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Special Outlook Issue

Five trends that will shape our future world

2031OutlOOk

FrOm the Special OutlOOk 2013 iSSue OF merrill lynch adviSOr

l

Five trends are primed to shape the world economy proFoundly in the decades to come

2031OutlOOk

By Scott Eden

ong-range economic forecasting has always

been an inexact business at best. Right now, it’s dif-

ficult for many investors to think two or three years out —never mind decades. The world is still feeling the aftershocks of the great global recession, and many people are concerned about the future impact of the steps that governments around the world have had to take in order to avert a deeper crisis.

But a handful of far-reaching and unde-niable factors are reshaping our world, and are likely to continue to do so for decades to come: A global population on pace to exceed 8 billion by 2030. A rapidly growing emerging-market middle class that will strain the world’s food, water and energy resources. A global climate in flux, with increasing incidents of extreme weather. Aging populations in countries around the world that could threaten economic growth and test national fiscal

stability. In the coming years, all these factors could present obstacles to global growth, but will also create opportunities for innovative thinking—and new markets we haven’t yet recognized.

a solution to the deficit Of course, the near term continues to be saddled with serious economic challenges. At the start of 2013 in the U.S., one of them will be the effort to tame the federal C

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OutlOOk 2013

MERRILL LYNCH • ADVISORtm 3

budget deficit. As a percentage of gross domestic product, the debt remains dangerously high— according to some recent readings, the figure topped 100%. How robustly and quickly Washington responds to this challenge will have an enormous bearing on the future strength of the U.S. and global economies. According to some political and economic observers, it could take another 10 years for the U.S. to produce a solution to its deficit problem that will endure.

While many people are focused on tax rates or Federal Reserve policy as the primary factors in our current fiscal situation, the key to solving it is tackling entitlements, according to Christopher J. Wolfe, chief investment officer, Merrill Lynch Wealth Management Private Banking and Investment Group. In his view, the country’s fiscal crisis will not truly be under control until both Medicare and Social Security are recali-brated. In 2011 the eldest members of the baby boomer generation turned 65. And for the next 17 years, 10,000 Americans per day will become eligible to draw both Social Security and Medicare benefits. That demographic swell will be the prevalent factor in any federal budget imbalances in the future, Wolfe believes.

Once our deficit issues are resolved, assuming they are, investors will almost cer-tainly be turning their attention to the global megatrends that have been evolving all the while. These are the five factors—as identified by analysts and investment experts at BofA Merrill Lynch Global Research and the Investment Management & Guidance teams—likely to have the most profound impact on the global economy within the next two decades.

As life expectancies have risen around the globe, there has been an inevitable rise in the average age of the world’s population. This is especially true in developed coun-tries. Nations with aging populations generally suffer economically and become less globally competitive, while

youthful countries—which boast more vigorous, productive workforces—tend to experience faster growth. By 2030, the median age in wealthy countries that are part of the Organisation for Economic Co-operation and Development (OECD) is expected to jump to nearly 43, up from 38 in 2010. Already, the median age in Japan and Germany is past 45. In the U.S., where the demographic swell of the aging baby-boom generation stands to imperil the nation’s fiscal stability, the median age is 37.

The problem isn’t limited to developed nations. “The demographic issues that many emerging markets may encounter over the next 20 years are the same issues that the de-veloped world is encountering now,” says Alberto Ades, head of emerging-market research at BofA Merrill Lynch Global Research. According to the Global Trends 2030 report recently published by the National Intelligence Council, the median age of almost all societies around the world is rising rapidly, except in sub-Saharan Africa. For this reason, the report maintains, the so-called “frontier markets,” especially countries in Africa, are likely to experience the fastest economic growth over the next 20 years. As Mark Mobius, executive chairman of the Templeton Emerging Markets Group, notes, many institu-tional investors have grown enthusiastic about some of the more politically stable frontier markets, attracted by their fast growth and young populations.

Because of its one-child policy, China has the most daunting aging problem among the major emerging economies. Though the country hasn’t yet felt the full

“ FrOntier marketS” are likely tO See the FaSteSt ecOnOmic grOwth in the next 20 yearS.

43the median age

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effect of its maturing workforce, the trend could curb its growth prospects over the course of the next two decades. Today, just 8% of the Chinese population is 65 or older. By 2030, that will double to 16%, while the percentage of Chinese citizens of working age will fall from its recent high of 72% to 68%. China’s new leadership is certainly aware of the problem, recently signaling a potential repeal of the one-child law. “They have big ambitions,” Ades says of the Chinese regime, “and I’m sure they don’t want to be hindered by a policy that was instituted 30 years ago.”

Another huge structural imbalance has developed across the globe over the past 20 years: the increasing disparity in wealth between the very rich and everyone else. In the U.S., the top 1% of earners collects nearly a quarter of all income, and the top 10% takes home

half—more than at any time since the pre-Depression 1920s. In other words, the base on which economic recoveries are built has meaningfully shrunk. If this imbal-ance continues, or gets worse, recessions could last longer and recoveries could be less robust.

