Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update, First Quarter 2015

US Economic Conditions

“Warning: For safety, you should be in good health and free from high blood pressure, heart, back, or neck problems, motion sickness, or other conditions that could be aggravated by this adventure.”

These are the words of warning as passengers approach Space Mountain, the famous roller coaster at Disneyland. Lately, the same warning could apply to equity market investors. The first quarter of 2015 resembled a roller coaster ride in more ways than one. While there were many jarring ups and downs, at the end of the ride we finished only steps from where we started.

During the first quarter of 2015, the S&P 500 generated a total return of 0.95%. Excluding dividend payments, the return was even a more meager 0.44%. Despite the absolute numbers, the quarter was anything but dull. Major indexes moved more than 1% (either up or down) during almost one out of three trading days. Unusual for this level of volatility, the S&P 500 has been relatively rangebound. The Index spent only one day below 2000 and never closed above 2110 during the first quarter. Going back to 1926 there has never been a quarter with this many 1% trading days while the market remained so tightly contained. If the first quarter is a precursor for the balance of the year, the market could finish the year “violently flat.”

The federal funds target rate has remained the same for sixty-three consecutive months, far and away the longest the Federal Reserve Board has gone without changing short term interest rates (with seventeen months from 1992 to 1994 running a distant second). In its March statement the committee removed the word “patient” from its monetary policy commentary, indicating that short term rates could rise as soon as June. The question for investors is… after the first rate rise, what’s next? Will the Fed embark on a typical tightening schedule with steady rate increases at almost every subsequent meeting? Or will the Fed proceed more cautiously and adopt a significantly slower cadence? We think the latter is more likely. If correct, we expect the market to resume its six-year rise as jitters and uncertainty about the impact of the Fed move subside and investors once again focus on fundamentals.

Of course the rate rise won’t come at all unless U.S. economic conditions remain positive. We think they will. Although some economic data continues to be mixed, there has been a meaningful and positive change in labor markets. While attention has focused on the declining unemployment rate and job creation, higher average wages are an important driver to economic growth. Anecdotally but significantly, companies like Walmart are delivering. Walmart raised wages for almost half a million of its 1.2 million U.S. employees, a sure sign of a tightening job market.

While this is good for consumers and companies that sell them stuff, it is not necessarily good for the profit margins of companies paying higher wages. For some labor-intensive subsectors, the unprecedented margin expansion seen over the course of this cycle may be ending. However, for companies whose primary costs are materials and other inputs, the continued strength of the U.S. dollar and low commodity prices should support steady or improving margins.

On balance, moderately rising wages and increased consumer confidence should act as a stimulant, rather than a drag, on overall corporate earnings. The divergence between companies whose cost structure is heavily wage dependent versus those more material dependent is a factor in our investment thinking.

Another related factor in our investment thinking is that almost every sector of the economy (with the exception of financial services) has reduced the ratio of labor expense to gross output. In 1994, US manufacturers had a labor cost ratio of 20%. In 2004, that figure was 17% and in 2013 the ratio was 13.5%. These improvements achieved largely through automation have led to higher incremental profit margins. The margin on each incremental dollar of sales is greater than the previous dollar of sales, producing positive operating leverage. Thus, increased consumer spending should contribute to modest margin expansion.

As indicated, another contributor to margin expansion is automation. In our next quarterly letter we will discuss in more depth how transformative technologies such as robotics are at the precipice of expanding well beyond the traditional manufacturing floor and are poised to lead significant productivity improvements in a wide variety of service related industries.


We’re often asked about bubbles and whether we see any forming. We’ve generally answered “no” because we’ve been focused on public equity market valuations, which we see as high but not excessive, especially given the low levels of inflation and interest rates. However, one area where we do see excessive valuations and could potentially be in bubble territory is venture capital. Investors are chasing  performance in this asset class, pushing dollars and demand into a limited pool of opportunities. This is causing valuations to increase, in some cases to levels unmatched and likely unsustainable in the public equity markets. At the beginning of 2014, there were 42 startups with valuations exceeding $1 billion. Those that raised additional private funds over the past year saw valuations increase by an average 400%. Today there are 78 startups valued at over a billion dollars.  Twenty are in San Francisco and nine have higher valuations than 20% of the companies in the S&P 500.

These valuations pose a risk to public markets when, not if, shareholder capital is used to acquire overpriced assets. This is a potential tipping point, particularly in the  technology sector, which we are watching closely.

International Economic Conditions

Internationally, the macroeconomic data has come in  marginally better than expected in developed markets. Europe and Japan exporters have been bolstered by the  strengthening dollar and lower input costs from energy and other commodities. In fact, in the first quarter, the Nikkei  (Japan), FTSE (United Kingdom) and DAX (Germany) indices have simultaneously outperformed the S&P 500 for the first time since 2012. The past six months have seen the most dramatic dollar-move against a basket of these three countries’ currencies since 1981. This dollar strength actually diminishes the scale of outperformance in these  markets, traditionally reported on a local currency basis. So while the German DAX returned 22% in the first quarter, on a U.S. dollar basis, the return was more than 60% less.

We seek some exposure to European companies, particularly those with thematic tailwinds, but are overweight U.S. domiciled companies within our historic global equity allocations. While we try to consciously avoid home country bias, we are always cognizant that our clients are  overwhelmingly U.S.-centric, with lifestyle spending in dollars. Stellar foreign returns offset by currency drag are hard to spend.


Fixed income investors remain challenged by low rates and tight supply. Similar to the U.S. equity markets, the first quarter was volatile, with ten year yields on U.S. Treasury bonds reaching as high as 2.24% and falling as low as 1.68%. But, also like equity markets, the aggregate change for the quarter was more modest with yields ending the quarter at 1.92% compared to 2.12% at the start.

U.S. yields continue to be impacted by historically low rates abroad. Ten year yields in Japan are currently 0.39% and the German ten year bund is only yielding 0.18%. At the moment, the Portuguese government can borrow money at a better interest rate than the U.S., which is difficult to believe given the respective credit-worthiness of the two countries. In fact, the extremely low rates in other developed markets makes the approximate 2% yield in the U.S. seem relatively attractive, especially since foreigners buying our debt get the added benefit of a rising dollar.

But alas, as any investor seeking to generate real income from owning bonds knows all too well, 2% is an extremely low return from an historical perspective and effectively equal to the dividend yield of the S&P 500, a valuation arbitrage that hasn’t existed since the 1950s.

Nonetheless, we continue to believe that owning individual bonds plays an important role in client portfolios by diversifying risk, providing portfolio stability and as a source of liquidity. We are currently buying attractive cash management vehicles and intermediate term bonds to create short duration bar-belled portfolios to provide real returns and flexibility should rates rise. We are also buying municipal bonds because tax-exempt bond yields continue to be relatively attractive vis-a-vis taxable yields.

We believe that, in time, interest rates are likely to move back towards historical averages in a backdrop of economic growth and tighter Fed policies. However, in the short term, global headwinds should continue to put a ceiling on long term rates.