Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update, Second Quarter 2018

Equity Market Performance  — The S&P 500 Index began 2018 with an initial surge from 2,674 to a high of 2,873 on January 26th. It then quickly and sharply pulled back to a low of 2,533 on February 9th. Since then the Index has largely moved sideways, ending the second quarter at 2,718, 5.4% below its high and 7.3% above its low.

Year to date the global equity market represented by the MSCI All Country World Index (ACWI) has been relatively flat. For the first half of 2018, the ACWI generated a slightly negative return of -0.13%. The S&P 500, as the largest component of the ACWI, generated a positive return of slightly less than 3%. Most other regions, including Emerging Markets, Japan and Europe were down.



Last year, the global economy experienced a synchronized expansion. Global real GDP growth accelerated to 3.8% in 2017 from 3.2% in 2016. Euro countries, Japan and many emerging markets moved from laggards to leaders in global growth.

The opposite pattern is occurring in 2018. Global growth has slowed and the U.S. is the only major economy where leading economic indicators are still rising. The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth. 

This lofty pace cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48 year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. For the first time in the history of the Bureau of Labor Statistics’ Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers. 

In addition, the central bank is raising rates, equity valuations are relatively high and forward earnings estimates are at their highest level in nearly 20 years (see chart below).  All of these factors indicate that the U.S. is in the late stages of an expansion.



As the chart shows, even with high expectations, the market can overshoot to the upside and equities may rally to fresh highs before this cycle is over. Given our bias for capital preservation and view that it is the late stage of this business cycle, we think it is prudent to be moderately defensive. However, we do not believe we are on the cusp of a recession. Traditional recession signals that we watch do not suggest a recession is imminent. For example, the spread between yields of 2 year bonds and 10 year bonds is falling, but still positive. This metric tends to turn negative approximately 12 to 14 months before recessions commence. Leading indicators (LEIs) also usually fall below zero when a recession is imminent. The May LEI rose by 6% year over year. Initial claims for unemployment insurance for the week ending June 16th were 24,000 below their reading six months earlier. Typically, a six month increase in unemployment claims of between 75,000 and 100,000 would presage a recession. Absent a recession, equity market corrections tend to be shallow and short-lived.



Our rule of thumb in investing is to ignore politics and focus on fundamentals. This has served us well. However, we view trade differently. We believe many investors and politicians may be underestimating the potential consequences of tariffs.

In our opinion, a trade war is one of the greatest risks to the U.S. equity market. The current cycle has not been about top-line growth. In fact, in terms of revenue growth, this has been one of the slowest recoveries on record. This cycle has been defined by the exceptional margin progression of “manufacturers,” defined broadly as companies who make something somewhere.

The S&P’s steady rise in profit margins over the last two decades has been driven by manufacturers. There are currently 182 manufacturers in the S&P 500. Their net margins have risen from 8% in 2000 to 14%, an astounding 75% increase. Roughly half of the manufacturing stocks are drawn from the technology, industrial capital goods and auto sectors, and represent about a quarter of the earnings of the entire S&P 500.



While there have been four primary drivers behind margin expansion: moving production to lower cost regions, lower interest expense, benefits of robotics and automation, and a decline in effective tax rates, globalization has been the gift that just kept on giving. The world operates far differently than it did 20 years ago. Sales from foreign affiliates of U.S. multinationals are roughly $6 trillion, nearly four times the $1.6 trillion of exported U.S. goods. The U.S. trade position with China looks decidedly more balanced when revenues from foreign affiliates of U.S. companies are taken into account.



Trade is no longer a matter of producing goods in one country and selling them to another. Trade is now dominated by intermediate goods. The exchange of goods and services takes place within the context of a massive global supply chain. Automobiles, technology and apparel are produced from components sourced all over the world. Some components cross borders multiple times. As a result, trade in intermediary goods (components) now exceeds both trade in primary goods (raw materials) and finished goods. This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60% of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. We believe the impacts of a global trade war would be seismic by comparison. Given current lofty earnings expectations, a trade war would likely inflict disproportionately more harm on the U.S. equity market than it would on the U.S. economy.

