From Headlines to Trendlines - US Bank · addressing wealth expansion with investment dollars that are committed over an extended ... driving global productivity growth and wealth

From Headlines to TrendlinesLong-term Investing for Wealth Expansion

THOMAS M. HAINLIN, CFA — GLOBAL INVESTMENT STRATEGIST

Important disclosures provided on page 50. 1

The focus

of a wealth

expansion

portfolio is on

identifying how

to capitalize on

medium-term

dislocations and

opportunities, as

well as longer-

term economic,

social and

geopolitical

trends and

themes.

From Headlines to TrendlinesLong-term Investing for Wealth ExpansionTHOMAS M. HAINLIN, CFA — GLOBAL INVESTMENT STRATEGIST

Families of significant resources often have wealth that goes beyond meeting the basic expenses of life. They have the ability to deploy a portion of their “excess” wealth towards pursuing longer-term interests. For example, they may be interested in effecting positive social change through social impact investing or philanthropy. They may wish to pursue personal or shared family interests such as investing in fine art, classic cars or other collectibles. Or, their goal may be to grow their wealth beyond their lifetimes—over time and across generations. It is this goal, or investment objective, of long-term growth that we refer to as wealth expansion.

WEALTH EXPANSION

In our view, money invested toward a long-term growth or wealth expansion objective can truly be thought of as long-term or “patient” money. Patient money is generally invested in longer-term investments that can be much less sensitive to the potential volatility triggered by daily headlines, near-term events or shorter-term market cycles. One approach to addressing wealth expansion with investment dollars that are committed over an extended period of time would be to focus on global events that create the potential for favorable investment opportunities.

For example, while patient money portfolios were probably impacted by shorter-term events and dislocations of the last decade (Argentina’s default; the events of September 11, 2001; the bursting of the dot-com bubble; the Lehman Brothers bankruptcy and resulting financial crisis; and the housing bubble implosion), they may also have taken advantage of the decade-long rise in the price of gold (up more than 400 percent), emerging markets equities (up nearly 350 percent in U.S. dollars) and oil (up nearly 250 percent).1

We believe a wealth expansion portfolio should be invested with a focus on medium-term dislocations and opportunities as well as on longer-term trends, toward areas that may play a prominent role in the future direction of the global economy.

The world is constantly changing. Whether these changes evolve slowly or occur rapidly and disruptively, they can impact an individual business or an entire industry. They can transform selected countries or even the entire global economy.

2

InsightsFrom Headlines to Trendlines

Important disclosures provided on page 50.

INDUSTRY TRANSFORMATION: Kodak/Instagram

The history of Kodak and Instagram offers an insight into how transformational change can disrupt an industry, creating both opportunity and risk. The film and camera company today known as Eastman Kodak was founded in 1881 by George Eastman. After 100 years, Kodak reached $10 billion in annual sales. At its peak, Kodak employed over 150,000 people worldwide, including 60,000 in Rochester, New York, alone, accounting for 15 percent of that city’s entire workforce. Kodak invented the digital camera in 1975 and yet, despite nearly every smartphone and tablet having at least one if not two digital cameras today, Kodak filed for bankruptcy protection in January 2012.2

Meanwhile, in October 2010, two Stanford University graduates, Kevin Systrom and Mike Krieger, came up with a way to share digital photos over smartphones. Their company was called Instagram and employed just 13 people. Currently, Instagram has 150 million active users sharing more than 50 million photos per day. In April 2012—just a year and a half after the company’s inception and only three months after Kodak, the inventor of the digital camera, filed for bankruptcy—Instagram was sold to Facebook for $1 billion.3

For investors in a wealth expansion portfolio, the most important question becomes, “Am I positioned to take advantage of the changes happening in the world around me, or is my portfolio going to be disrupted by the changes taking place?”

THEME INVESTING

Theme investing addresses that question with a process of effectively identifying the catalysts for long-term, transformative change. Our work suggests that these catalysts, or themes, are less likely to be related to specific policies or the current state of the economy and are more likely to be found in developments both nationally and around the world in one of five broad categories:

• Geopolitics

• Society

• Environment

• Technology

• Demographics

Investors with a wealth expansion portfolio should step away from the microscope and peer through the telescope. Looking into the distant future for opportunities, they should ask, “Will the trends and themes of the past repeat themselves, or will the future witness new regimes, new winners and new losers?” In other words, “Is my portfolio positioned for where the world has been or where the world is going?” Thus, for long-term, patient investors, we believe the focus should be less on today’s headlines and more on tomorrow’s trendlines.

MEGATRENDS OF THE LAST 25 YEARS

A megatrend is an important shift in the progress of society. While trends can persist for years, decades or even centuries, often the impacts of these shifts are not readily apparent at their beginning. The impacts of megatrends can be negative as well as positive and some trends can be more easily reversed than others.

Of all of the trends that have transformed the post-war world, none has been as important as globalization.4 In Capitalism 4.0, author Anatole Kaletsky identifies “vast and irreversible changes” that have transformed the world politically, economically and technologically and whose effects have reverberated across the capital markets.5 These include:

3Important disclosures provided on page 50.

More than four

times the size

of the U.S. labor

force has been

added to the

global economy.

• The fall of the Berlin Wall in 1989, which symbolized the end of communism, opened up the so-called “Second World” (the Soviet Union, its allies and satellites), spread to areas such as India, Southern Africa and Turkey, and provided the major world powers with a “peace dividend” (a period of substantially reduced defense spending)6

• The subsequent end (or was it a pause?) of the Cold War between the Soviet Union and the United States, which opened up the so-called “Third World,” put an end to proxy wars, and led to political liberalization and economic development across Southeast Asia and Latin America

• The opening of China, capped by its entry into the World Trade Organization (WTO) in 2001

• A technological revolution that dramatically increased the speed and lowered the cost of communication, computing, data storage and air and sea transportation

Together, these developments led to a long-term and potentially permanent shift in the world’s economies and capital markets. The “closed” economy of the First World (with a combined population of 800 million in 1989) became a global economy with billions of new workers, consumers, producers and savers.7 Manufacturing industries moved from advanced economies to the developing world, helping to create more than 575 million jobs worldwide since 2000.8 Put into perspective, this equates to an addition to the global economy of nearly four times the size of the entire U.S. labor force.9

Total world employment

2,000

2,200

2,400

2,600

2,800

3,000

3,200

3,400

Fig

ures

in m

illio

ns

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014*

2,613

3,191

Source: “Global Employment Trends 2014: Risk of a Jobless Recovery?,” International Labour Organization 2014, International Labour Office, Geneva, 2014. *Projection.

4



APPLE’S iPHONE: A miniature study in globalization

Apple’s iPhone 3G, released in

2008, illustrates the principles

of globalization, specialization

and comparative advantage.

The design and software of the

3G were developed by Apple,

a U.S. company. Broadcom,

another U.S. firm, supplied the

Bluetooth, FM and wireless LAN

components. Cirrus Logic, also

a U.S. firm, was responsible for

the audio components. However,

the majority of the hardware

was sourced from non-U.S.

companies. Toshiba, a Japanese

firm, supplied the flash memory,

display module and touch

screen, while another Japanese

firm, Murata, provided the Wi-Fi

modules. The processor and

system memory were sourced

from South Korea’s Samsung.

From Germany, Infineon and

Dialog Semiconductor supplied

the baseband, camera, RF

transceiver, GPS and power

management functions. All of

these components were shipped

to Shenzhen, People’s Republic

of China, where they were

assembled into final products

by Foxconn, a Taiwanese

company, and exported to the

rest of the world.12

The combination of urbanization and rising employment in the developing world has led to an increase in standards of living and a commensurate rise out of poverty. In East and Southeast Asia, more than 400 million workers have risen above the poverty level (defined as earning $2 or less per day) since 2000, helping to create a new global consumer class.10

In addition, lower tariffs, free-trade agreements and technological advances, such as containerized shipping, drove a sharp rise in global and intra-regional trade. In the three decades prior to 2000, total world merchandise trade grew by an average of $370 billion annually. Following China’s entry into the WTO in 2001, growth in world merchandise trade accelerated to an average of $1.4 trillion annually in the decade of the 2000s and to more than $3 trillion so far in the decade of the 2010s.11 Globalization led to the disaggregation of the manufacturing process based on the principles of specialization and comparative advantage, driving global productivity growth and wealth creation.

World trade has accelerated since China joined the World Trade Organization (WTO) in 2001.

Average annual growth in total global trade by decade

$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

$3.0

$3.5

1950s 1960s 1970s 1980s 1990s 2000s 2010s

U.S

. do

llars

(in

trill

ions

)

Source: World Trade Organization. 2010s as of year-end 2013. Trade as measured by total merchandise trade.

We believe these political, economic and technological megatrends of the last 25 years will continue to exert influence on economies and capital markets into the future. The global economy continues to become more open. Global trade continues to grow, particularly in trade among developing economies (often called the “south-south” trade). Myanmar is a recent example of a former “pariah” country beginning to enact political reforms in order to join the global economy.


THREE THEMES THAT DEFINED THE DECADE PAST

Within the 25-year megatrends, the last decade witnessed many trends that influenced and shaped the performance of global capital markets. Three events in particular, at the beginning of the decade, stand out in offering examples of trends that lasted for years but the impacts of which weren’t readily apparent at the onset:

United States – Twin deficits and a declining dollar

In 2001, the United States had just enjoyed three consecutive years of budget surpluses. The Congressional Budget Office (CBO) estimated that if policies continued, the entire net debt of the U.S. Treasury would be eliminated by 2009.13 Unfortunately, by 2002, anticipated future budget surpluses had already turned to deficit, and by 2010 the annual federal deficit had reached nearly $1.5 trillion.14 Rather than being eliminated, marketable debt held by the public mushroomed to nearly $9 trillion by 2010.15 Meanwhile, the trade deficit, which averaged $100 billion annually from 1984-1997, soared to more than $700 billion annually from 2005-2008.16 The decade of rising “twin deficits” (fiscal and trade) saw the real trade-weighted value of the U.S. dollar fall by nearly a quarter against other major currencies, while over the same period U.S. equities generated an annualized rate of return of just over 1 percent.17

Europe – One currency, many distortions

With the introduction of a common currency in the euro area, 19 countries now share a single exchange rate. Interest rates across the euro area converged toward the low rates of “core” nations, such as Germany. Lower interest rates in peripheral nations provided consumers in countries such as Ireland and Spain access to more affordable mortgages, leading to an overheated real estate market. Lower interest rates also allowed governments in France, Italy, Portugal and Greece to increase debt issuance, and European banks and insurance companies proved to be eager and willing buyers for government debt. When world capital markets began assessing each of the euro area countries as separate and distinct borrowers rather than as a united Europe, a sovereign debt crisis ensued and European banks and insurance companies were caught in the crossfire. During the first decade of the new euro, European stocks generated an annualized rate of return of less than 1 percent (in local currency).18

China – Labor shock, infrastructure awe

The dominant trend of the last decade was the rapid urbanization and industrialization of China. China joined the WTO in 2001, bringing hundreds of millions of workers into the global labor force. Access to abundant and low-cost labor, combined with advantageous exchange rates (enforced by strict capital controls), provided a comparative advantage and

Will these three

events from

the last decade

continue to

influence the

markets?

