline, averaging around 2.5% until 2050 with only minor differences across different climate scenarios. Higher inflation will gradually push real yields into negative territory reaching -0.5% (Below 2°C ) and -0.7% (Current Policies), respectively, by 2050.
Equity investors will face a future of higher risks and lower returns amid rising risk premia and lower dividend growth. Investors are likely to discount future returns at a higher rate due to increased physical and transition risks, which would compound the slowdown of economic growth. Annual total equity returns are set to fall on average to 5.4% until 2050 (Below 2°C) and 4.7% (Current Policies), yielding still slightly positive real returns at the end of the forecast horizon. In the credit space we expect spreads to widen to 140bps in the Below 2°C scenario and to 170bps in the Current Policies scenario by 2050.
From 60/40 to 40/60 – the optimal portfolio allocation could shift in the future. An increase in negative supply shocks amid climate change will reduce the effectiveness of bonds as a hedge against equity volatility while at the same time reducing the risk-return profile of equities. Optimizing risk-adjusted returns would call for more bond-heavy portfolios. Nevertheless, the average projected total returns of such a portfolio until 2050 will drop to around 4.1% (Below 2°C) or 3.8% (Current Policies) compared to the 10.4% returns of the past, while volatility is increasing.
25% higher equity prices in 2050 – the reward for keeping temperature rise Below 2°C. On top of all the other positive effects, prioritizing the fight against climate change would also pay off financially. In this context, it is essential to raise awareness and prepare monetary policy accordingly. Institutional investors will need to adjust their strategies to account for lower returns and higher volatility both in their portfolios but also in their communication to customers – in particular to future pensioners.