Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: First Quarter, 2008

Economic Conditions
The expected slowdown is underway; 4th quarter GDP grew at .6%, a sharp deceleration from the prior quarter 4.9% increase. Preliminary data covering early 2008 point to a contracting economy. Unemployment is trending higher; residential business investment has fallen 25%; corporate profits are under pressure; and surveys of business and consumer sentiment are pessimistic.

Confidence is being dampened by the U.S. housing problems and losses in most sectors of the financial industry. Consumer spending, two thirds of GDP, is not likely to recover for at least a year because disposable income is affected by increases in energy, food, and services costs—with incomes stagnant. Because consumer and government debt levels are very high, reserves for economic emergencies, such as this one, are low.

The Government response has been unprecedented in scope and creativity, with participation from the Federal Reserve Board, Treasury, and Congress. Policy actions should, in time, work to restore stability, but only after housing inventories and prices reach levels that induce a pick-up in activity; poorly designed mortgage bonds have been absorbed; and credit facilities become more available.

The monetary and fiscal response to the weak economy will soon face limitations. In addition to the aforementioned debt levels, many policy actions have significant inflationary implications. Also, monetary ease does not in itself clear the credit markets; institutions need to resume lending, very difficult when risk levels are reached and customer balance sheets are leveraged.

In short, the economy will be sluggish through at least 2008 and the recovery will be protracted.


Investment Strategy
Our portfolios have been prepared for the slowdown and to take advantage of areas of strength. Consequently, they have performed materially better than comparison benchmarks.

We continue to favor energy, materials, water, and agriculture for two important reasons: (1) companies in these areas will participate in the development of China, India, and other emerging economies and are likely to do well even in a weak U.S. economy; and (2) investors are coming to realize that the needs in these areas are a long-term story. It makes sense to look for companies holding deep asset reserves in politically safe parts of the world and companies working on water and food supplies, as well as, medical services and electrical transmission.

As noted, we focus on economic needs that we project to be so substantial that attractive investments can be made under most economic scenarios. Take energy: one of our favorites is natural gas, which we believe is well situated to meet electric demand that is likely to grow rapidly because of increasing requirements from electronic devices, communications and computers, and electric cars. Natural gas is a clean-burning fuel that is available and relatively safe.

In spite of ample inventories and a weak economy, natural gas prices are firm; this is an important technical indicator. In our view, it underscores a long-term trend. The Oil and Gas Journal reports that gas-fired electric power supply accounted for 90% of new megawatts of electric capacity installed since 1995. Difficulties in supply of alternatives, coal and nuclear fuels, and their concomitant environmental issues, also make natural gas attractive. In addition, reduced supplies of natural gas, e.g., tighter supplies in Europe, due, in part, to Gazprom’s decline in production, and in the Middle East, due to internal consumption and political constraints, add to the value of our natural gas investments. These are just a few of the reasons we continue to hold natural gas securities, many of which were purchased at a small fraction of current prices.

As to water, a GAO study states that most state water managers expect either local or regional water shortages in 10 years. This probably understates the problem. According to 13D Research, if new power plants continue to be built with evaporative cooling systems, consumption of water for electricity production could more than double to 7.3 billion gallons per day by 2030. This is to say, consumption by the electric sector alone would equal the nation’s entire domestic water consumption in 1995. As reported in prior quarterly reports, this is not just a U.S. problem. This is why we continue to favor water investments. One can go without a lot of material possessions; but water is not one of them.

Similar long-term forces are evident in world-wide food supply, electric transmission, and the aging population of developed and many developing countries.

Given our inflation concerns, bond portfolios continue to emphasize short-term maturities. One exception is the value in long-term municipal bonds, where yields are attractive because of turbulence in the credit markets.

While the economic challenges are severe, we will eventually work through them. Our investment strategy is focused on profitable opportunities on a worldwide scale within the framework of the “needs” noted above.