Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: Second Quarter, 2012

Economic Conditions (Audio Version)
Real GDP increased at an annualized rate of 1.9% in the first quarter of 2012. For all of 2011, real GDP increased by 1.7%. Unemployment in May was 8.2%, and consumer confidence dropped to 64.9. Current economic data point to continued slow growth through the second half of 2012; consequently, we have reduced our estimate of real GDP growth in 2012 to 2.1%. Please note that economic forecasting, always a hazardous exercise, becomes particularly risky when the big story is not about economic and business cycles, but about massive sovereign debt levels and the need for savvy decision making in world capitals.

As noted in our previous report, we are optimistic about a resumption of economic growth after we work through the formidable problems in front of us. The United States is especially well situated for long-term secular growth. Its new domestic energy discoveries are a game changer. Manufacturing will return and the synergy of our technological-entrepreneurial capabilities with new energy resources and improved logistics will put us in a singularly strong position. Indeed, in a surprising reversal, the United States may become the supplier of choice to the growing middle class in emerging markets.

However, the period immediately ahead is full of challenges, economic and geo-political. Most are widely reported but, unfortunately, most reporting is a distraction from our fundamental problem: the anemic growth rate of real GDP. Coming out of such a deep recession, we should be growing at twice the approximate rate of 2.4% since the second quarter of 2009. Indeed, one can argue that growth should have been more than double what it was in view of the unprecedented stimulus. Weak U.S. growth is the result of a still heavy consumer debt load, only modest employment gains and even slower growth in real wages. In short, when consumer buying power is weak, GDP growth is likely to be weak.

Consumer buying power is a long-term issue. Household debt as a percent of disposable income is still too high—about 70% higher than the mid 1980’s and only about 12% lower than the bubble high. This debt level is a big drag on the economy. Consumers are unlikely to increase their spending when debt levels are high, their inflation adjusted income is weak, and, importantly, their assets have diminished in value with uneven prospects. The old option of borrowing against assets, i.e., real estate, to maintain lifestyle is, gratefully but painfully, history.

We are not optimistic that employment will improve meaningfully in the near term. Private hiring is unlikely to be strong when the demand for goods and services is weakening and when the growth rate in profits is slowing. Moreover, the lack of government hiring will continue to have a negative impact on employment. Also, we can expect no help from abroad: (1) most of Europe is in or heading into a recession; (2) Brazil has stopped growing; (3) India has slowed with a serious inflation problem; and (4) China has underlying structural problems and slowing growth.

With regard to the Euro, much will be done to save it because the consequences of its failure would be deflationary at the worst possible time, and very messy. Our view for a long time has been that the structure of the Euro is seriously flawed and works only in benign times and in the “best of all possible worlds.” To work, when economies are really tested, requires fiscal and political union. That is to say, Europeans must give up their national sovereignty, which is unlikely in a region noted for its ethnocentrism for thousands of years. We suspect many European nations have quietly put in place multi-year transition plans back to their old currencies.

That said, our reasons for intermediate, possibly, and certainly longer-term optimism, derive from glimmers of realization that grand compromises, including entitlement reform, more flexible labor rules, and a re-thinking of revenue sources, may be in sight. There are also massive global reserves of cash, individual, institutional, and corporate, awaiting signals to redeploy.

Investment Strategy

In brief, we want a presence that looks through the current downturn, preserves capital, and provides reserves to purchase assets at attractive prices when markets overreact, as they always do.

We are maintaining equity investments in our core sectors because there are many high quality companies, here and abroad, with strong balance sheets, cash flows, dividends, and ability to increase earnings in periods of modest growth. They are also attractively priced relative to other asset classes, and will benefit greatly when economic conditions improve. We are looking through the current gloom because the long term outlook is bright, driven by a pent-up demand in both developed and emerging markets.

We are preserving capital by maintaining equity exposure at the lower end of each client’s range, as determined by individual investment objective. Also, fixed income allocations are largely short duration and high quality. These measures provide flexibility to increase equity exposure when our assessment of risk-reward tilts more toward reward.

We promised to elaborate on more of our central themes for long-term investments. Last quarter, we addressed energy and water. This quarter, we highlight food:

In the not too distant future, we believe that the growing demand for food, world-wide, will create some attractive investment returns. The historical growth in demand for food is in the early stages of a substantial acceleration stemming from changes in tastes and financial means of the growing middle classes in emerging economies. For example, feed grain use in China has risen nine-fold since 1978, and in 2010, China replaced the U.S. as the world’s top feed grain user. Previously self-sufficient in grains, China has become a net importer. The share of world soybean exports to China has risen from zero in 1994 to more than 60% today, while world output of soybeans has dropped 1% in the last decade from the prior ten year period.

Attractive long term investments emerge when growing demand meets secular supply constraints (as opposed to cyclical supply constraints that produce temporary profit possibilities). Here are some secular supply constraints to future food production:

• Global arable land per person is half the level of 1950;

• About one-fourth of farmland soil in the world is degraded and subject to rapid erosion;

• About 40% of the world’s population is living in water- scarce regions; and

• Global grain deficits have occurred in 7 of the last 11 years with food inventories near a 50-year low.

Security selection in this area is challenging; food (and water) are widely viewed as basic public rights, and enthusiasm for private company participation can wax and wane. Consequently, our food investments will include companies both directly involved in the food supply chain and those that participate as indirect beneficiaries or catalysts. In the period ahead, food will be one of the high priority investment themes of Chevy Chase Trust.