Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update, Fourth Quarter 2015

Going Nowhere Fast

The S&P Index ended 2015 at 2,044, almost exactly where it started the year at 2,059. Including dividends, the Index’s total return for the year was +1.38%. Volatility was higher than in any year since 2008. Market performance was very concentrated. The ten largest S&P stocks were up 17%, while all others were down 5%. In sum, it was not a banner year for US equity investors, particularly if you didn’t own the winners.

What now? If the only statistic that mattered was the aggregate return for 2015, there would be reason for optimism. Since 1970, in every year after a relatively “flat” year, the S&P generated a double digit return. Results varied between +11% and +34% with an average of +17%. However, in these “following years” S&P earnings increased by 12% on average. Given the current macroeconomic backdrop, we think it will be very difficult to achieve double digit earnings growth in 2016.

Due to extremely low inflation, weakening nominal GDP growth, elevated corporate credit spreads and slower money growth, we think 2016 S&P earnings will only grow a modest 5% or so. Pricing power remains a major impediment to faster growth. Deflation plagues more than half of the 60 major industry groups. Selling prices in 32 industries are declining. Six other industries have been unable to raise prices by more than 0.5% per annum, while another seven are below 2%. Thus, more than two-thirds  of industries can’t keep pace with core inflation. This does not bode well for future corporate profit growth.

Coupling our modest 2016 earnings growth projections with already relatively high price/earnings multiples, leads us to conclude that aggregate returns in 2016 will once again be below long-term averages. Despite this relatively pessimistic view, we believe our thematic approach will  continue to present selective investment opportunities.


We expect 2016 US GDP growth will remain low but positive. Key factors we’re watching include:

Interest rates – Historically, small changes in interest rates have not had a large impact on GDP growth. However, the global economy looks very different than it did in the past due to major shifts in demographics. A greater percentage of the global population is no longer in the workforce, the workforce is aging, and birthrates are declining. These demographic changes suggest that small movements in interest rates may matter more now.

The December 16 Fed rate hike was the first time since 1967 that the start of a Fed tightening cycle coincided with a drop in corporate profits. Volatility will likely remain elevated and markets will struggle if the Fed continues to tighten into a slow growth, low inflation US economy. We would not be surprised if the Fed reverses course, particularly if inflation remains low. All else being equal, we would be more optimistic about equity markets if Fed policy moves to a more neutral stance.

Energy prices – Energy prices are a key input to inflation. Oil has fallen more than 65% since mid-2014. We don’t expect another 65% decline from current prices. Just as important, we do not expect a sustainable and significant price increase. Equity markets are in a bit of a catch-22. Companies need some inflation to drive profitability, but if inflation grows too fast, the Fed will almost certainly tighten more aggressively. We think lower for longer inflation levels are better for equity markets, because lower earnings growth will be balanced by price/earnings multiples that remain high.

The US dollar – One of the most important factors for global investors to consider when allocating assets geographically is the relative strength or weakness of the US dollar. When measured in their local currencies, the German, French and aggregate Euro equity indexes generated positive returns of between 3% and 10% during 2015. However, when converted to US dollars, returns were uniformly negative. Since early 2014, we’ve been bullish on the US dollar, expecting it to strengthen against other currencies. This was one of the primary reasons we reduced our non-US equity exposure. Since July, 2014, the US dollar has risen 20% compared to a trade-weighted basket of other currencies.

Going forward, we think dollar strength will be more muted. This view is based on the belief that the divergence in central bank policies that has been a driver of recent dollar strength will revert to a more synchronized and uniformly accommodative stance. As mentioned, although the Fed finally raised interest rates after a nine year hiatus, we’re skeptical that the economy will weather many more increases before the Fed pauses or potentially reverses course. Conversely, the European and Japanese Central Banks have recently disappointed markets by their reluctance to ease policies more aggressively. On the margin, we think the gap between our monetary actions and those abroad will shrink, which should reduce interest rate differentials and limit the strength of the US dollar.

Improving fiscal policies – One area of potential economic upside that has not received much investor focus is the large fiscal stimulus enacted by Congress in late December. The legislation significantly increases discretionary spending by over $40 billion and repeals the crude oil export ban. It also extends a number of tax credits and provides relief from taxes imposed by the Affordable Care Act. This package alone may add roughly 0.7% to GDP growth next year. However, it will also increase the deficit  by 0.9%, which may contribute to US dollar weakness.


We are maintaining equity allocations at the low to midpoint of specified ranges. Within our holdings, we’ve made changes to reflect our updated outlook.

  • Increased the weighting to our Automation theme – In a low inflation environment the best way to increase profitability is to improve productivity. Economies of scale have driven down the cost of robotic technology so that it is now a cost effective option in a wide array of industries. Many of our core holdings in this theme are domiciled outside the US. Given our more balanced view on the US dollar, we’re increasing our holdings in these companies and marginally reducing our U.S. overweight.


  • Moved to a neutral stance in energy – As mentioned, we think the lion’s share of the price declines have occurred. We were not surprised by the stealth collapse of OPEC after participants failed to reach an agreement with regard to pumping limits at its last meeting. However, since most OPEC members are already pumping oil at or near capacity, we don’t expect a flood of new supply to come to market as a result of the cartel’s breakdown.


  • Reduced exposure to our Data Inundation theme and increased weightings in defensive sectors – Many companies in the Data Inundation theme significantly outperformed the market during 2015, some more than doubling in price. We have taken some profits and reallocated to well positioned, reasonably valued companies in defensive sectors with a focus on those with improving pricing power. In particular, consumer staples and telecom services are exhibiting price firming after long periods of decline.


  • Global exposure – We have modestly increased our exposure to developed markets outside the US, while continuing to avoid emerging markets. Earnings of emerging market companies are more positively correlated with international trade than with world GDP growth. International trade continues to slow with the Baltic freight index reaching an all-time low in December 2015. The current deflationary impulses benefiting consumers in developed markets continue to plague many emerging economies saddled with enormous extra production capacity. Until we see the incessant decline in global trade subside and utilization levels rise, we will avoid emerging markets.


Most US fixed income investments generated very low returns in 2015. Outliers were high yield bonds which declined over 4% and municipals which were up over 3%. Nominal yields for ten year Treasury bonds averaged 2.27%, versus an average yield from 1958-2015 of 6.23%. Real yields (yields adjusted for inflation) in 2015 were even more anemic at 0.25%, versus the 57 year average of 2.46%.

Over the past six months, in anticipation of Fed tightening, US two year interest rates have nearly doubled to over 1%. Ten year yields remain unchanged around the 2.30% level. This has resulted in the yield curve moving to its flattest level since the Eurozone crisis in 2012, although it is still a long way from inverting. On the margin, given our outlook for relatively modest economic growth, we favor intermediate duration instruments which are more impacted by inflation expectations and are not as explicitly linked to Fed policy. Currently, we are maintaining client portfolio durations in the three-to-four year range.

Market expectations for future rate rises are still well below the Fed’s published targets, but have moved up recently. Recognizing that any future Fed rate decisions are data dependent and given our economic outlook, we question whether even the market’s expected rate rises will be realized. This makes us relatively optimistic about the outlook for bonds. If we see signs of rising inflation and a faster growing economy, we will grow more cautious since yields across the curve would move higher and bond prices would broadly decline. However, this is not our base case. In the current macroeconomic environment we believe fixed income continues to be an important counterweight to more volatile equity markets.