6



China’s rapid

urbanization and

industrialization

was the

dominant theme

of the last

decade.

facilitated a migration in manufacturing from developed economies to Asia. The combination of export profits and “captured” domestic savings (via low or negative real savings rates, so-called “financial repression”) financed an infrastructure boom, supporting the migration of hundreds of millions of workers from rural areas to the cities. This migration has been called the largest peacetime movement of people in history.19 Rapid urbanization fueled soaring consumption of commodities, particularly industrial metals. In 1995, China consumed less than 10 percent of the world’s nickel, copper and aluminum. By the end of 2010, China alone accounted for more than one-third of the world’s nickel and nearly 40 percent of the world’s copper and aluminum consumption.20 The decade saw copper prices rise more than fourfold, oil prices more than double, and broader emerging market equities generate a 15 percent annual rate of return (in local currency) for investors.21

United States = S&P 500 Total ReturnEurope = MSCI Europe Gross Return (local currency)Japan = MSCI Japan Gross Return (local currency)Emerging Markets = MSCI EM Gross Return (local currency)

Cumulative performance of select equity indices

50

100

Dec2000

Dec2001

Dec2002

Dec2003

Dec2004

Dec2005

Dec2006

Dec2007

Dec2008

Dec2009

Dec2010

150

200

250

300

350

400

450

Reb

ased

to

100

as

of

Dec

200

0

Emerging Markets United States Europe Japan

Source: Morningstar EnCorr


U.S. industrial

companies may

be positioned

to benefit from

access to

abundant and

low-cost energy.

SIX INVESTMENT THEMES FOR THE DECADE AHEAD

With the dramatic geopolitical and economic changes in the world, critical questions for long-term investors are:

• Will these three events that helped define the last decade continue to influence and impact the markets in the decade ahead? Or are we at an inflection point?

• Have these past trends run their course?

• What are the emerging trends that will define the decade ahead?

Within the context of the ongoing political, economic and technological megatrends described by Kaletsky and an examination of outcomes of the events of the past decade, we believe that we are indeed at an inflection point. We have identified a number of seismic shifts occurring around the world that may lead to different outcomes for industries, for countries and for the global economy. We anticipate the impact of these changes could be reflected in the performance of the capital markets in the decade ahead. It is from this perspective that we derive a list of the following six themes that we believe have potential implications for long-term wealth expansion investors.

Investment Theme #1 — The U.S. energy revolution: a global game changer

OverviewThe world economy is once again going through a transformative change. Labor costs around the world are converging. Advancements in technology are fundamentally shifting the balance of energy supply and demand, and various energy policies around the world have led to diverging outcomes for the world’s major industrial economies.

As a result, access to abundant and low-cost energy may become a comparative economic advantage in the decade ahead. If so, the United States may be uniquely positioned to benefit from this shift, similar to the labor cost advantage that China enjoyed in the last decade. We see a number of isolated events and developments in the United States and around the world that, when taken together, support this view, including political, economic, technological and environmental drivers.

Key pointsThree primary production factors go into finished goods and services: land (real estate), labor (workers) and capital (money and machines). Other production costs include commodities such as oil, natural gas and industrial metals.

The last decade was marked by a global labor “shock.” China joined the WTO and access to abundant and low-cost labor became a comparative production factor advantage that helped facilitate a shift in global manufacturing from developed countries to emerging economies.

8



Workers in

emerging

economies

demand higher

wages and

better workplace

conditions.

Today, however, labor costs are converging as workers in emerging economies demand higher wages and better workplace conditions. Real wages in East Asia (primarily China) have risen by more than 8 percent annually since 2000, while real wages in developed economies have risen by less than one-half percent per year over that same time.22 In addition, social pressures are rising as China’s burgeoning middle class is demanding a greater focus on environmental issues, such as addressing air and water pollution and food quality concerns.

Meanwhile, energy costs around the world have diverged due to different energy policies pursued by the world’s major industrial powers, the United States, Europe and Japan:

• After the oil supply shock in the 1970s, France and Japan made significant investments in nuclear energy. However, after the Fukushima Daiichi nuclear disaster of 2011, Japan announced that it would join Germany and other countries in shutting down its nuclear plants to pursue alternative energy sources. France announced a goal to reduce dependence on nuclear energy from 75 percent to 50 percent by 2025.23

• Germany and Spain (and to a lesser degree Italy and the United Kingdom) have made significant investments in wind energy, installing more than 75 terawatts (TW) of wind capacity through 2013.24 However, these investments have not resulted in fully realized performance in wind farms to date.25 Meanwhile, taxes on fossil fuels to subsidize renewable energy sources have resulted in significant increases in electricity costs for Germany, hurting export competitiveness.26

• The United States may be in a position to benefit from recent technological advancements in energy production, namely the combination of horizontal drilling and hydraulic fracturing techniques to access oil and natural gas from previously inaccessible shale rock formations.

Access to abundant and low-cost energy may ultimately provide U.S. industrial companies with a comparative advantage (a global energy “shock”) in global manufacturing in the decade ahead, more than offsetting comparatively higher labor costs. Lower natural gas prices help provide a potential benefit to U.S. companies in two ways: through direct consumption of natural gas (particularly in industries such as petrochemicals and fertilizer) and through the continued shift of electricity generation from coal to abundant and low-priced natural gas.


Energy costs

have diverged

for the world’s

major industrial

powers.

Natural gas prices for major industrial economies

Japan = LNG Japan Corp Import PriceGermany = Russian Natural Gas Border PriceKorea = Monthly LNG ImportsUnited States = Henry Hub Spot Price (IMF)

Dec1998

Dec2000

Dec2002

Dec2004

Dec2006

Dec2008

Dec2010

Dec2012

Dec2014P

rice

per

mill

ion

Bri

tish

The

rmal

Uni

t(B

TU

)

Japan United States South Korea Germany

$0

$5

$10

$15

$20

Sources: Bloomberg, Korea Energy Economics Institute. Data as of December 2014.

Two-thirds of U.S. industrial energy comes through direct consumption of coal, natural gas, petroleum and renewable energy. Natural gas is the largest single source of direct energy for the industrial sector, at 43 percent, with petroleum accounting for an additional 39 percent.27 Access to lower-priced oil and natural gas can be a direct benefit for the U.S. industrial sector.

The remaining one-third of U.S. industrial energy is consumed indirectly through electricity. The share of electrical power generated by natural gas has nearly doubled from an average of 12 percent in the 1990s to 21 percent so far in the 2010s. Meanwhile, the share of electrical power generated by petroleum has fallen from an average of 16 percent in the 1970s to less than 1 percent in the 2010s.28

10



Natural gas

is the largest

source of

primary

energy for

U.S. industrial

companies.

U.S. industrial sector primary energy consumption

7%

43% 39%

11%

Coal

Natural gas

Petroleum

Renewables

Source: U.S. Energy Information Administration. Trailing 12-month data as of December 2014.

An increase in consumption of domestically produced natural gas for electricity production provides the United States with an excess of coal that can be exported to other nations. In 2009, the United States exported just under 60 million short tons of coal. In 2012, U.S. coal exports doubled to a record 126 million short tons.29

In addition, the United States has reversed a 25-year trend of declining domestic oil production and rising oil imports. In 1985, the United States was producing nearly three-quarters of the oil it required. By 1994, imports of oil had surpassed domestic production, and by 2006, the United States was importing two-thirds of the oil it required.30

The application of new technologies has led to a dramatic increase in domestic oil production. In North Dakota, oil production increased fivefold from 2008-2014, and the state is now the country’s second largest oil producer (behind Texas), having passed both California and Alaska in 2012.31

As a result, imports of oil have declined for the first time in 25 years, and in 2014 the United States produced more oil than it imported for the first time since 1994.32


U.S. oil “jaws”

have closed.

U.S. annual crude oil production and imports

Bar

rels

(in

mill

ions

)

ImportsProduction

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Will trendscontinue?

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Source: U.S. Energy Information Administration. Annual data as of 2014.

The U.S. energy “shock” has already had a dramatic effect on the global price of crude oil. The price of Brent crude averaged a fairly steady $110 per barrel from 2010-2013, but fell sharply to $57 at the end of 2014.33 This has created a windfall for energy-importing nations, primarily the advanced industrialized economies of the United States, Europe and Japan, as well as emerging economies such as China, India and most of East and Southeast Asia. The United States stands to benefit uniquely from the dual combination of lower import volumes (due to rising domestic production) and lower import prices.

Additional beneficiaries of the energy price “shock” are households in the United States and around the world. For lower-income households in particular, food and energy costs consume a vast majority of income. A long-term drop in the price of energy may allow for additional spending on discretionary consumer goods and services, such as dining and entertainment.

In 2010, the United States began exporting refined gasoline for the first time in 50 years.34 The combination of falling oil import volumes and prices, coupled with rising coal and refined gasoline exports, have already led to a drop in the U.S. trade deficit, approximately one-half of which is due to oil imports. The trade deficit has fallen from an average of more than $700 billion from 2005-2008 to an average of less than $500 billion from 2009-2014.35

The U.S. fiscal deficit also continues to fall, declining from $1.2 trillion in 2011 to less than $500 billion in 2014.36 If this trend continues, a decline in the U.S. twin deficits would mark a shift from the past trend of the last decade. This could conceivably lead to a stronger dollar in the decade ahead, making U.S. assets more attractive to both domestic and foreign investors.

