Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update, Fourth Quarter 2017

Enjoy It While It Lasts — 2017 was an extraordinary year for stocks. The S&P 500 generated a total return of 21.8%, and rose every single month of the year. Declines were small as the market set record after record. The largest peak-to-trough decline was a mere 3%; since the S&P 500 was created in the 1950s, there has been only one year, 1995, with a smaller intra-year drop. The index reached a new all-time high on more than one in four trading days, more frequently than in all but a single year, also 1995.

Volatility was low. Breadth was strong. The only people who did not enjoy the U.S. market performance in 2017 were those on the sidelines and those betting against the market.

Many of the year’s positive trends started earlier. Despite the long-held and widely shared view that equity investors should expect low returns, the S&P 500’s annual return has averaged above 15% for the past five years.

All good things must come to an end–but not necessarily soon. Given the remarkably steady advance in 2017, the risk of temporary pullbacks is elevated, but returns could well remain healthy, in our view.  The average return for the year following low volatility years is about 5%. The average return for years following those when the market set multiple new record highs is over 7%.  The macroeconomic conditions which drive the market do not change because we turn the page on the calendar and put a new digit on the year.

While it’s hardly a bold call to say that 2018 is going to be a more challenging year than near perfect 2017, we do not believe the U.S. is nearing bear market territory. Recessions and bear markets tend to go hand in hand, and right now, recession indicators are not flashing red. U.S. economic data continues to be bullish for market returns. The new orders component of the ISM manufacturing index rose to 64 in November, while the inventory component sank to 47. Historically, a wide gap between the two is a powerful predictor of positive stock market returns. The current gap is wider than it’s been 87% of the time historically. Core durable goods orders, initial unemployment claims, capex intentions, consumer and business confidence, global PMIs, and other leading indicators also paint an upbeat picture.

History suggests the 7th and 8th innings of a business cycle expansion are often the most profitable for equity markets. Since inception, the S&P 500 has delivered an average annualized total return of 14.2% in the 13 to 24 months preceding U.S. recessions, well above its 10.1% annualized average during full business cycle expansions. The S&P 500 did even better in the 7 to 12 months prior to the beginning of the last three recessions, generating annualized total returns of 22.2%, 20.0%, and 13.6% leading up to the recessions of 1990-1991, 2001 and 2007–2009, respectively.

Bottom line: With recession likely a year or more away, the probability of rewarding equity market returns is high.

Globally, the picture is even brighter. The MSCI All Country World Index generated a total return of 24.6% in U.S. dollar terms in 2017, beating the S&P 500 by almost three percentage points. For the first time in more than a decade, global economic growth is widespread. Almost 75% of developed economies are at full employment, and most global macroeconomic indicators are pointing to strong growth. The Global PMI is broader than it’s been in a decade, and its manufacturing component is at its highest level since early 2011.

Notably, the global manufacturing PMI has peaked a median 15 months before the beginning of global recessions, while the global OECD Composite Leading Indicator has peaked a median seven months before recessions. At this point, there is little indication that either of these indicators has reached its high point in this cycle. Taken together, they suggest that the current global expansion has longer to run than the U.S expansion, which began much earlier and is likely further along.

Even regions plagued with long-term structural problems are experiencing a cyclical bounce. For example, the Japanese and European economies are seeing some of their best growth in years, and policymakers are taking advantage of this strength to address difficult issues. In France, President Macron is implementing many of the labor reforms that were successful in Spain. France’s production outlook is at its highest level in 17 years.

In Japan, Prime Minister Abe’s economic restructuring efforts are finally bearing fruit. The decline in the labor force due to Japan’s aging population has recently been mitigated by rising female labor force participation and an increase in foreign guest workers. The female labor force participation rate in Japan for women aged 15-64 is now 70% and foreign guest workers have increased from 720,000 in 2013 to an estimated 1.3 million last year.

Importantly, corporate profit margins in Japan are now at a 70-year high. This is significant because Japanese companies traditionally put a higher priority on sales growth than profitability. We think this augurs well for Japanese stocks.

Our bullishness on Japan makes us somewhat unusual. In Barron’s October 2017 money manager survey, only 6% of managers expected Japan to outperform other regions over the next 12 months. This compares to 45% of respondents who chose emerging markets to outperform, 29% who chose Europe, 13% who chose the U.S., and 7% picking China. We believe most managers are underappreciating investment opportunities in Japan. We like being early and think the
risk/reward trade-off is now favorable for Japan. Most of all, we like the fact that many companies in Japan fit squarely in our themes.


What We Worry About

Change tends to occur more slowly when inflation is low, but inevitably, market dynamics do shift in response to economic and societal developments. We are on guard for economic distress signals. As Charles Darwin famously said, “It is not the strongest of species that survives, nor the most intelligent, but the ones most responsive to change.”
In the U.S., year-over-year earnings comparisons are becoming more challenging, and the recently passed tax cuts may overstimulate the U.S. economy, and thus hasten the end of the business cycle. The tax bill represents incremental stimulus to an already strong economy. Unemployment today is just 4%, versus its 7% average when the last seven major tax cuts were enacted. No major U.S. tax reduction has been enacted when the unemployment rate was this low. If too much stimulus leads to higher levels of inflation, the Federal Reserve could boost interest rates faster than expected, choking off economic growth.

