Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update, Second Quarter 2015

For the first six months of 2015, the S&P 500 Index has traded in one of the narrowest ranges in its history. The Index closed at its highest 2015 level of 2,131 on May 21st and its lowest level of 1,993 on January 15th. Every other day it ended within that 138 point range. A number of events in the second half of the year appear poised to disrupt this stability. Two in particular are worth discussing. First is the situation in Greece. Second is the potential for the first Fed Funds rate increase in nine years.

Greece Lightning
In the first few days of the third quarter, Greeks delivered a shocking but strong message to European leaders by decisively rejecting a deal offered by the country’s creditors. It now appears likely that the European Central Bank will soon stop providing liquidity to Greek banks, which will force the Greek government to issue a new currency to pay wages and pensions. In the short term, this will be disastrous for the Greek economy.

Defaults and devaluations in Thailand, Indonesia, Russia and Argentina provide some context for what may be in store. Currencies typically lose 70% of their value against the dollar after these events occur. Stock markets plunge by 75% or more and dollar based GDP levels collapse to about 50% of pre-devaluation levels. All of this typically occurs within three to five quarters of the catalyst default. Longer term, Greece, like other countries, may use a more attractively valued currency to entice higher levels of foreign investment and rebuild its economy.

As investors, it is impossible to ignore major economic events such as those currently transpiring in Greece. However, it is also virtually impossible to predict their outcomes. We try to minimize the risks associated with “unresearchable” and often politically motivated exogenous events like those in Greece, and concentrate on researchable themes where our efforts are far more likely to provide us with a durable competitive advantage. Only 10%-15% of our equity holdings are domiciled in Europe, with most located in non-euro denominated countries such as the UK and Switzerland.

Where we do have euro-based holdings, we believe thematic tailwinds will more than offset any potential contagion stemming from events in Greece.

Is it Finally “Go” Time?
The second event that has the potential to influence equity markets is the first increase in the Fed Funds rate in nine years. The last time the Federal Reserve raised the Fed Funds rate was 2006. The rate was raised from 5.00% to 5.25%, where it remained for the rest of 2006. In 2007, the Fed lowered the rate three times, once by half a percent and twice by a quarter percent. At the end of 2007, it stood at 4.25%. The following year, 2008, was the start of the global financial crisis which threatened many financial institutions and ultimately led to the demise of Lehman Brothers. During the crisis, the Federal Open Markets Committee, led by then Chairman Bernanke, lowered the Fed Funds rate seven more times to an ending range of 0.00%-0.25%. It has remained unchanged since.

The current Federal Reserve Board Chair, Janet Yellen, and many Board governors have communicated a strong possibility that the FOMC may raise the Fed Funds rate before year-end. This is far less likely to happen if the situation in Greece continues to deteriorate, and if a rate increase does happen, it will likely be by a modest quarter of one percent.

Given that interest rates are likely to remain very low and most individual and corporate borrowers have either significantly reduced their debt or refinanced to lock in low rates for years to come, we do not believe a small increase in the Fed Funds rate will hurt economic growth or equity markets. In fact, paradoxically, it may stimulate growth by signaling that the Fed believes the economy is on solid footing. We think the Fed action, its anticipation, and its near-term aftermath may create some short term volatility, but the long term impact will be modest. In and of itself, it is unlikely to herald the end to a six year bull market for U.S. equities.

Investment Strategy
Although not much ground was gained in the second quarter (the S&P 500 generated a modest 0.28% total return), U.S. equity markets continue to benefit from the “Goldilocks” backdrop of improving labor markets and low inflation. Excess capacity amassed during the commodity supercycle coupled with significant productivity improvements in the energy complex globally, particularly in the U.S., are keeping price increases for goods historically low. Modest growth and low inflation tend to support high multiples and strong equity market returns. Until one of these two key metrics change, we favor the higher end of equity allocation ranges.

Sector performance varied widely during the quarter with Healthcare up 3.0% and Utilities down 5.8%. Interest rates rose sharply, with the 10-year yield up over 20% from 1.94% to 2.35%. Typically, financial companies perform well when rates rise and the yield curve steepens. Conversely, high-yielding equities such as utility stocks perform poorly in this backdrop. We think rates will continue to move higher, although not dramatically, and our sector weightings reflect this thinking.

