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Report identifies investment opportunities and risks from global drought conditions

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The ongoing drought is the worst in the US since at least 1956, with 63 per cent of the lower 48 states suffering drought conditions at the end of August.



While conditions are far from those in the Dust Bowl years of the 1930s, drought conditions are the new normal, according to “Global Drought – Opportunities and Risks,” a new BofA Merrill Lynch Global Research report. It follows thematic megatrend reports from BofA Merrill Lynch Global Research on obesity, energy efficiency, safety and security and water.

The US and global drought underscores increased long-term challenges to global food, water and energy security, as demand for food and energy each are expected to climb 50 per cent by 2030 with the demand for water growing by 40 per cent over the same period, potentially creating a perfect storm of interlinked challenges.

These changing conditions pose a range of opportunities and risks for investors. For investors interested in the themes of fighting drought and in promoting food, water and energy security, Bank of America Merrill Lynch has introduced a screen that identifies liquid stocks exposed to global drought-related themes under the Bloomberg ticker MLEIARID. The stocks included in the screen are those that it considers to be long-term solution providers in such areas as water, fertilizers, crop science, energy efficiency, second-generation biofuels and renewables.

“The severity of the global drought underscores the long-term challenges for national and global economies,” says Sarbjit Nahal, equity strategist with the Bank of America Merrill Lynch Global Research ESG (environment, social and governance) and sustainability team and a co-author of the report. “Food, water and energy security are increasingly bigger issues, and as governments, businesses and other players struggle to adapt to and mitigate drought conditions, there will be an evolving set of opportunities and risks for investors.”

The report, prepared collaboratively by the firm’s global strategy, commodities, economics and sector teams, incorporates research and insights from a wide range of resources within the Global Research franchise.

Commodities are experiencing immediate impacts from the drought, with all key agricultural commodity markets having tightened dramatically on the deteriorating outlook for supply. The immediate result is high prices. Corn and soybean prices are expected to stay elevated in the near term. Although further spikes cannot be ruled out, grain prices are expected to cool off by mid-2013. In the US, the government could issue a temporary waiver of its ethanol-blending mandate, which could alleviate the tightness in the corn market, since 40 per cent of US corn is used to produce ethanol.
 
In the agricultural and chemicals sectors, there are short-term opportunities and risks. Providers of agricultural inputs such as seeds, fertilizers and crop-protections chemicals stand to benefit from increased incentives for growers to maximize production. As a result, there are attractive investment opportunities in all major regions of world.
 
In the consumer sector, weather conditions should have minimal impact on packaged foods. There could be some low- to middle-single-digit cost impacts on certain European Union members in 2013, negative impacts for agribusiness companies and higher grain prices that could test the pricing power of food companies.
 
In the industrials and insurance sector, drought conditions are actually a positive for farmers as soft commodity price increases more than offset production decline and help extend the global agriculture cycle. According to disaster modeller AIR Worldwide, the drought could cause losses of USD1bn to USD3bn after recoveries, a manageable event for crop insurers and their reinsurers.
 
Although the drought is likely to curb farm production and boost food prices, the macroeconomic impact should be limited in the US, since the farming industry is a small share of the economy and higher crop prices are only partially passed through into processed food prices. The drought should not affect the overall outlook for the economy in the coming months.
 
The global impact of weather conditions, including a possible El Niño, should be similarly moderate, with limited, but generalized, upward inflation pressures resulting from an increase in grain prices. The effect will be greater in global emerging markets, since food prices command a bigger share of expenditures there than in developed economies, but that should be limited to a one-time spike in inflation.
 
The impact should be similarly moderate in the growing Chinese and Indian economies. As China becomes wealthier, higher meat consumption is likely to push corn imports sharply higher due to animal feed demand, with resultant tightening of prices. In India, an autumn harvest drought could slow growth to five per cent for the second half of 2012, but projected late rains should protect next summer’s crop and avoid an impact in 2013.
 

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