NOTEWORTHY

Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update, Fourth Quarter 2012

Economic and Market Conditions (Audio Version)
Economic growth in the U.S. and worldwide weakened in 2012, despite unprecedented monetary and fiscal stimulus. For 2013, CCT Asset Management projects continued weak growth in the U.S., around 2% real GDP, and perhaps 3% in the global economy. Growth at these levels will not improve employment. Other concerns include: a further loss of consumer and business confidence if no credible growth policies are formulated in the U.S. and Europe; an increase in currency “adjustments” by nations to promote internal
growth at the expense of trading partners; and a breakdown of China’s growth machine.

Coming off a low base, performance of most asset classes—stocks, bonds, commodities, real estate—was surprisingly positive in 2012, considering the sub-par economic climate. Much of this performance can be viewed as asset inflation brought on by excess liquidity in the financial system. For 2013, Chevy Chase Trust believes carefully selected stocks may continue to provide attractive returns. Some other asset classes face stronger headwinds. Bonds have far greater downside risk than upside potential. Commodities, with few exceptions, have high inventories and slowing demand from weak economies. Real estate, except for a few geographical areas, also will reflect weak demand, a continuing downtrend in real incomes and financing hurdles. However, real estate comes off a particularly low base, so growth may look impressive despite modest volume. (See Investment Strategy for our priority investments.)

As noted, U.S. economic growth is weak: 2012, Quarter 1, 2%; Quarter 2, 1.3%; and Quarter 3, 3.1%—not enough to improve employment. Moreover, the 3.1% for the third quarter is misleading. Much of this growth came from businesses accumulating inventory and a one-time rise in defense spending. Consumer spending grew at only 1.4% and spending on equipment and software, an indication of business investment, fell 2.7%. Also, exports were weak. The key point is that business inventory accumulation made up about one-third of the 3.1% increase. More than one past recession has been sparked by overspending on business inventories when consumer spending was deteriorating. Of the last five recessions (1975, 1982, 1991, 2001, and 2009), the current recovery, despite unprecedented stimulus, is the weakest in terms of consumer credit, disposable personal income, personal consumption, and employment.

Because of disappointing data on personal income and consumption, final revised fourth quarter GDP growth is very likely to be under 2%. Even with a political solution to the fiscal problems, one can expect only slightly better growth in early 2013 as the impact of belt tightening and new taxes take hold in a still fragile U.S. economy. Consequently, we predict unemployment will be stuck at about 7.8%. Growth in residential housing will not be sufficient to offset weakness in other areas. Importantly, inflation will be under the Federal Reserve target of 2.5%, allowing the Fed to continue massive monetary stimulus—more on the risks of this later.

Outside the U.S., prospects for a healthy global economic recovery are not reassuring. Another contraction in the Eurozone is a real possibility. Along with an unsatisfactory resolution of U.S. fiscal issues, these combined drags would put a stop to already weak worldwide growth. After five years of crises, the greatest danger to the global economy continues to be the stability of European banks. The solvency of euro financial institutions and their governments is being maintained by monetary creation without limits. The printing of money on the scale being undertaken or planned by the U.S, the Eurozone, possibly Japan and others is risky policy.

The step-up in monetary stimulus by central bankers is worrisome and bears close watching because of its current and possibly significant long-term adverse effects and because it will be very difficult to wind down. The Federal Reserve plans to purchase $85 billion a month ($45 billion of Treasury securities and $40 billion of mortgage-backed securities) in 2013. This is an unprecedented level of stimulus being added to an already unprecedented $3 trillion balance sheet. Moreover, the Fed has pledged not to raise interest rates until the unemployment rate falls to 6.5%, provided inflation does not exceed 2.5%. This level of stimulus is an experiment, the outcome of which no one can reliably predict.

Also, the U.S. stimulus model is growing in popularity. The European Central Bank announced a plan to buy the bonds of distressed Eurozone countries. This, too, is money creation without limit. The new government in Japan appears ready to charge in the same direction, adding leverage to the most heavily indebted base of any developed economy. The Bank of England is on the same risky path. Governments believe this is a short-term way to reduce burdensome debt levels and cover promises that can no longer be met. And economists believe controlling resulting inflation is manageable while controlling a deflationary spiral is less so.