Outside the U.S., Greece notwithstanding, developed markets such as Europe and Japan continue to benefit from stimulative measures by their central banks. Although the Stoxx 50 European Index declined 7.4% during the quarter (largely due to Greece), it is still up meaningfully for the year after increasing over 17% in the first quarter (in euros). The Nikkei 225 performed even better, rising 5.4% in the second quarter after a 10% rise in the first (in yen). Leaders in both geographies are trying, with some modest success, to address structural and demographic issues which otherwise are a drag on economic growth. European loan growth is picking up from very low levels and employment is generally improving. In Japan, wage growth is accelerating and a number of other metrics are pointing to stronger growth ahead. Both regions are benefiting from lower oil prices and monetary policies that are intentionally weakening their currencies. Weak domestic currencies help exporters. However, although Europe and Japan may experience some transitory positives, we think it will be difficult to reverse entrenched fundamental problems facing both economies. Additionally, continued strength of the U.S. dollar relative to the euro and yen will reduce positive market returns in these regions for U.S. investors.

The situation in non-developed or emerging markets is much different. Countries like Brazil and Russia which have economies largely dependent on commodities are experiencing economic slowdowns. Other regions, like China and India, while benefiting from lower commodity prices, are facing issues like rapidly slowing growth in China, and rampant corruption and lack of infrastructure in India. We have reduced direct exposure to emerging markets.

Thematic Update
One of our core investment themes is transformative technologies. Dramatic improvements in the collection, transmission, processing and storage of data are creating new businesses benefiting early adapters and innovators. Also, robotics and automation are changing the nature of jobs and labor productivity.

A key driver of robotics is the demographics of aging. The working age population in Japan peaked 20 years ago. The European Union saw its working age population peak five years ago and China, the most populous country in the world, crossed this juncture in 2012. It’s no coincidence that Japan is the leader in robotics adoption and China has begun construction of the first factory that will use only robots for production. The demographic urgency in China, exacerbated by the one child policy, is particularly acute. Its dependency ratio, which is the ratio of those not in the labor force to those in the labor force, will double in the next 45 years. China, once known for its immense low-cost workforce, was the largest purchaser of robots in 2013 and 2014. Hon Hai, the largest assembler of smart phones in the world with over one million employees, has a stated goal of utilizing over one million robots.

Another driver of robotic adoption is productivity improvements. Advances in machine vision, processing technology and connectivity are enabling machines to do much more at increasingly lower costs. The average robot today compared to one built 30 years ago costs 80% less, is 60% lighter, contains 80% fewer parts and is three times more productive. These improvements reduce the initial capital outlay, streamline requisite training and shorten the payback period. A study by London’s Center for Economic Research has quantified the impact of industrial robots on labor productivity. Across 14 industries in 17 countries between 1993 and 2007, the use of robots contributed 10% of total GDP growth in the countries studied. This magnitude of economic growth makes robotics a singular “general purpose technology,” one that has pervasive impacts on a number of diverse industries.

Since the 1970’s, robots have been used almost exclusively for manufacturing, primarily in automobile production. Now, robotics are being extended from traditional manufacturing applications to service-oriented industries. It’s ironic that robotics started in auto manufacturing and today, one of its most prominent applications is the driverless car. Major car manufacturers have announced plans to build self-driving cars. Google’s self-driving cars have driven some two million miles with only 11 minor accidents.

Healthcare should be a natural market for robotics. Labor costs for nurses, nursing assistants and orderlies are rising 90% faster than the overall employment market, making these jobs prime targets for robotics. Today, some 65 million people are confined to wheelchairs, sitting in a world designed for standing. The development of robotic limbs that can sense objects and maintain balance may relegate wheelchairs to museum exhibits in the not distant future. Major advances in surgical robotics are dramatically improving minimally invasive surgery, remote surgery, and the precision of open surgery. It’s only a matter of time until costs decline and utilization increases.

Beyond enhanced productivity, economic growth, and new applications, robots have the potential to improve quality of life. The personal computer may evolve into the personal robot. We focus our research on factors and catalysts that will drive the next wave of robotic technologies. Investment opportunities are varied and just around the corner.

Recent months have seen quite a significant rise of global long-term bond yields. As previously mentioned,10-year U.S. Treasuries ended the quarter at 2.35%, up from 1.94% at the beginning of the quarter and a low of 1.68% in early February. The German 10-year Bund had an even more dramatic move, rising from a low of 0.07% to 0.76%. These increases are a reaction to signs of a global economic recovery, particularly in developed markets, and rising inflation expectations, or, more accurately, reduced concerns of deflation.

According to futures markets, investors expect the Fed Funds rate to gradually rise from 0.00%-0.25% today to 1.75% by the end of 2017. This is hardly high by historical standards and remains well below the Federal Reserve’s expected year-end 2017 rate of 2.75%. Nonetheless, even moderately rising yields translate to lower bond prices. As a result, we expect bond portfolios to offer only modest total returns. Higher interest income will result from new purchases and reinvestment of maturing proceeds. On the other hand, principal values will decline as portfolios are marked to market. Fortunately, since we generally hold bonds until maturity, any unrealized losses should remain unrealized and be fully recaptured at maturity.