We are also concerned about geopolitical risks, including North Korea, rising tensions in the Middle East, impending elections in Italy and the consequences of Brexit, as it proceeds. A trade war or an unexpected exit from NAFTA would almost certainly have a negative impact on equity markets.

In sum, there is no shortage of reasons to worry. We will monitor these situations and others that will almost assuredly arise.  As the facts change, we will react and reposition accordingly. The positive side of our 2018 outlook is that the secular bull market is well intact and should continue. The negative side is that the year is likely to include increased volatility and abrupt market corrections.


Only a Few Stocks Matter

As relatively concentrated thematic investors, we have never tried to know everything about every company or even every sub-industry in the market. Instead, we focus on what we believe are the most fruitful areas for investment, those tied to our themes.
Each of our themes made a positive contribution to portfolio performance in 2017 and over the past three years, but in each year, different themes have been the biggest contributor. In addition, in each year, a handful of stocks drove a disproportionate share of portfolio returns. Researching and picking these “winners“  is central to our thematic investment process.

According to the economist Hendrik Bessembinder, the net gain in the U.S. stock market since 1926 is attributable to the best-performing 4% of listed stocks; the other 96% percent collectively matched the return of one month Treasury bills. Bessembinder expressed these gains in terms of “lifetime dollar wealth creation,” the contribution to the equity market’s net gain from each stock, starting in 1926 or when the company first appeared in the database through the end of the measurement period or earlier delisting of the stock.

Some market experts use this analysis to tout the virtues of passive investing, claiming it is impossible for active managers to consistently find high-performing stocks. We disagree. We believe thematic investing is more likely to succeed than other active investment approaches because it focuses on companies that are disrupting the status quo and are well positioned to capitalize on structural and economic change. In financial terminology, thematic investing seeks to find investments with positive skewness: greater upside potential than downside risk. Our thematic research is dedicated to identifying these opportunities.


Portfolio Positioning

Global markets, generally, have performed well, and many regions still look promising. We are continuing to increase non-U.S. developed market exposure in portfolios. As noted above, we think there are compelling thematic opportunities in Japan and Europe, in particular.

Our thematic research has recently led us to a new focus area related to curation-influenced opportunities in consumer spending. Curation uses a combination of online data and offline expertise to winnow down the choices presented to shoppers. For many consumers, the proliferation of online stores, travel sites, media and entertainment offerings and other online outlets is overwhelming. Too many choices can sometimes lead to less spending. Technology and consumer companies are teaming up to help vendors customize offerings to specific consumer preferences and then help users navigate the vast array of options.

This avenue of research stemmed from our work on the growing importance of intangible assets. Data is quickly becoming one of the most prolific commodities in the world, and if used intelligently, one of the most important assets a company can own. Retail and media firms, as well as other consumer-focused companies, are cataloging our online purchases, the length of time we spend on each page of their websites and how we click from one item to the next. However, their ability to monetize this information effectively varies greatly.

Some companies are extremely good at using data. For example, Amazon has said that it had recommended roughly 70% of the items purchased on its site, based on either other consumers’ purchases or the shopper’s own purchasing history. Similarly, some 90% of shows watched on Netflix were Netflix-recommended. Many other companies don’t yet have the expertise to translate information into higher revenues.  We think this will change. Our research suggests that e-commerce is still in the early stages of improved curation, a trend that may eventually enable smaller companies to compete with industry behemoths.


Fixed Income

The 10 year U.S. Treasury bond ended 2017 with a yield of 2.41%. This is only 4 basis points (0.04%) lower than the 2.45% level when the year began. Volatility in the bond market, like the equity market, was very low. The 10-year yield reached a high of 2.63% on March 13, 2017 and a low of 2.04% on September 7, 2017.

The shape of the yield curve flattened rather dramatically throughout the year with the short end of the curve rising by approximately 75 basis points (0.75%) despite the long end remaining virtually unchanged. The yield curve is currently at its flattest level in 10 years.

The increase in government debt resulting from the recent tax bill is likely to raise equilibrium bond yields modestly. The Fed estimates that the equilibrium 10-year bond yield would rise on a structural basis by 3-4 basis points for each percentage point increase in the Federal government’s debt-to-GDP ratio, and by 25 basis points for every percentage point increase in the deficit-to-GDP ratio.

Bears have been calling for the end of the 30+ year bull market in bonds for several years now, and once again many fixed income forecasters are projecting significantly higher yields in 2018. We are not convinced that the end is nigh. However, by investing in individual bonds rather than mutual funds or bond ETFs, we dramatically reduce our risk if significantly higher yields do materialize.


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