Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: Third Quarter, 2008

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

Economic Conditions

While second quarter GDP increased at a 2.8% annual rate and the third quarter GDP is likely to be flat, a broad slowdown is underway. We expect a global recession in 2009, and, as noted in prior reports, we expect it to be a protracted affair. We will get through this mess with all sectors but the Government having better balance sheets and (including the Government sector) a better sense of risk.

The sub-prime crisis brought down Bear Stearns, Lehman, Merrill Lynch, Wachovia, Washington Mutual, Fannie Mae, and Freddie Mac and has kicked off deleveraging (debt reduction) throughout the global financial system. An extended period of very low interest rates induced a level of borrowing without precedent, leading to high prices for homes (in the United States and in many other countries), sustained consumer spending significantly greater than disposable income, and higher asset prices that gave false comfort to those with low levels of personal savings.

Credit markets are in disarray. The commercial paper market, which corporations use to fund short-term operations, is not functioning. The cascading effects include drawdowns on bank lines of credit at a time when banks are reluctant to lend, an erosion of suitable inventory available for purchase by money market funds and a reduced desire by these funds to purchase anything but government securities, and an overall reduction of economic activity as all sectors husband cash. The Federal rescue package is primarily targeted at this issue. Through the massive Federal purchase of illiquid bonds, and direct investment in banks, the Treasury hopes to restore liquidity to the financial sector.

It is not clear that the bailout will work. To work, the Government must overpay to provide capital to the banks. Perhaps the value of the assets will increase, but maybe not; in either case, risk is transferred from the security holders of the banks to the taxpayer. The direct capital infusion into the banking system should have similar effects. In both cases, Government debt would rise dramatically (more on this later). The aforementioned measures would likely clear the credit systems. But, in our view, the greater problem is that a very large part of the population is under considerable financial stress in meeting basic needs. In addition to housing, health care, energy, food, education, and tax expenses are pressuring American households. Lending officers are not likely to be generous with businesses and consumers under this magnitude of stress. Consumer expenditures are about 70% of GDP; therefore a healthy consumer sector is essential for the resumption of healthy economic growth and for the restoration of balance sheets. Even if successful, the bailout will not be a quick fix.

Looking into 2009, we expect an increase in unemployment, low short-term interest rates, and a generally deflationary climate, the latter a consequence of soft demand and lower commodity prices. Beyond 2009, we expect a systemic change in interest rates and the rate of inflation, both on an upward track. This will be the product of a huge monetary and fiscal stimulus that is likely to be undertaken during the next year.

Investment Strategy

After seven years of outpacing the S&P 500, our equity returns for 2008 are in line with the market. While we have largely (but not entirely) avoided the devastation of financial stocks, the selling is now broad based and indiscriminate. Indeed, no investment sector, stock, bonds, commodities (except gold), or real estate, shows a positive return.

Our core themes are unchanged: emphasizing resource-based companies with good balance sheets and deep, politically-safe reserves. We can add that these companies have highly-regarded managements who are willing to make long-term investments at the cost of short-term profits to meet the expected demands of a much larger global middle class.

A U.N. study of population trends projects a 50% population increase, to 9 billion, by 2050. This will greatly impact the demand for food, energy, and other resources. Economists are fond of observing that prices are set at the margins, and now marginal demand is slowing—much like the period after the Asian currency crisis in 1997-98. But this will change significantly in the next few years because a growing segment of the population in developing countries has had its first direct exposure to middle class amenities and they have an appetite for more.

Adding to the current volatility in stocks and bonds is the daily shrinking of the hedge fund industry. One industry study at the end of 2007 reported that there were nearly 20,000 active hedge funds—a 61% increase over the prior year. While their high fees and opaque reporting were overlooked during the good times, this fad is unwinding quickly. Redemptions during the next several months, and into 2009, are requiring forced liquidations—including in resource stocks, which have been one of the few profitable equity investments this decade.

While the gloom is pervasive, the reasons to remain invested are sound. Federal policy is to aggressively add liquidity to the financial system. With inflation at four percent, cash and short term bonds are providing a negative real (inflation adjusted) return. Our focus on real companies owning real and often irreplaceable assets should, over time, provide clients with returns well ahead of inflation—which is the goal of a stock investor.

While the magnitude of this crisis is substantial, so too are the cash reserves, in the U.S. and overseas, that will ultimately enter the market. Markets anticipate, and it is a fool’s errand to attempt to time the ins and outs. The key to successful investing is to establish the right asset allocation so that one avoids forced selling and has the reserves to exploit bargains.

Our bond portfolios remain structured for safety. For several years we emphasized Treasuries and other highly rated bonds. Forced institutional selling of municipal bonds has offered some bargains, with tax-free yields of 5%. While history suggests municipalities rarely default on bonds, we recognize these are unusual times and we are including “belts and suspenders” by emphasizing bonds backed by the full taxing authority of a State, other municipal bonds that are pre-refunded to their maturity with U.S. Treasuries, and other instruments that are well situated and well priced.

We are concerned about the long term impact of the bailout on the U.S. dollar and on inflation rates. For the present, these issues are tomorrow’s story, but they require careful monitoring.

Phil Tucker, Eric Kraus, Tom Frank, Sneha Mansukhani, John Edwards, Kathleen McGill, Ed Dobranetski, Christine Wallace