Putting aside the likely long-term inflationary impact of central bank expansionary policies, they have caused other undesirable market distortions and traps. For example, long-term Treasuries are too expensive. Many securities are priced off Treasuries, leading to pervasive non-market mispricing of risk. Also, near zero short-term rates are a disincentive to save in a conservative framework, especially for the retired. But the greatest harm rests in the dampened motivation for politicians to initiate structural reforms. Specifically, the longer that spending inertia is countered by stimulus, the less pressure to enact entitlement and growth policy reforms. In the private sector, necessary restructuring is postponed because loans can be favorably refinanced. Finally, of critical importance, the larger the size of central bank balance sheets, the more challenging it will be to sell their holdings at a measured pace when economies improve. This speaks to the central banks’ ability to control inflation.

Investment Strategy
Stocks – The single best reason to own stocks is the unprecedented monetary expansion underway or planned for the next several years. To a significant extent, a valuation floor is established by the magnitude of planned stimulus. Second, stocks, relative to other asset classes, are reasonably priced. Even with this current weak economic backdrop, there are some important long-term positive fundamentals:
• the growth in domestic energy production has traction and is positive for energy industry employment and our international financial accounts;
• because added domestic energy supply will have a positive impact on U.S. energy prices, we can expect a secular return of manufacturing to the U.S., a good sign for the domestic wage base; and
• a rebound in housing is one of a number of industry sectors that will benefit from deferred demand associated with years of weak economic growth.

Our first stock priorities—core holdings—are high quality multinational companies with the sophistication and scope to shift resources world-wide, where growth is most attractive. We prefer large-cap stocks with dividend yields higher than comparable quality bonds, a record of increasing earnings and dividends and, importantly, at valuations (price to book value, price to earnings, etc.) that are near or better than their sector indices. In this group, we give extra points to companies that match our investment themes.
Second, we hold positions in mid-size (mid-cap) companies that are usually purer “plays” on our major investment themes—energy, food, water, demographics and infrastructure. Most selections are a product of in- house research conducted by our portfolio managers, supported by analysts. This is quite different from most firms where research analysts (internal or external) operate independent from client portfolio management teams.

The third area also uses in-house research to identify special situations that include smaller companies that pass under the radar of large institutions or are unrecognized for other reasons. Also in this group are companies outside the U.S. (especially in Latin America), companies with promising new products not fully tested, and those with different organizational structures (royalties, leases and partnership arrangements, for example) that favor shareholders.
Bonds – We continue to maintain bond investments, in the aggregate, at an average short duration to preserve capital. As noted, we believe the interest rate curve is heavily biased by the central banks’ expansionary policies. Consequently, our allocation to longer-term bonds is and will continue to be low.
Investors have steadily moved out of stocks into bonds for several years, an understandable reaction to the economic climate and to the volatility of the equity markets. The perceived safety of many bonds is presently an illusion, in our judgment. The ultra-low interest rates of today mean that if bonds approach average interest rate levels experienced in the past, e.g., about 6.7%, a holder of a 10 year U.S. Treasury, and other securities priced off the Treasury, would lose about 30% of market value in such a move. At the current rate of under 2% for the 10 year Treasury, even an increase in interest rates to lesser levels would result in a significant price drop.

Many investment professionals have erroneously predicted higher interest rates for the past few years. We do not know when policy makers’ resolve to keep rates low will change or be overridden by markets. We do know, as said earlier, that downside risk outweighs upside potential in the bond market.

In addition to preservation of capital, we believe fixed income allocations in client portfolios perform other important functions; ballast against volatility, source of funds for future investments, liquidity for spending needs and absolute real returns. With these objectives in mind, we are avoiding most long dated maturities, bond mutual funds (with no stated maturities) and lower quality credits. We seek out high quality tax-exempt general obligations, essential revenue bonds, pre-refunded municipals, selective foreign and emerging market debt, and favorably priced taxable municipal and corporate bonds.
We believe the best solution for most clients (but not all) is a relatively short average duration of high quality issues that affords true protection for what should be the safest part of one’s holdings.