12



Falling deficits

may lead

to a further

appreciation of

the U.S. dollar.

Twin deficits and the U.S. dollar

U.S. twin deficit U.S. trade weighted dollar index

60

70

80

90

100

110

120

U.S

. trade w

eighted

do

llar index

-$2,0002000 2002 2004 2006 2008 2010 2012 2014

-$1,500

-$1,000

-$500

$0

U.S

. tw

in d

efict

(in b

illio

ns)

Source: Bloomberg. U.S. Twin Deficit = Trade Balance + Federal Budget Balance. U.S. Twin Deficit = trailing 12 months.

Finally, a diminishing reliance on imported oil may lead to a shift in U.S. strategic interests with resulting geopolitical implications. The U.S. “pivot” to Asia, highlighted by Secretary of State Hillary Clinton’s November 2011 essay in Foreign Policy, “America’s Pacific Century,” may be seen in this light.37

Potential beneficiaries: • U.S. manufacturing

• U.S. energy infrastructure expenditures

– Midstream, refining, exporting

– Services

– Steel for piping

• Other U.S. industries with direct natural gas energy input

– Electrical power generation

– Petrochemicals

– Fertilizer

• Other potential beneficiaries

– Transportation and transportation infrastructure—conversion of fleets, automobiles from gasoline to natural gas

– Residential and commercial construction—conversion of residential heating from heating oil to natural gas

– Households in the United States and around the world, particularly lower-income households, who would benefit from falling energy prices


China’s

economic

growth may

be shifting

toward more

consumption

and productive

use of capital.

Potential investmentsfor consideration:

• U.S. energy infrastructure

• U.S. industrial/utility sectors with significant natural gas input (manufacturing, chemicals)

• U.S. investments focused on conversion of transportation or residential heating to natural gas

• U.S. dollar and dollar-denominated assets (particularly for foreign investors)

Risks to outlook: • Adoption of similar energy production techniques in other countries with previously inaccessible shale oil and gas that offsets the U.S. energy advantage

• Environmental disaster or negative environmental side effects related to horizontal drilling and hydraulic fracturing techniques that restricts or prohibits the use of those techniques

• U.S. energy policies that slow or restrict overall domestic oil and gas exploration and production

• Regulations that restrict exports of domestically produced coal or use of imported U.S. coal by energy-dependent nations

• More rapid substitution of alternative or renewable energy sources (such as wind, solar or hydropower) for domestically produced oil and natural gas

• Slower-than-expected growth in U.S. oil and natural gas production because of wells depleting faster than anticipated

• Price declines (due to sharp increases in global supply or price competition from oil-producing nations such as OPEC) that make further investment in energy exploration and production unprofitable

Investment Theme #2 — China: Growing up to economic adulthood

Overview

A number of momentous growth shifts are taking place in China that may have a significant impact on investors and businesses in the coming years.

The last decade, what we call China’s “economic adolescent” phase, was marked by policies that supported rapid urbanization and industrialization. China’s urban population doubled and, as a result, China’s demand for commodities, particularly industrial metals,

14



China’s urban

population

exceeded its

rural population

in 2011.

soared. The ability to mobilize hundreds of millions of workers migrating to urban areas supported a competitive manufacturing economy due to China’s ability to keep labor costs low.

We see several forces at work that suggest China is facing a turning point, where future wages and other production costs may rise faster than benefits gained from ever-increasing investment. At this point, productivity begins to fall and economic growth begins to slow.

If China has reached such a turning point, the primary drivers of China’s high-growth economy in the decade ahead are likely to shift from investment in rapid growth toward productive growth, consumption and more liberalized financial systems.38 We believe new opportunities may exist by shifting investments from China’s rapid past growth toward opportunities that could possibly benefit from the increase in Chinese urban income and spending, deregulation and competition.

Key points

China’s “old normal” was marked by the parallel developments of rapid urbanization and industrialization. China’s rural population peaked at 859 million in 1995 and represented more than 70 percent of the country’s total population. From 1995 to 2012, China’s rate of urbanization accelerated as the urban population doubled, while the rural population declined by nearly 220 million. By 2011, China had reached a developmental milestone: Urban population exceeded its rural population for the first time.39

In b

illio

ns

Urban Rural

China total urban and rural population

0

200

400

600

800

1,000

1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

Urban is nowexceeding rural

2014

X

Source: Bloomberg. Data as of 2014.


China may

be reaching

a turning

point where

production

costs begin

to rise faster

than the rate

of productivity

growth.

In China’s “adolescent” economic phase, economic efficiency, productivity and environmental impact were of secondary importance to rapid economic growth. The mobilization of a seemingly unlimited supply of migrant workers from farming to higher-value-added manufacturing and service sector industries (the global labor “shock”) generated incredible economic growth.

Rapid industrialization and urbanization on a scale never before seen necessitated the accumulation of enormous quantities of commodities, particularly industrial metals. In 1995, China consumed less than 10 percent of the world’s nickel, copper, and aluminum. As of 2013, China was consuming more than half of the world’s nickel and nearly half of the world’s copper and aluminum.40

China’s economic adolescence was characterized by political and economic policies that supported rapid urbanization and industrialization, such as:

• Low (or negative) real interest rates in order to capture domestic savings (a policy known as “financial repression”)

• Advantageous exchange rates (supported by strict capital controls) to support manufacturing competitiveness and thereby capture export profits

• State control of critical industries (banking, utilities, resources)

• Preferred/exclusive access to domestic capital and resources for China state-owned enterprises (SOEs) to facilitate credit creation and mobilize a rapid build-out of infrastructure

• Urban hukou (China’s system of household registration) suppressing migrant labor costs by limiting or preventing access to urban social benefits and public services such as healthcare, utilities subsidies and housing benefits41

Key beneficiaries of China’s economic adolescence phase included Chinese SOEs that took advantage of preferred/exclusive access to domestic capital and resources and firms in commodity-producing nations (often state-owned or state-sponsored in other developing economies) that could mobilize vast amounts of natural resources to meet China’s insatiable demand. Investors in China’s “old normal” focused on China’s absolute level of gross domestic product (GDP) growth and policies in support of that growth, namely bank reserve requirements, credit growth and infrastructure spending.

At some point during a country’s development, however, production costs begin to rise faster than the rate of productivity growth. This is known as a Lewis Turning Point, named after economist Sir Arthur Lewis. Rapidly accumulating production factors become counter-productive and from that point forward, efficiency and productivity become the drivers of economic growth.42

16



China’s next

phase: Shift

from investment

to consumption.

China may already have reached such a turning point. Workers are demanding higher wages and better workplace conditions, suggesting China’s supply of virtually unlimited migrant labor may be nearing or at an end due to a diminishing supply of young or skilled agricultural workers. Social pressures are rising as China’s burgeoning middle class is demanding that more attention be paid to environmental issues, such as addressing air and water pollution and food quality concerns.

If this is the case, according to the Lewis Turning Point, the primary driver of economic growth in China’s transition to “economic adulthood” shifts from investment and rapid accumulation of capital to consumption and more productive use of capital. Policies in support of China’s future growth may likely be in contrast (in some cases, sharp contrast) to those that supported the country’s old normal phase, such as:

• Higher wages paid to urban workers and higher real interest rates paid on domestic savings in order to boost household financial income and increase consumer spending

• Deregulating production factors (natural resources, land, electricity) and broadening access to capital for smaller public and private companies, which generate higher return on assets than SOEs in order to drive competition and increase efficiency and productivity

• Hukou reform, which would provide subsidized housing to migrant workers and expanded access to social services in order to spur greater consumption of urban goods and services

Ind

ex le

vel (

T=

100)

Taiwan (T=1965) China (T=1990)

Consumption share of GDP per capita

50

60

70

80

90

100

110

0 5 10 15 20 25 Years after T

Source: Feenstra, Robert C., Robert Inklaar and Marcel P. Timmer (2013), “The Next Generation of the Penn World Table,” available for download at www.ggdc.net/pwt.


China’s next

phase of

economic

adulthood

may see a

deceleration

in the level

of economic

growth.

This is not to suggest that China’s urbanization and industrialization has completely run its course. China still has 45 percent of its population living in rural areas, in contrast to other emerging market nations such as Brazil (15 percent) and South Korea (18 percent).43 China still has significant needs for additional urban housing (particularly low-cost housing for migrant workers) and for continued infrastructure development.

However, China’s next phase of economic adulthood may see a marked deceleration in the absolute level of economic growth if the deceleration in capital spending growth is faster than the acceleration in the growth in the private and household sectors.

Thus, more balanced policies emphasizing efficiency and productivity may influence investment focus from the absolute rate of GDP growth to the sources of that growth. We believe the sources may include:

• Higher real interest rates, more market-determined prices of production factors and broader access to financing, which should increase private sector competition for SOEs

• Increased private sector competition, which may lead to reforms of SOEs, unlocking the potential for significant productivity gains

• Relaxation of capital controls, which may allow for greater market determination of currency exchange rates and expanding offshore (dim sum) bond market, enabling the renminbi to potentially become more active in international trade

• Increasing use of China’s renminbi in international trade could boost intra-regional infrastructure investment across Southeast Asia, potentially benefiting Chinese exports of higher-value-added heavy machinery and technology, and spurring the economic development of its trade partners.44

18



China’s renminbi

jumps ahead of

15 currencies to

achieve top-five

payment status.

World payments currency in value

January 2012 December 2014

1. Euro 44.04% 1. U.S. dollar 44.64%

2. U.S. dollar 29.73% 2. Euro 28.30%

3. British pound 9.00% 3. British pound 7.92%

4. Japanese yen 2.48% 4. Japanese yen 2.69%

5. Australian dollar 2.08% 5. Chinese yuan renminbi 2.17%

6. Canadian dollar 1.81% 6. Canadian dollar 1.92%

7. Swiss franc 1.36% 7. Australian dollar 1.79%

8. Swedish krona 1.06% 8. Swiss franc 1.39%

9. Singapore dollar 1.03% 9. Hong Kong dollar 1.27%

10. Hong Kong dollar 0.95% 10. Singapore dollar 0.90%

11. Norwegian krona 0.93% 11. Thai baht 0.88%

12. Thai baht 0.82% 12. Swedish krona 0.78%

13. Danish krone 0.54% 13. Norwegian krona 0.72%

14. Russian ruble 0.52% 14. Polish zloty 0.56%

15. South African rand 0.48% 15. South African rand 0.45%

16. Hungarian forint 0.34% 16. Danish krone 0.40%

17. New Zealand dollar 0.33% 17. New Zealand dollar 0.39%

18. Mexican peso 0.31% 18. Mexican peso 0.39%

19. Turkish lira 0.27% 19. Russian ruble 0.36%

20. Chinese yuan renminbi 0.25% 20. Turkish lira 0.32%

Source: SWIFT Watch. January 2015 report.

