Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: First Quarter, 2012

Economic Conditions   (Audio Version)

Real GDP increased at an annual rate of 3.0 % in the fourth quarter of 2011, up from the third quarter increase of 1.8 %. For all of 2011, real GDP increased by 1.7 %. For 2012, Chevy Chase Trust analysts project real GDP growth of 2.6 %, reflecting modest domestic growth because of continued high debt levels, sluggish housing, weak employment, and higher energy costs. In addition, the slowdown in China, recessionary conditions in Europe, and many geopolitical issues are formidable obstacles to
near-term higher growth levels.

After we work through the aforementioned challenges, we expect a powerful, new secular trend of world-wide economic growth with many investment opportunities. This is a fundamental change in our view, at odds with many who project a very long period of slow growth. The basis of our new outlook includes many economic and demographic trends, but the big one continues to be realization of enormous demand for goods and services from the new middle class of the emerging markets. For the first time, hundreds of millions of new consumers have been exposed to a more pleasant life and no government is likely to stand in their way for very long. We are convinced that this secular trend now has sufficient traction and that it is much less speculative. See below for
our investment strategy for this coming growth period.

As noted, for the period just ahead, growth is likely to be slow and uneven. Demand for goods and services, adjusted for inflation, will continue to be weak. The unemployment rate has declined from a recession high of 10% to 8.3% at the end of February, 2012. However, it is taking workers 39 weeks on average to find a new job; prior to this recession, 22 weeks was the post World War II high.

The continued slump in housing, the high level of household debt and tightening fiscal policies driven by expiring tax credits and tighter Government budgets are not conditions to promote economic growth. It is very likely that monetary policies will be used aggressively to offset these drags on
the economy.

Our attention is focused on an underlying buildup of inflationary pressures. The Federal Reserve has tripled the size of its balance sheet, adding $2 trillion to the money supply. The size of this stimulus is unprecedented. Moreover,

real short-term interest rates have been maintained at approximately minus 2%. Implicit in the Fed’s monetary policy is a perceived severity of economic problems and a high level
of confidence in its ability to unwind policies without significant adverse effects. In other words, monetary policy makers are more confident in their ability to tame inflation than the effectiveness of available measures to deal with deflation.

While we accept that buildup of the Fed’s balance sheet may have been justified for near term stability, we are less than confident in the Fed’s ability to mitigate the adverse effects of a wind-down. The size of the Fed’s holdings and its composition—not just short-term Treasury securities, but other securities that are more difficult to deal with— and the size of the Federal deficit, including its refunding requirements, comprise a unique set of conditions that no
one heretofore has managed. Moreover, recent data show a decline in domestic productivity and clear evidence of less foreign demand for Treasury debt. The aforementioned all point to a high risk of inflation, higher interest rates, and very hard choices regarding future monetary policies that promote growth but may add to a growing underlying inflation problem; the Fed is bobbing between its Scylla and Charybdis.

Investment Strategy
In our December, 2011 report, we noted the attractiveness of equities relative to other asset classes. Markets seem to agree; equity performance in the first quarter, 2012 was very positive. After the first quarter run-up, considering the challenges ahead, we believe equities generally are reasonably priced and we see few compelling purchase candidates.

We are at an important juncture. The long-term outlook is extremely bright but the near-term can only be viewed as difficult and complex. Here is our current strategy:

• No one can predict the exact timing of the resolution of the economic problems ahead and anticipation of their resolution is often the catalyst for strong equity performance. Because our long-term outlook is so positive, some equity exposure is justified for almost all clients.

• In general, equity exposure will be maintained at the lower end of each individual client’s range, as determined by the investment objective. The lower range will retain flexibility to increase equity exposure at a better risk-reward time while adhering to CCT’s high priority of managing risks.

• Equity investments will continue to be concentrated in areas experiencing strong secular trends: energy, food, water, infrastructure and healthcare. If we are wrong about the next growth period, performance of these investments should still be relatively attractive because they are in the front of strong demographic and economic trends.

Quality companies with dividends, especially U.S. and foreign multinationals are well represented throughout our portfolios and, to our mind, are still well situated.

The following are some continuing thoughts about energy and water:

Energy: Clients have asked whether the developments in domestic oil fracking, conservation, weakening economies, and increased supply and use of natural gas, taken together, suggest less emphasis on oil stocks in our holdings. We think not; and with the help of our friend, Charles Maxwell, the dean of oil energy analysts, other research sources, and our own studies, here is why:

• About 32 billion barrels of oil are used each year, expecting to increase about 2% annually for the next few years, as economic growth improves. Discoveries of new oil may reach 15 billion barrels a year. The average annual discovery during the last decade was 10 billion barrels. Clearly, we are using a lot more than we are finding, resulting in the depletion of the inventory of proven reserves. Significant price pressures are likely as the decade unfolds as a consequence of this imbalance.

• About 85% of the world’s oil reserves are owned by national oil companies. Many of these governments are not using oil and other revenues on capital expenditures necessary for future production. Indeed, production is down significantly (e.g., Venezuela and Mexico).
About 14 million barrels a day out of a total world production of 89 million barrels a day are in countries experiencing civil wars or insurrections.

• The major investor owned international oil companies are not finding enough oil to meet long-term demand. Also, new finds are characterized by much higher extraction costs.

• Producing countries’ own use of oil in developing economies is growing rapidly, resulting in less available for export. A controversial issue is how much spare capacity actually exists. No one knows for sure; but we are of the opinion that it is less than most published data.

Like energy, water issues have been a focus of our investment research for many years. We believe that water shortages are intensifying. One of our research services recently reported an increasing number of rivers running dry before reaching the sea and more ground water supplies nearing depletion from over-pumping of aquifers. Prior reports to you have discussed water problems in Asia, the Middle East and the United States. Global agriculture consumes 92% of fresh water used annually and it is expected to grow 45% by
2030. About 2.7 billion people are currently experiencing severe water scarcity. Charles Fishman, author of The Big Thirst, argues that most municipal water systems are not prepared for a significant drop in water availability.

Our portfolios include investments in the water industry and related food, seed, and fertilizer companies. Seed technology, especially, offers promise in dealing with water scarcity.
Direct investment in irrigation and water technologies that meet our investment criteria is extremely limited, but recent corporate reorganizations have put several new companies on our watch list.

Our fixed investments continue to be relatively short duration, high quality bonds. With interest rates at or near
all-time lows, we see little utility in taking a substantial risk in loss of capital to gain a modest increase in income. However, some higher yield investments are made with longer durations when we believe mispricing presents a compelling investment, and when cash flow is required to meet other portfolio objectives. Cash balances available for investment may be held at higher than normal levels because we see better risk-reward opportunities coming.

Better days ahead!