But income inequality isn’t solely an American phenomenon. Other developed economies have seen this gap widen as well, as have many emerging nations. Deeper income inequality around the world will have geopolitical implications that could include greater risk of unrest and heightened political instability in the developing world. In China, the wealth imbalance is already a divisive and potentially volatile issue, with the country’s ruling party leadership recently taking steps to stamp out the grossest corruption among the governing elite, who have reaped much of the wealth throughout China’s run of staggering economic growth.

In the U.S., Wolfe believes, successfully addressing this issue will require making changes in mandated entitlement programs. When Social Security was created as

part of the New Deal, there were 159 taxpayers in the workforce for every retiree receiving benefits. That ratio now stands at just three to one—a level

that is clearly unsustainable. By 2033 the Social Security Administration will run out of money, according to the fund’s own trustees, and payroll taxes would be able to cover only three-quarters of eligible Americans.

By adjusting policy to reduce the load on today’s workers, Wolfe believes that their compensation would have greater potential to rise—allowing more younger workers to purchase houses, for example—a key

trigger for a new economic cycle.

As a result of the revolution in shale-gas extraction through hydraulic fracturing—known as “fracking”—the holy grail of energy independence appears to be a real possibility for the U.S. At the same time, concerns over climate change and carbon emissions, along with rocket-ing demand for energy as global middle-class consump-tion increases, may force the world’s economies to find

iF the diSparity

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income inequality

3:1 ratio of taxpayers

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16%percentage of

chinese citizens over age 65

by 2030

Unless otherwise indicated, statistics come from the OECD; the National

Intelligence Council’s Global Trends 2030 report; the Social Security

Administration; and BofA Merrill Lynch Global Research as of Dec. 10, 2012.

OutlOOk 2013

MERRILL LYNCH • ADVISORtm 5

ways to lower their energy costs, says Sarbjit Nahal, head of sustainability megatrends analysis at BofA Merrill Lynch Global Research. Those gains could come through in-creasing reliance on non-fossil-fuel energy sources, or through improved efficiency.

Demand is set to explode. According to Nahal’s estimates, world energy consump-tion will jump 50% over the next 20 years. That kind of rise will almost certainly result in higher oil and energy prices across the board. Today, the equivalent of about 9% of global GDP is spent on energy costs. “We simply think that’s not sustainable from a long-term perspective,” Nahal says. “The world cannot afford to be spending that amount of money on energy.”

The good news is that enormous opportunities exist for innovation in energy efficiency. Buildings, for example, account for 40% of energy use in terms of emissions worldwide, says Nahal. “Even in the U.S. a huge percentage of buildings are under-insulated. People are upping the air-conditioning, and it’s literally going out the window.” Elsewhere, the sprawling server farms and data centers that power the Internet now consume as much as

7% of the electricity produced in the developed world—information technology has now overtaken the airline industry as a source of emissions. As with automo-

biles, the next generations of IT equip-ment must be designed to reduce

energy consumption, Nahal says. If history is any guide, the effi-

ciency gains will come. Were it not for the technological advances of the past 40 years, energy use would

be as much as 60% higher than it is today. It only makes sense for the

private sector to continue this trend. “The general rule of thumb is that for

every dollar you invest in energy efficiency, you achieve two to four dollars in terms of long-term cost savings,” Nahal says. “You may or may not believe in climate change, but energy efficiency is all about reduc-ing costs. And it’s hard to argue against economics.”

A second critical demographic shift is the con-tinuing mass migration from rural to urban environments. Even though the gulf between rich and poor will remain wide in many regions, the net result of this movement into

cities will be an expanding global middle class—because, generally speaking, urbanization tends to coincide with rising income levels. According to the Global Trends 2030 report, within 20 years a majority of the world’s population will, for the first time in history, have risen out of poverty. Even according to conservative estimates, the number of people in the middle class worldwide—which has differing definitions, depending on the source—will likely double to 2 billion by 2030.

The changes produced by this trend will be radical—as radical, some believe, as the disruptions wrought by the Industrial Revolution in the 18th century. Because a dispro-portionate amount of that middle-class expansion will occur in developing and frontier markets, those nations will account for an even larger portion of global economic growth. Already, the bulk of economic expansion comes from the developing world—emerging

energy demand on the riseConsumption is expected to increase by 50% in the next 20 years, according to BofA Merrill Lynch Global Research. As a result, improving energy efficiency will assume critical importance.

a rising global middle class

9% the amount of

global gdp currently spent

on energy

0

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Other renewablesBiomassHydroNuclearGasOilCoal

Sources: International Energy Agency, BofA Merrill Lynch Global Research

OutlOOk 2013

www.ml.com/insightsFor more global investment insights, visit www.ml.com/insights

6 www.ml.com/mladvisor

markets are responsible for more than half of global GDP growth, and 40% of investment worldwide. According to the World Bank, China alone is likely to provide a third of the

world’s economic growth by 2025, even taking into account any potential slowdown caused by its aging demographics.