Japan, South Korea and Taiwan are East Asian economies that pursued a similar, two-stage economic development strategy. The first stage of rapid growth and productivity gains coincided with strict capital controls and a tightly managed exchange rate. Economic growth soared, but equity market performance lagged. In the second stage, capital controls were loosened and exchange rates became more market determined. While past performance is not a guarantee of future results, in all three cases strong equity market performance coincided with financial liberalization, even though economic growth as measured by GDP decelerated.45

Finally, an economically adult China would likely be more active geo-economically and geopolitically. China’s “New Silk Road” initiatives envision the construction of a Eurasian land bridge (the “Silk Road Economic Belt”) and a series of ports across the Indian Ocean (the “21st Century Maritime Silk Road”), financing infrastructure such as roads, railways


An economically

“adult” China

would likely be

more active

geopolitically.

and ports to further trade growth and investment opportunities for Chinese companies.46 The new Asian Infrastructure Investment Bank (AIIB), backed by China and signed on by 32 other nations spanning Europe, Asia and the Middle East, provides up to $100 billion for infrastructure investment as an alternative to Western-oriented institutions such as The World Bank and the International Monetary Fund (IMF). Politically, recent events such as establishing an East China Sea Air Defense Identification Zone, positioning an oil rig in disputed waters near Vietnam and disputing who owns the Senkaku/Diaoyu islands with Japan may be seen as indications of an increasingly active and adult China.

Potential beneficiaries: • Chinese household income, spending and investment

• Smaller public and private Chinese companies that compete with SOEs

• Chinese exports of higher-value-added heavy machinery and technology

• Subsidized housing construction

• Urban spending on goods and services

• Southeast Asian economies that stand to benefit from additional source of trade finance (renminbi) and Chinese investment


• Providers of goods and services that benefit from increased income and spending among Chinese households

• Small- and medium-sized public and private companies based in China

• Heavy equipment and technology companies based in China

• Offshore renminbi (dim sum) government bonds

Potential risks to outlook:

• China’s new leadership slows or reverses reforms

• Social unrest results in a political crackdown

• Development of an offshore (dim sum) bond market fails to materialize

• Costs of hukou reform (providing migrant workers with social services) proves too fiscally expensive

• Escalation in regional political tensions with Japan, Korea or Southeast Asian nations disrupts intra-regional trade and development

20



The combination

of urbanization

and rising

employment

in emerging

economies has

led to rising

standards of

living.

Investment Theme #3 — The rising global middle class

Overview

The emerging market consumer has truly started to take shape and this may have a significant impact on investors and businesses in the coming years.

Consumer spending in emerging market economies has now surpassed that in the United States and is likely to accelerate in the decades ahead, led by growth in Asia.47 There are a number of drivers behind this development: political, technological, economic and social.

While the last decade has seen a significant increase in the size of the global middle class, the trend is far from over. We believe these changes may make it possible for billions of people in emerging market economies to rise out of poverty and join the middle class in the decade ahead. And as incomes in these countries continue to rise, spending will become increasingly discretionary and directed toward personal and other household goods and services.

However, domestic consumption patterns are influenced by other factors beyond economic growth. We believe it is important to consider the policies and population characteristics of individual countries as their economies tend to develop at different rates.

Key points

The megatrends of the last 25 years (political, economic and technological transformation of the world) have given rise to a global economy with billions of new workers, consumers, producers and savers. Manufacturing industries have moved from advanced economies to the developing world, helping to create more than 575 million jobs worldwide since 2000.48

The combination of urbanization and rising employment in emerging economies has led to an increase in the standard of living. In East and Southeast Asia, 400 million workers have risen above the poverty level (defined as earning $2 or less per day) since 2000.49

The term “middle class” can be loosely applied to individuals who can enjoy stable housing, healthcare and educational opportunities (including college) for their children, reasonable retirement and job security, and discretionary income that can be spent on vacation and leisure pursuits.50 Consumption of discretionary goods and services, product differentiation, name brands and status goods are important features of a middle class.

The rise of the global middle class has occurred rapidly. Since 1999, household spending in emerging market economies has quadrupled, surpassing U.S. consumer spending in 2008.51 The acceleration of consumer spending in emerging market economies is likely to continue for decades, led by growth in Asia. Currently home to 60 percent of the world’s population, Asia’s middle class population is projected to exceed 3.2 billion by 2030.52


in m

illio

ns

Middle class population by selected region

338 333 322 664 703 680 525

1,740

3,228

0

500

1,000

1,500

2,000

2,500

3,000

3,500

2009 2020* 2030*

North America Europe Asia

Source: Kharas, Homri, “The Middle Class in Developing Countries,” OECD Development Centre Working Paper No. 285, OECD 2010. *2020 and 2030 projections.

The rise in spending by emerging market consumers is an outgrowth of increasing income levels and access to consumer credit. Per capita Gross Domestic Product (GDP) is often used as a measure of national wealth. In 2000, nearly three-fourths of the world’s population, almost six billion people, lived in countries with GDP per capita below $5,000. Since 2000, countries representing more than one-half of the world’s population, more than four billion people, saw national incomes rise above $5,000 per capita.53 This represents the first stage (or emergence) in the evolution of the global middle class.

GD

P p

er c

apit

a

Durab

le go

od

s ow

nership p

er100 urb

an househo

lds

China per capita GDP and ownership of selected durable goods

$15,000

$10,000

$5,000

$0

150

100

50

019951990 2000 2005 2010 2011 2012

Air conditioner Computer Automobile

Sources: International Monetary Fund, World Economic Outlook Database, October 2014; China Statistical Yearbook 2014, National Bureau of Statistics of China. GDP Per Capita in Purchasing Power Parity (PPP).

By 2020, Asia

is projected to

be home to a

majority of the

world’s middle

class.

22



THE “ACCELERATION EFFECT”

A prime example of this can be found in the evolution of air conditioner sales in China. In the 1990s, air conditioners were considered a discretionary “white good” consumer item. In 1990, China’s GDP per capita was around $950. Fewer than one-half of 1 percent of urban households in China owned an air conditioner. From 1990-1995, China’s GDP per capita nearly doubled to $1,800. Ownership of air conditioners grew to 8 percent of urban households, an increase of nearly seven and one-half units for every 100 urban households. In the next five years, from 1995 to 2000, per capita GDP rose to $2,800. Ownership of air conditioners accelerated to 31 percent of urban households, an increase of 23 units for every 100 households. Finally, in the five-year period from 2000 to 2005, China’s per capita GDP reached nearly $5,000. Purchases of air conditioners continued to accelerate, with ownership rising to 81 percent, an increase of nearly 50 units for every 100 households.57

In this example, during the 15-year period of 1990-2005, penetration of air conditioners

Per capita GDP below $2,500 limits consumer spending to only the basic needs (food, clothing and shelter), certain “white goods” (major appliances such as washing machines and refrigerators) and color televisions. Per capita GDP of greater than $2,500 is associated with increasing levels of discretionary spending beyond basic goods toward personal and other household goods and services, accelerating as per capita GDP rises above $5,000.54 Today, more than half of the world’s population, four billion people, live in countries with national incomes between $5,000 and $15,000 per capita.55 This represents the second stage (or acceleration) of the global middle class.

Notably, consumer spending on goods and services in emerging economies typically does not exhibit a linear growth pattern. A key moment for consumer products occurs when the majority of a country’s population can afford the goods or service. At that moment, consumption of those products rapidly accelerates.56

Rising national incomes are associated with increasing levels of discretionary consumer spending

Current GDP/Capita < $5,000 $5,000 - $10,000 $10,000 - $15,000

Selectedcountries

Income status Low income Lower-middle income Upper-middle income

BangladeshKenya

PakistanMyanmar

IndiaNigeria

PhilippinesVietnam

4 billion

ChinaColombiaIndonesiaThailand

Total worldpopulation 1.2 billion 1.8 billion 2.1 billion

Representative consumer goods/services

Color TVs, refrigerators,

washing machines

Air conditioners, microwave ovens,

mobile phones

Automobiles, cosmetics, dishwashers,

game consoles, tourism

Source: International Monetary Fund, World Economic Outlook Database, October 2014. GDP Per Capita in Purchasing Power Parity (PPP), 2014 estimate. Population estimate as of 2014.

China is already the world’s largest market for automobiles, with sales having surpassed the United States in 2009 and Europe in 2010.59 Yet, as of 2012, less than one-quarter of urban households owned an automobile.60 With China’s per capita GDP expected to reach $15,000 by 2016, automobile sales should continue to accelerate and may likely surpass those in the United States and Europe combined in the decade ahead.

(continued on next page)


in China’s urban households rose from less than one-half of 1 percent to more than 80 percent. However, the rise was not linear. Rather, consumption accelerated as China’s per capita GDP rose beyond $2,500, the dividing line between spending only on basic needs or expanding spending to include more discretionary items. In the case of air conditioners in China’s urban households, consumption accelerated from seven and one-half units per 100 households in the first five-year period to 23 units in the second five-year period to 50 units in the third five-year period.

Notably, this “acceleration effect” in consumer spending occurs at different income levels for different consumer products and services. In China, washing machines, color TVs and refrigerators were the first to reach 40 percent penetration of urban households.58 Later, as national income rose, household consumption shifted to other major appliances such as air conditioners and water heaters, along with personal goods such as mobile phones. Most recently, consumption has accelerated for goods such as computers and microwave ovens and leisure services such as domestic and international travel.

