Capital market returns in times of climate change; Fed pivoting, BoE pausing, Poland’s fiscal risks and the US yield curve disinverting

All eyes on the upcoming central banks’ meetings next week: The Fed is finally about to embark on its easing cycle, and we expect back-to-back 25bps interest rate cuts in each FOMC meeting until July 2025. Meanwhile, we expect the Bank of England (BoE) to pause next week after delivering its first rate cut in August. in today’s What to Watch publication, we also look at the economic and fiscal situation of Poland, balancing a difficult trade-off between growth and fiscal consolidation. Finally, we explore what the end of the US yield curve inversion means for capital markets. The US Treasury yield curve has a long history of raising alarms among investors and economists, and when it’s flipped upside down from its usual upward slope in what’s called an inversion, this raises questions on the health of the economy. The impact for investors also take center-stage in our deep-dive: In this report, we discuss the increasingly undeniable impact of climate change on financial markets, we provide insights into what investors can anticipate in the forthcoming decades and how to effectively adapt to these emerging challenges.

Long-run capital market returns in times of climate change

Our in-depth analysis for you here.

As climate change unfolds, its effects on financial markets are becoming impossible to ignore. In this report, we outline what investors should expect in the coming decades and how they can best adapt to these new challenges:

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 NGFS , with the latter “Hot House” scenario having more severe outcomes on the economy and financial markets. Both scenarios also consider 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.?

Our in-depth analysis for you here.

What to Watch this week: And the Fed pivoted, BoE on pause, Poland’s fiscal risks and what happens once the US yield curve disinverts

The complete set of stories for you here.

The Fed is finally about to embark on its easing cycle, and we expect back-to-back 25bps interest rate cuts in each FOMC meeting until July 2025. Meanwhile, we expect the Bank of England to pause next week after delivering its first rate cut in August. We also look at the economic and fiscal situation of Poland, balancing a difficult trade-off between growth and fiscal consolidation. Finally, we explore what the end of the US yield curve inversion means for capital markets.

• Fed: the pivot we’ve all been waiting for. After the sharpest monetary tightening in decades, the Fed is set to cut interest rates for the first time since March 2022. The August CPI print indicated that inflation continues to soften. Meanwhile, the unemployment rate is on a firm upward trajectory, and is likely to rise further in coming months, close to 5% from 4.2% in August. Nevertheless, the US economy has remained remarkably resilient so far, helped by loose fiscal policy and strong immigration, as well as the strength of corporate balance sheets, and although recession risks have risen, we continue to expect a ‘soft landing’. In this context, the Fed must tread carefully between the risk of being behind the curve and the risk of re-heating the economy. We expect a balanced approach of back-to-back 25bps interest rate cuts in each meeting starting next week, which would bring the Fed funds rate (upper range) down to 3.5% in July 2025 from 5.5% currently.
• Bank of England (BoE): on pause amid solid momentum. After delivering its first rate cut in August, we expect the BoE to pause its loosening cycle at next week’s meeting as inflation is set to pick up again to +2.8% y/y in November on the back of unfavourable base effects and the Ofgem energy price cap increase by +10% in October. The inflation outlook should improve again from December onwards and we expect the 2% target to be reached sustainably before mid-2025. In this context, the BoE is likely to cut the bank rate by 25bps in November, skip December and then cut by 25bps in each meeting in 2025, stopping in September 2025 once it reaches 3.25%.?
• Poland: Favouring growth over fiscal consolidation carries risks. Poland’s economic growth should remain robust, driven by domestic demand on the back of expansionary fiscal policy (2024: +3%, 2025: +3.8%). However, the budget proposal for 2025 calls fiscal consolidation into question and harbors medium-term fiscal risks. We expect the government to begin to consolidate its budget from 2026 onwards, thereby stabilizing the public-debt-to-GDP ratio at around 56%. In a downside scenario with no fiscal consolidation, public debt would continue to rise and exceed 60% by 2027. In the short term, the Polish budget proposal poses inflationary risks and is likely to delay interest rate cuts until Q2 2025.?
• The end of the US yield curve inversion: what now? After the longest inversion in history, the US yield curve has returned to a positive slope. Does this mean a recession is looming? Not quite as we still believe in a soft landing without a sharp sell-off in risky assets. Nevertheless, we prefer bonds over equities currently. Historical evidence shows capital flows have typically moved in the opposite direction at this stage of the yield curve shift; hindsight reveals this was often not the optimal financial choice.???

The complete set of stories for you here.