Importantly, many industry reports are minimizing trade war impacts, particularly on equity markets. The analysis laid out in these reports is as follows: a 25% duty on $34 billion worth of products, which represents the amount of the first section 301 tariffs set to be imposed on July 6th, is roughly $8.5 billion, a fraction of the $800 billion in fiscal stimulus expected this year. Even if this amount is raised to include the $16 billion of Chinese imports that are under further review by the USTR and another $200 billion of Chinese goods under consideration for a 10% tariff, it will not approach the amount of stimulus. There is little discussion of the negative impact on companies and financial markets. Nor is there analysis of the implications to supply chains.  This underestimation will likely be revealed and its impact felt in financial markets later in the year when quarterly results begin to reflect companies’ increasing inventories on hand in anticipation of new and changing tariff and trade rules. Bottom line, although we have no way of handicapping the odds of a full blown trade war, the risks are clearly up. Like a nuclear standoff, the only thing preventing a trade war is mutually assured destruction.



Things have gone from bad to worse for value investors, with value stocks underperforming in all regions around the world so far in 2018. While the performance gap is reaching an unprecedented level, we still do not see the catalyst to overweight value. Weaker global leading economic indicators and a stronger dollar clearly favor longer-duration growth companies.



Among growth stocks, technology was again one of the market’s best-returning sectors in the first half of 2018, up almost 11% and outperforming the S&P 500 by over 800 basis points (8%), driven entirely by an increase in tech’s relative earnings multiple. Actual earnings growth was relatively muted. Moreover, year-to-date multiple expansion was broad-based across the tech sector, in contrast to last year when it was concentrated in a few stocks. The technology sector now trades at 1.13 times the market’s multiple on a capitalization weighted basis, higher than it has in nearly a decade, but still less than half of the peak reached in 2000. 

The risk profiles of technology stocks have become significantly more favorable over the course of this cycle. Free cash flow margins have been rising for 20 years, due in part to a sustained decline in capital intensity. In the last four quarters, tech’s top-line growth rate has been double that of the market. These are fundamental strengths. As important, we don’t see signs of self-undermining excesses. None of the time-tested indicators of systematic risk – price volatility, share turnover, equity issuance, retail flows, or the performance of initial public offerings, are even flashing yellow. Tech’s free cash flow production has become large enough to be crucial to the outlook for the entire market. In 2005, the sector accounted for 20% of aggregate output and now that share tops 30%. In this cycle, the tech sector has been responsible for most of the cash flow generation of the market.


Soon, almost every company will be a tech company in some respect. The leaders in this equity market: Facebook, Apple, Amazon, Netflix and Google, (FAANG), have not only reshaped the investment landscape, they have also reshaped the consumer by capturing their time and their wallets. As a group, they have added over $300 billion in sales over four years. The five FAANG companies now have as much brand equity as the top 50 consumer brands put together. Profits of these five companies now account for a greater share of the U.S. profit pool than all the large capitalization consumer staples companies combined. 

We have recently trimmed some of our largest technology winners and will be closely watching for signs of relative weakness. However, leading companies today are nowhere near as “risky” as the leaders were 20 years ago. If the fundamentals remain solid, we will continue to own technology stocks that are some of our highest conviction thematic holdings.



When 2018 began, still-strong global growth and extremely robust earnings led most fixed income analysts to predict that yields would rise across the curve and the U.S. 10 year bond yield would lift towards 3.5%. While the 10 year yield finally did exceed 3% for about ten days during the second quarter, the high point was only 3.11% and it closed the quarter at 2.86%, only 12 basis points (0.12%) higher than at the end of the first quarter. 

The Fed has now hiked short rates seven times (175 basis points or 1.75%) and plans on two more this year followed by three next. The Fed’s balance sheet is now down $200 billion from its peak and is set to continue falling at a quickening pace into the fall. The spread between 2 year bond yields and 10 year bond yields fell to 33 basis points at the end of quarter. This is roughly the lowest spread since August 27, 2007. We are closer to an inverted yield curve today than at any point in this cycle.

The Fed’s Summary of Economic Projections suggests a yield curve inversion next year (assuming long rates remain near current levels) and a 100 basis point rise in the unemployment rate, something that has never occurred outside a recession.

Periods when the curve is flat are consistent with much lower excess returns than when the slope is greater than 50 basis points. Given the low potential reward, we believe sticking with a strategy of buying relatively short duration, high quality bonds makes prudent sense.

We expect the 10 year yield will remain in a range between 2.50% and 3.00% until the threat of a trade war either lifts, in which case yields will likely rise across the entire curve, or a trade war causes a rush to safety and long term yields fall below 2.5%.