Ann

ual a

uto

sal

esin

mill

ions

China is the world’s largest car buyer

24

5

8

10

13

15

18

20

23

25

2006 2007 2008 2009 2010 2011 2012 2013 2014

Europe United States China

Source: Bloomberg. Data as of 2014. U.S. = Auto vehicles all sales not seasonally adjusted; Europe = Vehicle sales; China = Total automobile sales

With the potential for billions more to rise out of poverty and join the middle class, consumer spending in emerging economies may potentially become increasingly directed toward personal and household goods and services and other items a middle class society demands: quality housing, educational opportunities for children and, as we are already witnessing in China, a greater focus on environmental issues such as addressing air and water pollution and food quality concerns.

Household consumption patterns in economies are heavily influenced by factors beyond growth in GDP per capita, however. Two serious considerations are income inequality (how broadly economic growth benefits the total population) and household indebtedness (current level of debt and overall access to credit).

Potential beneficiaries: • Multinational corporations domiciled in developed economies that provide goods, services, technology and infrastructure consistent with the consumption patterns in emerging economies as income levels rise

• Local affiliates of multinational corporations that trade on local exchanges

• Locally based providers of consumer goods and services in emerging market economies

24



The world’s

population is

aging, with

population growth

increasingly

occurring among

older age groups.


• Global and local consumer product and service companies at various stages of a country’s economic development and income thresholds (basic goods, discretionary household and personal goods, services, luxury goods)


• An overall global economic slowdown

• A rise in protectionism that slows down or reverses growth in global trade

• A regional or global conflict or pandemic that inhibits development of emerging market economies

• Policies in individual countries that hamper economic development and growth

• Rising interest rates or increasing lending restrictions that inhibit growth in consumer credit

Theme #4 — The aging of the world’s population

Overview

Two long-term, powerful demographic forces are colliding. First, the oldest members of the post-war generation (baby boomers) in the United States and Europe began turning 65 in 2011. Second, life expectancies are increasing and birth rates are falling in high-population emerging market countries as their populations rise above poverty and more residents attain middle class status. As a result, global population growth is slowing, with growth increasingly concentrated among older age groups.

Population dynamics are causing a divergence in age structures between developed and emerging market economies. The United States, Europe and Japan are experiencing a demographic “tax,” while emerging markets are enjoying a demographic “dividend.”

One of the likely consequences of an aging global population is that healthcare and other entitlement spending will consume more economic resources for all countries, potentially generating significant strains on government finances.

Also, aging developed economies are likely to see an increase in the age that people retire, either through workers voluntarily working into later years or because of mandatory increases in the age when retirement benefits become available. An older workforce will likely exhibit consumption patterns related to the effects of aging, such as demand for particular goods, services and specific types of real estate.


Although still on

the rise, the rate

of global growth

has leveled off.

Key points

Although still on the rise, the rate of global population growth has leveled off. In 1972, average annual world population growth was 2 percent. By 1992 it had slowed to just above 1.5 percent per year. In 2012, it was less than 1.25 percent.61 In the 20th century, world population doubled nearly twice, rising from an estimated 1.6 billion in 1900 to more than 6 billion in 2000. If current projections for future population growth are accurate, the world’s population won’t double even once in the 21st century.62

Studies suggest that economic developments such as urbanization and rising levels of education, employment and household incomes may correlate to declining birth rates.63

In a rural economy, children are a source of income. They provide additional labor for a family, and a large family can provide greater support for parents in their old age. In an urban economy, however, there are few employment opportunities for young children. Rather, children need to be supported by their parents into later years, even into their twenties, and the costs of housing and educating urban children are significant. As societies urbanize, children go from being a productive asset to a “liability.” Though incomes and standards of living may rise as an economy urbanizes, families may have fewer children out of economic necessity.

Declining birth rates are reflected in the changing composition of the world’s population. In the last 15 years, the number of children under 14 years of age has increased by only 10 million, barely enough to keep up with infant and child mortality rates (which are also declining) and to replace those who have grown to older age groups.64

Meanwhile, over that same 15-year period, the world population aged 65 and over increased by more than 150 million. Europe and Japan are now home to more people 65 and older than children under the age of 14. And this was occurring just as the first of the baby boom generation in the United States and Europe began reaching what is considered the traditional retirement age of 65. There are now more than 900 million people in the world between the age of 50 and 64.65 Or, as the headline of a recent issue of The Economist proclaimed, there are now nearly “A Billion Shades of Grey.”66

26



Where have all

the children

gone?In

mill

ions

15-year growth of world population by selected age groups

Children Householdformation

Peakearnings

“Boomers” Pensioners

10

339 367

304

154

0

50

100

150

200

250

300

350

400

0-14 15-34 35-49 50-64 65+

Source: UNData. Data as of 2009.

Increasingly, population growth rates are becoming skewed, with the fastest growth occurring on the older side as life expectancies continue to increase. The fastest growing age group in the world is 70 and above.67

We believe these demographic trends have two potentially significant implications for long-term investors in the decade ahead:

• Diverging age structures between the developed economies of the United States, Europe and Japan and those in emerging economies

• Healthcare spending, entitlements and government finances, retirement age and increased life expectancy beyond retirement, and consumption patterns that correspond to an aging population

Population dynamics are important factors affecting economic growth, household consumption patterns and inter-generational transfers of resources. The 15-64 age group typically forms the labor force, a key building block for economic growth and the primary source of tax revenues to fund entitlement programs for retirees. By examining the growth trends of this age group, the fiscal challenges facing Japan and Europe can be seen more clearly: Japan’s 15-64 population peaked in 1995 and has declined every year since, while annual growth in Europe’s working-age population slowed to zero in 2010.68

Within the adult labor force (ages 15-64), there are two key subgroups:

• The 20-34 age group, which represents peak household formation ages

• The 35-54 age group, which represents peak earning ages, generating the greatest surplus of production relative to consumption


Will China follow

Taiwan and

South Korea to

wealthy nation

status?

Thus, the potential for a positive demographic influence is related to a positive long-term change in age structures within an economy. Due to a decline in birth rates, there is an initial transitional period of slow growth (or decline) in the number of children and relatively rapid growth of youth and middle-age adults.69

This period, called a “demographic window,” is defined by positive growth in the number of working-age adults (“workers”) relative to children and the elderly (“consumers”).70 Positive growth generates surplus resources, a demographic dividend that can be used to increase current consumption or to invest in future productivity and help boost the standard of living.71 When a positive demographic dividend is combined with access to education, employment opportunities, policies to reduce inequalities of income, and investment in technological and social infrastructure, the result is often a rise in wages, living standards, household consumption and economic growth.

Today, emerging market economies are enjoying a positive demographic dividend, though many have passed peak years and the positive contribution to economic growth from changing age structure is already in decline.72

In p

urch

asin

g p

ow

er p

arit

y

GDP per capita of selected countries

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

1961 1966 1971 1976 1981 1986 1991 1996 2001 2006

Which trend will China follow?

2011

Taiwan South Korea China (1984-2011)

Source: Feenstra, Robert C., Robert Inklaar and Marcel P. Timmer (2013), “The Next Generation of the Penn World Table,” available for download at www.ggdc.net/pwt.

28



ECONOMIC GROWTH GOES BEYOND POSITIVE DEMOGRAPHICS

A positive demographic

“dividend” in and of itself is not

a guarantee of future economic

success. Without necessary

investments and policies, the

positive growth in the number of

young adults relative to children

and elderly may instead lead to

increasing youth unemployment,

rising social disorder and

stagnant economic growth.

South Korea and Taiwan offer

two historical examples of

countries that successfully took

advantage of a past positive

demographic “dividend” (both

are in decline now) through

policies and investments that led

to decades of strong economic

growth and achievement of high-

income status. They became

the only countries in “recorded

human history” to achieve five

consecutive decades of greater

than 5 percent annual economic

growth.73 Today, more than 94

percent of South Koreans are

considered to be part of the

middle class or above.74 The

decade ahead may see further

differentiation among emerging

market economies due to

diverging policies, investment,

and distribution of resources.

In contrast to emerging economies, the developed economies of the United States, Europe and Japan are experiencing a negative demographic trend, what could be referred to as a demographic “tax” on economic growth.

This period is defined by a decline in the number of working-age adults relative to children and the elderly due to an aging population and low birth rates. This deficit of production versus consumption (such as financing retirement and healthcare benefits for retirees) creates a negative demographic drag on economic growth, all other things being equal.

As examples:

• The growth rate of 35- to 54-year-olds (peak earnings ages) has slowed to zero in the United States, Europe and Japan

• Europe and Japan are home to more people over the age of 64 than children under the age of 14

• In Japan, the population of the 15-64 age group (the labor force) has declined for 15 consecutive years75

As a result, the emerging market economies are expected to continue to reap the rewards of a demographic dividend in the form of increases in labor forces, living standards, household consumption and resulting economic growth. Meanwhile, much of the developed world will continue to experience the potentially painful effects of a demographic tax, which include strains on government finances from entitlement spending and sluggish economic growth (or contraction) due to slower growth, or even an outright decline in the labor force.

Po

pul

atio

n (in

mill

ions

)

Emerging market countries are enjoying a demographic “dividend”

24 27 27

29 31

37 38

40 46 46

20

25

30

35

40

45

50

0

200

PhilippinesIndia

MexicoIndonesia

BrazilChina

United StatesKorea

GermanyJapan

400

600

800

1000

1200

1400

1600

Med

ian age (in years)

Source: CIA, The World Factbook. Estimates as of 2014.

(continued on next page)


Investors need to consider that the fundamental drivers of the economies of high-population, consumer-oriented countries such as Turkey, Indonesia and the Philippines will be significantly different from the drivers of export-oriented economies such as Malaysia, Taiwan and Thailand. Like South Korea and Taiwan before it, China appears to have reached a turning point in policy choices even as it faces its own rapidly aging population due to its past one-child policy and the decline in birth rates due to urbanization and rising incomes. As Sri Lanka looks to leverage and invest a “peace dividend” resulting from the end of its civil war, it may have more in common with Colombia, a country that waged its own internal war, than with other East Asia neighbors such as Bangladesh or Pakistan. Poland does not share the common euro currency but enjoys significant trade benefits from being part of the European Union and is home to Europe’s largest shale gas reserves. Finally, the landslide election in India, giving the opposition Bharatiya Janata Party and Prime Minister Narendra Modi the first pure majority in India since 1984, may be the catalyst for the world’s largest democracy to implement structural reforms enabling faster growth and lower inflation as India looks to catch up

to the other Asian “tigers.”

