Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: First Quarter, 2011

This is a quarterly update of economic conditions and investment strategy.

Economic Conditions

The first quarter of 2011 showed a continuation of the major trends in the U.S. economy that were evident at the end of 2010. Fourth quarter, 2010 GDP was revised upward to 3.1%, from 2.8%, with growth for the full year at 2.8%.

The employment picture improved at a moderate pace although the unemployment rate, at 8.8%, is still very high by historical standards. Housing prices remain mired in a slump with most major markets at or below post-bubble lows. Case-Shiller data through January, 2011 show a decline of 3.1%, year over year, for the 20-City Composite, with only San Diego and Washington, DC recording gains.

We are witnessing an unusual juxtaposition of weak consumer confidence with robust corporate profits. It is likely that these two forces will moderate as confidence improves with new hiring and profit margins compress when labor costs rise. Still, growth is likely to be muted. Wages, salaries and benefits, accounting for about 75% of personal income in 1970, have dropped to 64% in 2010. No statistic better highlights the contraction of the U.S. middle class. Together with the widening and unhealthy upper/lower income gap, it explains the weak economic recovery because spending by middle (and lower) income earners is much greater than that of more affluent households.

Without growth in wage income and healthy financial and housing markets, we see a pattern of very slow economic growth, interrupted by fits and starts caused by the usual unpredictable natural and geopolitical events of our times. Consequently, we project GDP growth at under 2% for the first half of 2011.

We are concerned about the high level of government intervention (fiscal and monetary stimulus) that was required to return the economy to only a moderate level of growth. Further fiscal stimulus is increasingly unpalatable from a political perspective and monetary policy may be on the verge of transitioning from accommodative to restrictive in the face of nascent inflation. In the event that Government stimulus is removed, it is not clear that there is sufficient momentum in the economy to sustain even the current level of growth.

Budget challenges continue to confound policy makers. Several States and municipalities, with their balanced budget mandates and weakened ability to access debt markets, are making tough choices on spending and taxes. At the Federal level, present and future liabilities continue to grow. Stanford University’s Institute for Economic Policy Research, in a joint effort with former U.S. Comptroller David Walker, created a “Sovereign Fiscal Responsibility Index” that assesses the 34 countries in the OECD and the “BRIC” countries. In this assessment, the U.S. ranked 28th, behind Italy. The study noted “…our analysis suggests the United States is three to five years away from an indebtedness crisis like that of the European nations currently facing fiscal strain.”

We are also concerned about the slowing pace of the global economy. Turmoil in the Middle East and North Africa, the European debt crisis, and the pressure on interest rates in developing economies to deal with clear inflationary signs are not conditions to enhance growth. Also, Japan’s natural disaster and ensuing nuclear crisis will dampen global economic activity for the remainder of 2011, at least. In addition to the horrific loss of life, and the destruction of property and infrastructure, there are disruptions to global industrial supply chains, most prominently in the automotive and electronics sectors. Inventories will run down by May, 2011 for many goods which will reduce sales and pressure prices.

Finally, international oil prices have increased from $90 prior to the first demonstrations in Egypt to $108 on fears of supply disruption. While we have not reached a price that will tilt the global economy into recession, sustained high prices are worrisome because they are a tax on consumers in a weak economy, and because they have been closely linked to recessions in the past.

Investment Strategy

U.S. stocks, as measured by the S&P 500, have increased sharply from the lows of the economic crisis in March, 2009, raising questions about current valuations. The S&P 500 trades at 15.5 times trailing (last year’s actual) earnings and 13.7 times this year’s expected earnings, superficially not an extended valuation. But, corporate profitability is high on an historical basis; input prices are rising (oil, grains, metals); inflation in the supply chain is increasing; and wages are starting to firm. Therefore, profit margins are likely to come down and stock prices may follow.

In an era of slow economic growth our investments will focus on sectors that are likely to grow at a rate faster than the overall economy. They should be further concentrated in products and services that are necessary or very desirable for which substitutions are not readily available.

Our approach to equity investing is to seek out individual companies that are well positioned to take advantage of secular global trends that we believe will be in place for many years. We have written extensively of these themes, e.g. natural resource scarcity and demographic trends of urbanization in emerging markets and aging populations in developed markets.

Not only is it important to be in the growth sectors of the world economy and in the best names in each sector, it is also important to have appropriate positions at sensible costs. To accomplish this, thoughtfully, it is often necessary to initiate and establish positions over time. Sometimes, we find a bargain and we immediately establish a large position, but more often it is a methodical monitoring that produces the large successes over time. This is one of the reasons that client portfolios differ, even those with the same objectives and circumstances. In time, all client portfolios tend to reflect our top priorities, but sensitivity to prices paid influences the time frame.

When an investment meets our price and other criteria, we tend to hold it for a long period, selling only if fundamentals deteriorate or valuation becomes unreasonably high. Thus, equity weightings in our client portfolios tend to rise (within individual long-term guidelines) when we find more attractive opportunities and fall when opportunities are scarce. For example, Mid East unrest and associated removal of Libyan oil production contributed to the aforementioned increase in the spot price of oil. Our energy investments, selected to participate in the longterm supply/demand imbalance of oil that we envision, have appreciated sharply this year. Near term, this may not last; we expect normal volatility to afford opportunities to establish positions for new clients, and to reshape energy positions for longer-term clients.

The same dynamics are beginning to unfold in our favored agricultural companies. Grain yields are not growing in many countries because of soil erosion, droughts, over pumping of aquifers and other factors. Even the U.S. will face water shortages for agriculture and not just in the West. The Ogallala Aquifer, the largest body of fresh water, stretching from South Dakota to the Texas Panhandle is depleting at a rapid rate. This will affect about 20% of U.S. grain production. Food production in China, India, and Russia has been strained for different reasons, conditions likely to persist. These are strong signals that the worldwide productive capacity of food will be challenged by rising demand, year over year, and that prices are headed higher.

The quintessence of the issue is that additional food production will by necessity be a product of increasing yields because the amount of arable land for each person is declining. In our view, countries with ample water and land are best situated; seed technology companies capable of producing drought resistant seeds will be a big part of the solution; and fertilizer and infrastructure/irrigation companies, such as those using pivot and drip irrigation, will benefit from increased demand. We hold stocks of many of these, and plan to add to client holdings when the timing and values look right.