Meanwhile, spending by middle-class consumers in North America and Europe is expected to rise by just 0.6% per year on average over the next 20 years, while middle-class consumption in Asia is expected to increase by 9% annually. As Mobius has pointed out, a kind of snowball effect could develop: If developing countries are perceived as having more promising opportunities for middle-class growth, that could attract the skilled workers necessary for

further prosperity.

A growing global middle class is a double-edged sword. While reducing poverty is an undeniable good, consump-tion levels are virtually certain to rise along with income levels. This, in turn, will place unprecedented strain on the planet’s resources.

One major issue involves diet: The higher the household income, the more often people eat meat. As protein-heavy

diets become more prevalent, demand for food and water will increase. “It takes 15,000 liters of water to produce a kilogram of beef. It takes 1,500 liters to produce a kilogram of grain,” Nahal notes. “And this puts increasing pressure on global food security and water security.” If current trends continue, Nahal says, within 30 years water demand will exceed water supply by 40%.

The problem will only be worsened if global temperatures continue to rise, and if the extreme weather cycles predicted by many climate scientists threaten crop yields in the world’s breadbaskets. By the end of August 2012, 65% of the continental U.S. was in a state of moderate to exceptional drought. As of November 2012, the average global temperature in each of the previous 333 consecutive months has been higher than the 20th-century average.

When it comes to water sustainability, the problem is both local and global. For example, half of China’s GDP is now derived from water-stressed provinces. Meanwhile, 46 countries are currently suffering from water stress or water scarcity. (“Water stress” refers to a temporary regional condition in which demand for freshwater exceeds local supply; “water scarcity” refers to long-term or even permanently degraded water-supply conditions that can ultimately lead to famine.) Over the next decade, says Nahal, “we’re looking at an increase of anywhere from three to nine times in water stress in different regions of the world.”

According to Nahal’s team’s calculations, if the status quo remains and no efficiency gains are made, the world’s diminished freshwater supply could cut the forecast for 2050 global GDP almost in half. On a more immediate level, water stress could begin posing

challenges to companies. Their concerns range from ensuring adequate water supply to dealing with the realities of large population shifts because of freshwater scarcity—or rising seas and coastal flooding, in the case of a warmer planet.

As with all these large trends, the issues of food and water security will nonethe-less create opportunities for innovative problem solvers. Says Nahal, “Water today is

Food and water

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growth china will provide by 2025

MERRILL LYNCH • ADVISORtm 7

probably a $500 billion market. We think that’s going to grow to $1 trillion by 2020.” This will include new technologies and new infrastructure that allow for more efficient treatment and re-use of water, both residentially and industrially. Currently, eight barrels of water need to be treated for every barrel of North American crude oil that’s refined. By 2025, with the rise in shale gas and oil sands extraction—both of which require large amounts of water—that ratio will increase to 12 to 1. According to Nahal, “We’ve got to put into practice the logic of the closed loop, where a company uses water, treats it and then re-uses that same water.”

Other opportunities for innovation include water management at the household level—currently, in the U.S. up to 60% of freshwater is wasted—as well as more advanced irrigation systems in agriculture and improved water infrastructure. “Given that governments are cash-strapped,” Nahal says, “we see the private sector playing a greater role” in creating infrastructure in emerging markets and upgrading it in the developed world. He sees the private sector accounting for 30% of such investments over the rest of the decade, up from 19% today.

While these five trends touch on each other in a number of ways, there’s one factor they all have in common—none of them is exclusive to a country, or even a region. In other words, from more than just an economic standpoint the world’s borders are getting blurrier all the time. In this new world, Wolfe maintains, geography is a less important factor in an investor’s decisions than sectors, industries and individual com-panies that have clear leadership positions.

He also believes that investors should consider taking an active role in following the trends that are shaping growth—regardless of where they originate. That, by necessity, means cultivating an openness to somewhat more speculative growth ideas—from small-cap companies to frontier markets—as part of a truly diversified strategy. It means betting once more on a future that’s about solving problems, not succumbing to them.

40% percentage by which water

demand will exceed supply within

30 years

a thirsty planetForty-six countries currently suffer from some degree of “water stress.” Researchers at BofA Merrill Lynch Global Research believe that the degree of water stress could increase between three and nine times over the next decade.

Current baseline water stress

Low (<10%) Moderate (10-20%) Medium–High (20-40%) High (40-80%) Extremely High (>80%) Arid and Low Water Use (N/A) Missing Data

Source: World Resources Institute–Aqueduct Project

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