A second important implication of global demographic trends relates to healthcare spending, entitlements and government finances, retirement age and increased life expectancy after retirement, and consumption patterns that correspond to an aging population. As the world’s population continues to age, healthcare spending will consume greater economic resources for all countries, particularly in developed economies. By 2040, the 65 and older population is expected to make up 25 percent of Europe’s population and 20 percent of the populations of both the United States and China. Healthcare spending as a percentage of GDP is projected to double in the United States to more than 30 percent in the next 30 years. Brazil, China, Russia and India will likely not be far behind.76

Per

cap

ita

heal

thca

re e

xpen

dit

ures

Healthcare expenditures consume greater economic resources in aging populationsOld-age dependency ratio and per capita healthcare expenditures for selected countries

Philippines

India

Mexico Indonesia

Brazil China

United States

Korea

Germany

Japan

Nigeria

U.K. Italy

France

$0

$2,000

$4,000

$6,000

$8,000

$10,000

0 5 10 15 20 25 30 35 40

Old-age dependency ratio

Canada

Sources: World Health Organization; UNData. Healthcare expenditures as of 2012. Old-age dependency ratio as of 2010. Healthcare expenditures in Purchasing Power Parity

(PPP). Old-age dependency ratio = population age 65 and older per 100 working-age population (age 15-64).

Entitlements will continue to strain government finances in developed economies that are experiencing a demographic tax. In the United States, Social Security and Medicare are the two largest federal programs, accounting for 47 percent of total federal outlays in 2014.77 Enrollment in Medicare is projected to rise from nearly 48 million in 2010 to more than 81 million by 2030.78 Across all developed economies, life expectancy after pensionable age has increased by nearly 50 percent, from 13½ years in 1958 to 18 years in 2010.79

To resolve these challenges, developed countries are likely to see an increase in retirement age, with aging members of the labor force voluntarily working into later years and through increases in the mandatory retirement age. In the United States, the increase in labor force participation by older workers has been credited to a need for continued access to employment-based health

30



insurance and for more years of earnings to accumulate savings in 401(k)-type retirement plans.80 While Japan’s working age (15-64) population declined by 6 percent, or 4.8 million, from 2000-2010, Japan’s labor force declined by only 2 percent as more women and older citizens entered or remained in the work force.81 Australia, the Czech Republic, Denmark, Germany, Greece, Hungary, Italy, South Korea, Spain and the United Kingdom have all instituted increases in retirement ages to take effect between 2010 and 2050.82

Finally, aging populations in developed economies, urbanization and rising life expectancies in emerging economies are presenting another healthcare challenge. Non-communicable diseases (NCDs), attributable to increased longevity and urban lifestyles, are now the leading cause of death in the world. These diseases include diabetes, cancer, and heart disease and were responsible for 63 percent of all global deaths in 2008. The healthcare cost for treating this “invisible epidemic” is estimated to be $30 trillion dollars over the next two decades.83

For investors, an aging population and an older workforce may be expected to consume goods and services that address the effects of aging, such as cosmetics and regenerative/ rejuvenating products, services and procedures. Financial services for an aging population would address increased life expectancy after retirement. Investments in infrastructure would be needed to support an aging population, with urban real estate possibly in greater demand, particularly in the United States, as an older workforce may desire to be physically closer to employment, shopping and medical care.

Potential beneficiaries: • Emerging market economies, particularly those pursuing policies and investments intended to harvest a current demographic dividend for long-term economic growth

• Healthcare spending, both in developed as well as emerging economies

• Spending on consumer products and services that address the effects of aging and increased life expectancy

• Infrastructure investments in support of an aging population

• Urban real estate (commercial, retail, residential), particularly in the United States


• Individual emerging market economies

• Healthcare related to aging and increased life expectancy

• Consumer products and services that address the effects of aging (cosmetics, rejuvenation, lifestyle)

• Life insurance

• Infrastructure necessary to support an aging population

• Urban real estate

An aging

population and

older workforce

may create

challenges.


A reversal of

suburban sprawl

and a return to

urbanization

may have

significant

implications for

investors.


• A pandemic or global conflict that suddenly shifts global demographics

• A shift in immigration policies in advanced economies (that leads to a migration of population from developing economies to advanced economies)

• Another baby boom in advanced economies

Theme #5 — Re-urbanization of America

Overview

Significant changes are taking place in American society. For the first time in decades, city populations in major U.S. metropolitan areas are growing faster than their respective suburban populations. Driving this development is a combination of social, technological, demographic and economic forces.

In the post-World War II era, cheap gasoline and affordable housing led to suburban sprawl. Today, volatile energy prices and longer commute times have made suburban living seem less attractive than urban living. Technological advancements such as online access to education, entertainment and shopping may also be reducing the perceived advantages of suburban living.

In addition, the social preferences exhibited by the millennial generation as they reach family formation ages appear significantly different from those of previous generations.

A reversal of suburban sprawl and a return to urbanization may have significant implications for real estate trends in residential, office and retail dynamics.

Key points

After World War II, the combination of low gasoline prices and affordable single-family homes and automobiles led to rapid suburbanization in the United States. As the baby boom generation reached family formation ages, they exhibited a preference for single-family homes on relatively large suburban lots in communities that were deemed to have good educational opportunities for their children. According to one measure, by 2010 more than one-half of the U.S. population lived in suburbs.84

Businesses followed this migration, with suburbs gaining a greater share of retail and office space. In the 22-year period from 1955 to 1977, an estimated 15,000 regional shopping centers were built in the United States, all of which were located in the suburbs. Downtown areas experienced a regional office space decline from 70 percent in 1970 to 30 percent by

32



2000, and as of 2009, 45 percent of employees in the top 98 metropolitan areas worked at least 10 miles away from historic city centers.85 Urban centers were often defined by single-use office buildings (empty after dark), falling real estate values, declining populations and rising crime.

However, beginning in 2011, city population in major metropolitan areas (defined as having greater than one million in population) grew faster than their respective combined suburban population for the first time since the 1920s, reversing a 90-year trend of suburbanization.86 A combination of social, technological, demographic and economic forces are likely behind this development.

Population growth of major U.S. metropolitan areas

0.4%

1.1%

1.4%

0.9%

0%

0.5%

1.0%

1.5%

2000-2010

Ann

ualiz

ed

July 2010-July 2011

Primary city Suburb

Source: Frey, William H., “Demographic Reversal: Cities Thrive, Suburbs Suffer,” The Brookings Institution, June 29, 2011. U.S. metropolitan areas with population greater than one million.

Today, nearly 200 of the Fortune 500 companies are headquartered in the 50 largest metropolitan areas. An increase in the pool of educated, skilled workers in urban areas is creating a powerful incentive for firms to locate or relocate to metropolitan centers, creating a virtuous circle of available employers and workers. Increasingly, businesses are finding potential employees and consumers in higher-density urban centers, and workers and consumers are increasingly finding employment opportunities and access to desired amenities there as well.87 Population density in urban centers is far greater than in suburbs, creating a potential “critical mass where inventors, entrepreneurs, investors, talented workers and customers intermingle to create opportunity and growth.”88

Rising energy prices and lengthening commutes have made suburban living less attractive relative to urban living. From 2001 to 2012, gasoline prices increased more than two and a half times greater than the overall rate of inflation.89 And since 1990, the average round-trip

City populations

are now growing

faster than

their respective

suburbs.


Suburban sprawl

appears to have

reached an

outer limit.

commute time has risen by more than seven minutes per day.90 Due to decades of negative transportation “productivity” (higher costs and longer commuting times), suburban sprawl may have reached its outer limit. Total vehicle miles driven per person in the United States peaked in 2004, suggesting that we may have already reached that inflection point.91

Total U.S. vehicle miles driven per capita

5,000 1970 1974 1980 1984 1988 1992 1996 2000 2004 2008 2014

6,000

7,000

8,000

9,000

10,000

11,000

In m

iles

Source: Bloomberg. Population = U.S. Census Bureau, 2014 estimate; Total vehicle miles driven = Federal Highway Admiration data; 2014 = Trailing 12 months

Technological advancements have influenced daily lifestyles, facilitating online access to education, entertainment and shopping (Internet powerhouse Amazon.com as a competitor to strip malls), further reducing the advantages of suburban living. Already, nearly 13 million people in the United States live in so-called “live-work” environments, defined as being within one mile of a major employment center.92

Demographic and social forces in the United States also look positive for urbanization trends. The increasingly empty nest baby boom generation and coming of age millennial generations are equal in size, each representing 77 million in population and together amount to one-half of the total population of the United States.93

On the one hand, the leading edge of the baby boom generation in the United States is beginning to leave the work force. As empty nesters, both retiring and even still working boomers may be looking to downsize from relatively large suburban homes in order to reduce both the cost and effort of upkeep.

At the same time, the millennial generation is continuing a decades-long upward trend in ages of first marriage and first-child birth. The median age of first marriage in the United States stands at more than age 28 for men and 26 for women.94 Meanwhile, the median age of women giving birth to their first child has also continued to rise to nearly 28.95

34



Millennials are

continuing the

trend of waiting

longer to get

married.

U.S. median age of first marriage

23 23

25

26 27

28

20 21

22

24

25

26

20

22

24

26

28

30

1960 1970 1980 1990 2000 2010

In y

ears

Men Women

Source: U.S. Census Bureau, U.S. Department of Commerce.

Urban centers may prove to be more attractive than suburban living for single young adults, young married couples without children and baby boomers (both retired and still employed) who do not require access to primary or secondary education for their children and desire to be closer to work, shopping and other amenities. Social preferences exhibited by the millennial generation as they reach family formation age appear significantly different from those of previous generations. More than any other generation, millennials appear to value access to public transportation, desire short distances or walking distance to school or work and residing in large urban areas or urban-like areas in high-population suburbs.96

Desired attributes of community by U.S. generation

22

67

50

23

71

45

40

82

57

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Medium/big city

Distance fromwork/school

Publictransportation

Percent responding

Millennials Gen X Boomers

Source: Belden, Russonello Strategists, LLC, “Americans’ Views on their Communities, Housing and Transportation,” Analysis of a national survey of 1,202 adults, for the Urban Land Institute, March 2013.


U.S. housing

trends may be

reflecting social

preferences for

urban living.

This preference for living in closer-knit urban and urban-like areas in high-population suburbs can already be seen in the housing data. The homeownership rate in the United States peaked at 69 percent in 2006 but fell to a twenty-year low of 64 percent in 2014. From 1991 to 2010, single-family housing starts averaged approximately 80 percent of all housing starts in the United States, while structures of five or more units accounted for fewer than 20 percent of housing starts. Since 2010, housing starts for structures with five or more units have increased to nearly one-third of all housing starts, reaching 35 percent in 2014.97

Percentage of annual U.S. housing permits by housing type

0%

1984 1986 1988 1990 1992 1994 1998 2000 2002 2004 2006 2008 2010 2012 2014

20%

40%

60%

80%

100%

Single unit 5+ units

Sources: U.S. Census Bureau, U.S. Department of Commerce.

Millennials’ views on housing and homeownership were very likely shaped by the sharp drop in home prices from 2007-2011. Unlike previous generations, a significant percentage of millennials surveyed, 40 percent, believe that buying a home is no longer an excellent long-term investment. And nearly two-thirds (62 percent) believe that it is less likely today than 20 to 30 years ago to build equity and wealth through homeownership.98

Meanwhile, U.S. cities have been actively improving economic and cultural diversity to attract and retain young adults, families, professionals and aging empty nest baby boomers. As a result, businesses are following this migration back to urban cores. Urban land use is increasingly diversifying away from single-use offices that are empty after dark to include arts and sports, hospitality and leisure, shopping and dining, and educational and medical research and facilities.99

A reversal of suburban sprawl and a return to urbanization has significant implications, most notably for real estate investors looking for positive trends in residential, office and retail dynamics. A reversal of the 90-year trend of suburbanization may be disruptive to the supply and demand balance for housing. As the aging, 77-million-strong baby boomer generation

36



looks to sell single-family homes in sprawling suburban communities, they may find that natural potential buyers, the also 77-million-strong millennial generation, are more interested in living in higher-density urban and urban-like high-population suburban centers. This may result in an increase in volatility and variability of home prices due to an imbalance of current and future demand in the existing supply of homes.

Potential beneficiaries: • Cities able to attract urban residents with diverse employment opportunities, education and cultural amenities (dining, shopping, arts and sports, hospitality and leisure)

• Urban residential and commercial (retail, office) real estate (both existing and new construction)

• Urban infrastructure spending (public transportation, walkways/ bike paths, technology, utilities)

• Consumer spending in urban areas


• Urban real estate (residential, office, retail, mixed-use)

• Firms that provide goods and services specific to urban residents (education, shopping and dining, hospitality and leisure)

• Firms that specialize in design and construction of urban structures (smaller shopping stores, mixed-use buildings)

• Firms that specialize in multifamily or “right-sized” single-family home design and construction


• Rapid, long-term drop in gasoline prices (below the rate of overall inflation or wages) that increases competitiveness of suburban versus urban living

• Investments in transportation infrastructure (highways, mass transit) that significantly reduces commute times from the suburbs

• Price inflation in urban real estate (above the rate of overall inflation or wages) that crowds out prospective urban residents (young single adults, young married adults without children, empty nest baby boomers)

• Lack of investment/development or poor planning in urban areas that fails to meet the needs of employers and residents

• Competitive tax policies that encourage prospective employers to locate/move back to the suburbs

• Rising crime in urban areas

Millennials

exhibit a greater

desire for

urban living

than previous

generations.


Theme #6 – Robotics: A Post-Industrial Revolution

Overview

A combination of technological advancements (increased capabilities and lower costs) with economic and demographic trends is leading to rapid adoption of robotics beyond automotive assembly and other industrial applications to include a wide variety of industries and sectors. This may have far-reaching implications for businesses, economies, individuals, and investors.

With global labor costs converging, investments in robotics and autonomous systems (RAS) technology are increasingly viewed by the major industrial economies as a strategic initiative for economic growth in a global manufacturing “arms race.” RAS technology addresses some of the challenges of aging populations, slowing labor force growth and shortage of workers in key industries and services. Technological advancements and declining costs are accelerating adoption of RAS solutions in diverse industries such as aerospace, agriculture, defense, healthcare and personal services. Finally, RAS technology has the potential to provide significant improvements in healthcare access, affordability and quality, enabling greater mobility, quality of life and life expectancy.

Key Points

Industrial robots have been in use for more than 50 years. They were initially employed in tasks that were highly repetitive (such as welding, soldering and painting), required extreme precision (such as semiconductor fabrication) or dangerous (requiring “superhuman” speed and strength, such as material handling and assembly). The automotive sector remains the largest consumer of industrial robots today, accounting for 39 percent of installed systems.100

Today, RAS is moving beyond fixed automation. Advancements in software, hardware and sensor technology are enabling a new era that takes machines from automatic to autonomous.101 RAS is seen as “interactive, cognitive tools, able to variously perceive their environments, reason about events, make or revise plans and control their actions.”102

Three characteristics that define an RAS are:

• Actuation (hardware) – the ability to move both itself as well as other things

• Perception (scanners, sensors, and cameras) – the collection of data from the immediate environment

• Artificial intelligence (software) – the ability to process information, mediate between various sensory inputs, control motion, plan action and interface with people103

The rapid

adoption

of robotics

may have

far-reaching

implications.

38



The world’s

major industrial

economies

are making

investments in

RAS technology.

A McKinsey Global Institute research report estimated the global economic impact of advanced robotic applications to be between $1.7 trillion and $4.5 trillion annually by 2025, with a majority of the impact due to improving and extending people’s lives.104

Economic, social and demographic trends as well as technological advancements (combined with falling costs) are key drivers for continued accelerated adoption of RAS technology. Global competition requires constant modernization of production facilities. The life-cycle of consumer electronic goods continues to shorten, requiring flexible automation. Proximity to the end user is becoming a competitive advantage. Technological advancements and declining costs are enabling investment in RAS technology in small and medium enterprises for simple applications.105

RAS – Enhancing productivity and driving economic growth

The world’s major industrial economies have made investment in RAS technology a strategic initiative for economic growth. For example, RAS was specifically identified by the UK government as “one of the Eight Great Technologies that support the UK Industrial Strategy driving efforts to rebalance the UK economy and creating jobs and growth.”106

Japan’s Revitalization Strategy, the so-called “Third Arrow” of Prime Minister Shinzo Abe’s efforts to re-ignite the Japanese economy, outlined three issues facing Japanese companies that point to greater adoption of RAS technology:

• How to be more competitive in manufacturing and service when Japanese companies are exposed to cost competition on a global scale

• How to secure workers in small and medium enterprises when the average age of workers in Japan is increasing and labor force growth is slowing or in decline

• How to increase efficiency in industries with acute shortages of labor, such as medical and nursing care, agriculture and construction

In fact, one of the 10 key reforms of Japan’s Revitalization Strategy is stimulating “innovation through science technology and a ‘Robotics Revolution,’” with a goal to double the use of robotic systems in manufacturing and achieve a 20-fold increase in non-manufacturing services by 2020.107

Japan is not unique with an aging population, slowing labor force growth and a shortage of workers. Countries that produce many of the world’s goods and services, such as South Korea, Germany and China, have similar demographic characteristics and, together with Japan, are among the world leaders in installed robotic capacity.


China is set to

become the

world’s largest

market for

robotics.

0

2012 2013 2014 2017

100,000

200,000

300,000

400,000

500,000

In u

nits

Estimated stock of industrial robots in selected countries

China North America Japan South Korea Germany

Source: International Federation of Robotics, World Robotics 2014.

For the United States, RAS is seen as an enabling technology for a manufacturing “re-shoring.” According to Henrik Christensen, professor and director of robotics at Georgia Institute of Technology, next-generation industrial robotics will serve to “attract high-competence people back to manufacturing, dramatically increase U.S. manufacturing productivity and invigorate the re-emerging of a U.S.-based, next-generation, industrial robotics industry” as well as “make it easier to protect intellectual property for high-tech products.”108 Tech giants Google and Amazon in particular have been active in acquiring firms with RAS technology.

Rising labor costs in former low-cost producers such as China are also key drivers of a robot revolution. Falling prices of RAS technology may provide developed market economies with cost equivalence (if not a cost advantage) over formerly low-cost emerging market labor. However, improvements in automated manufacturing precision may allow emerging market firms to compete both locally and on a global scale on the basis of quality, not just on cost. In particular, China appears to be shifting from competing on low-cost labor to accelerating investments in RAS. In 2013, China became the largest market for industrial robots, accounting for 20 percent of global industrial robot sales.109 However, relative to Korea, Japan, Germany and the United States, robot density (the number of multipurpose robots relative to manufacturing employment) in China remains very low, indicating that there is still significant opportunity for future growth.

40



Adoption of

robotics in the

United States

and China

remains below

other industrial

nations.

0South Korea Japan Germany United States China

Average worldrobot density = 62

100

200

300

400

500

Uni

ts

Robot density in selected countries

Source: International Federation of Robotics, World Robotics 2014. Units = number of industrial robots per 10,000 manufacturing employees.

RAS – Addressing healthcare costs and the challenges of an aging population

An aging global population and rising healthcare costs are driving advancements in RAS technology for improved healthcare access, affordability, quality and personalization, including:

• Making surgical procedures less invasive, producing fewer side effects, faster recovery times and improved worker productivity

• Delivering healthcare services in remote, dangerous or inhospitable locations, such as rural areas, post-disaster sites and war zones

• Developing affordable systems for in-clinic and in-home diagnostics, monitoring and rehabilitation110

McKinsey estimates the economic impact of robotic surgery and prosthetics to be as much as $800 billion to $2.6 trillion annually by 2025 due to increasing life expectancy and improving quality of life.111 According to the World Health Organization, 10 percent of the world’s population live with disabilities and 10 percent of those require a wheelchair.112 While the current prosthetic market is very small, estimated at between $100 and $150 million, recent advancements in RAS technology are estimated to result in significant growth to over $1.5 billion in the next 3-5 years.113

Finally, wearable bionic devices, or exoskeletons, have potential applications that go beyond healthcare, including industrial, first responder and recreational. Applications include devices for lifting heavy objects, disaster recovery, mountain climbing and underwater heavy engineering.114


Robotics is

moving beyond

manufacturing.

RAS – Becoming a ubiquitous technology

Technological advancements and declining costs of RAS applications are moving robotics beyond manufacturing to many other sectors and industries, significantly increasing the opportunity for accelerated adoption in areas such as:

• Aerospace (drones)

• Agriculture (farms of the future)

• Military (automated combat, field support for troops)

• Mining and energy (deep sea, deep mining, wind, nuclear)

• Personal services (elder care, household services)

• Transportation and infrastructure (intelligent mobility, smart cities)

Aerospace

While unmanned aerial vehicles (UAVs), or drones, are used primarily by the military, there is increasing demand for non-military government uses, such as policing, border control, search and rescue, firefighting, ground traffic surveillance and pollution control.

There are also a number of potential commercial applications for drones. They have already been utilized to deliver prescription drugs to remote locations in Germany, spray crops and provide wildlife protection in Africa, monitor the U.S. border, and examine offshore oil platforms for damage and repair.115

Agriculture

RAS technology is already employed in the “farm of the future” for more effective land and energy use, reducing environmental impact (fertilizer, pesticides), enhancing yields, and improving shelf life by reducing time-to-market from field to shelf.116

Military

Unmanned ground vehicles (UGVs) and unmanned aerial vehicles (UAVs) have been deployed by the U.S. military in Iraq and Afghanistan, primarily to enhance combat capability and to reduce the risk to military personnel. An additional element of military use of RAS technology is reducing the cost of maintaining and deploying U.S. military personnel while being able to project force in a geostrategic environment of considerable uncertainty.117

Mining and Energy

RAS technology such as drones and marine robots may reduce the cost of inspection, repair and maintenance of offshore and subsea energy infrastructure. Robotic technology will help enable deep mining, subsea mining and recycling efforts in environments that are hazardous to humans. Mining and energy RAS technology will likely have applications in other industries, including first responders (search and rescue, firefighting, natural disaster) and space exploration.118

42



Adoption of

RAS technology

may have

both positive

and negative

impacts.

Personal Services

Personal service RAS technology offers significant potential due to improved technology and declining costs. The International Federation of Robotics (IFR) estimates that 2.7 million domestic robots were sold in 2013, an increase of 12 percent over 2012. IFR estimates that sales of all types of robots for domestic tasks (vacuum cleaning, lawn mowing, window and gutter cleaning) could reach nearly 24 million units in 2014-2017, with an estimated value of $6.5 billion.119

Transportation and Logistics

Self-driving cars and other autonomous vehicles could mitigate some of our most challenging social problems, including the economic and human costs of traffic accidents, the productivity lost in traffic jams, the “wasted” urban space taken up by parking lots, and the upkeep of transportation infrastructure.120

The National Highway Traffic Safety Administration (NHTSA) says that there are 35,000 automobile-related deaths and three million injuries each year, resulting in an economic cost of $230 billion. Professor Christensen identified three areas where RAS technology may benefit transportation networks:

• Driver habit monitoring – Robotic intelligence to monitor the driving abilities for new and aged drivers

• Vehicle-infrastructure integration – Technology that merges intelligent vehicle and intelligent highway information to create virtual traffic information networks to reduce delays and save fuel

• Smart public transportation systems – Robotics technology to provide operators with greater situational awareness in crowded corridors to help control costs and increase safety121

Transformational and disruptive technological changes can be both positive and negative. Adoption of RAS technology would likely be positive for productivity and economic growth. However, while robotics and automated systems may be an enabling technology for an aging population and a declining labor force and performing tasks that are repetitive or hazardous, they also may be disruptive to established labor markets.

A recent study estimated that 47 percent of all U.S. employment is at risk for computerization.122 If labor market disruption proves greater than productivity gains from RAS implementation, economic dislocation may lead to social pressures and political resistance.


Potential beneficiaries: • Industries with high labor costs that can achieve cost savings and productivity enhancements

• Industries with shortening product life cycles that can benefit from moving manufacturing closer to end users

• Industries encountering gaps in either supply of labor or human skill, such as elder and nursing care, data mining, diagnostics, or tasks that require “superhuman” speed or strength

• Industries and applications that require exceptional precision, flexibility, speed or maneuverability in small spaces

• Societal benefits from RAS replacing humans in hazardous or unpleasant tasks or enhancing first responder and disaster response

• Societal benefits from increasing life expectancy and improving quality of life


• RAS technology companies

• Sensor technology companies

• Software companies related to RAS technology

• Companies that are early adopters of RAS technology

• Companies or countries that benefit from re-shoring of manufacturing in developed economies


• Costs of RAS hardware, sensors and software may not continue to fall

• RAS may not prove as cost effective or safe as believed

• Skilled labor to operate RAS technology may be in short supply

• Government policy may slow, inhibit, or prevent adoption of RAS technology (such as commercial drones)

• Resistance from social pressures due to employment loss could inhibit adoption of robots in non-automotive industries

44



Long-term

investors may

wish to pursue

active portfolio

management

that can seek

out secular

opportunities

within the

broader market.

OTHER POTENTIAL INVESTMENT THEMES

While this paper outlines six investment themes, we have identified a number of other potential developments that could have an impact over the next decade. These include:

• Cybersecurity – protection from the dark side of the “Internet of things”

• Solar power/batteries/LED lighting – alternative energy goes mainstream

• Water – connecting supply and demand

• Mega-cities – the return of the city/state

• Distributed education, problem solving and research and development (R&D)

• Africa – from aid to trade

• Clash of civilizations – a shifting global balance of power and the end of the peace dividend

• Income inequality – “stars and superstars”

• Digital currencies and the future of commerce

• The new space race

• Korean reunification


We believe

the key trends

outlined in

this paper

will be drivers

of market

opportunity in

the years ahead.

CONCLUSION

One approach to wealth expansion includes investments committed over an extended period of time, selected to capitalize on global economic trends that may create the potential for favorable investment results. We believe such investments include generational trends that have been in place for a quarter century or more, including economic liberalization and globalization. We anticipate these broad trends may persist in the years to come. At the same time, we have identified a number of emerging trends that may represent a seismic shift in the direction of the global economy and should be considered in an investor’s long-term wealth expansion strategy. These include:

• The energy revolution in the United States

• The maturation of China’s economy

• The rise of a global middle class

• The impact of an aging world population

• Renewed urbanization in the United States

• A robotics revolution

One aspect of achieving the potential for a successful outcome is the ability to anticipate opportunities. This is why we believe incorporating key trends into a long-term investment plan is so important. Factors that may have driven investment performance in the past decade are not likely to be as prevalent in the decade ahead and should not be the focus of a forward-looking investment strategy. Rather, we believe key trends like the ones we’ve identified in this paper can be drivers of market opportunity in the years ahead.

How can you act on these potential opportunities? An important consideration may include active portfolio management that can seek out specific investments within the broader market. Passive approaches such as index funds may not be able to capture the full potential that could emerge from the trends we have described. Investors should consider working with active managers who seek to target investments that can include:

• Opportunities within specific geographic regions or countries

• Asset classes within certain industry sectors that are positioned to potentially benefit from the key underlying trends

As always, not all investments within these broad categories will perform well, and selectivity is important. A diversified approach is also critical to help guard against the risk of over-allocating toward a single investment or sector. We believe an investment strategy that incorporates the key trends we’ve identified may help create favorable opportunities for investors in the decade ahead.

46



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48



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94. Ibid.

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100. International Federation of Robotics, World Robotics 2014.

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103. Ibid.

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112. “Fact sheet on wheelchairs,” World Health Organization, 2010.

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114. GK Plus Alpha, Ltd.

115. “RobotEnomics – Tracking the march of the robot economy.” April 2014.


117. “A Roadmap for U.S. Robotics: From Internet to Robotics,” 2013 Edition.



120. “Self-driving cars: The next revolution,” KPMG and Center for Automotive Research.

121. “Electric sheep: Dreaming of a robot society.” CLSA-U Blue Books, CLSA Limited, 2014.

122. Frey, Carl Benedikt and Michael A. Osborne. “The Future of Employment: How Susceptible are Jobs to Computerisation?” 2013.

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Investment products and services are:

NOT A DEPOSIT NOT FDIC INSURED MAY LOSE VALUE NOT BANK GUARANTEED

NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY

This commentary was prepared April 2015. The views are subject to change at any time based on market or other conditions. This information represents the opinion of Ascent Private Capital Management of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this publication are not affiliates or associated with U.S. Bank in any way.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed-income securities is subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decreases in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high-yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties (such as rental defaults). An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks and bonds. Hedge funds are speculative and involve a high degree of risk. Private capital funds are speculative and involve a high degree of risk. An investment involves a substantially more complicated set of investment strategies than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales, which can magnify potential losses or gains. Always refer to a fund’s most current offering documents for a more thorough discussion of risks and other specific characteristics associated with investing in private capital funds. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Potential investors should remember that investments in private equity are illiquid by nature and typically represent a long-term binding commitment. The investments made by private equity funds are not readily marketable and the valuation procedures for these positions are often subjective in nature.

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ABOUT THE AUTHOR

THOMAS M. HAINLIN, CFAGLOBAL INVESTMENT STRATEGISTASCENT PRIVATE CAPITAL MANAGEMENT OF U.S. BANK

Tom Hainlin is the national head of global investment strategy for Ascent Private Capital Management of U.S. Bank. Using Ascent’s distinctive, purpose-based approach to investment management, he partners with Ascent’s regional office teams to provide client families with sophisticated analysis and recommendations for a variety of investment policies and liquidity preferences. A thought leader in investment management, Tom leads the theme-based investing discipline for U.S. Bank Wealth Management, identifying potential catalysts for long-term investment opportunities through an analysis of emerging social, political, demographic, environmental and technological trends and events.

Tom serves as a spokesperson for U.S. Bank Wealth Management, and his views on a variety of investment topics, such as emerging markets, commodities, collectibles and the future of the family office, have been published in national and international media outlets, including The Wall Street Journal, Bloomberg Markets, Private Art Investor and CNBC.com.

Tom has more than 17 years of investment experience and holds a bachelor of arts degree in diplomacy and interstate relations from the University of Minnesota, Twin Cities. He is a Chartered Financial Analyst (CFA) charterholder and a member of the Phi Beta Kappa society.

ascent.usbank.com

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