Economic Conditions
We expect fourth-quarter GDP growth to be about 3.5%, after final revisions, a dramatic increase from the prior two quarters of 1.8% in the third and 1.3% in the second. This strongest growth in more than a year was, surprisingly, led by the U.S. consumer again drawing down savings and resuming spending. We attribute this to improved sentiment resulting from the rebound in the U.S. stock and bond markets. Unfortunately, it is not likely to last. Employment, incomes, and housing remain weak and a further drop in the savings rate should not be expected in this environment. Chevy Chase Trust analysts project U.S. GDP growth at 2.0% in 2012, if the European financial crisis is contained in an
orderly manner.

A more vibrant U.S. economy requires a better housing market which requires jobs that pay well and access to credit, both
of which are in scant supply. Incomes are moving in the wrong direction: Census Bureau analysts report a post recession (June, 2009 – June, 2011) drop of 6.7% in inflation-adjusted median household income. Unemployment rates continue
at high levels, and access to mortgages is limited for all but gold-plated applicants. Nonetheless, housing-related data such as household formation, population trends, and latent demand is drawing our interest for eventual investment.

Outside the U.S., with a few exceptions, we see growth slowing. At best, we project zero growth in Europe – see below for our thoughts on the European financial crisis – and a slowdown
in China, India, and Brazil, already evident in preliminary manufacturing reports and weakening commodity prices in the forward markets.

We are especially concerned about inflation rates and their social implications in many of the developing countries, e.g., north of 7% in Brazil, near 10% in India, and 5.5% in China,
if one believes the published government data. Moreover,
India appears to be taking a big jump backward in its economic liberalization program; and China’s continued lack of transparency, especially in its banking system, is alarming considering how dependent the world is on its growth. Also, we believe that the emerging markets as engines of world economic growth will depend, more than is suggested by analysts, on demand from the developed countries for many years. In other words, we believe real purchasing power of the growing middle classes in the emerging markets will be increasing at a surprisingly slow rate, mainly because these countries’ excess reserves will likely be committed to containing loan defaults and other stabilization measures.

Last quarter, we reported extensively on the financial crisis in Europe. We will not repeat this discussion, except to outline our view of the options to deal with this complex problem, none of which are particularly attractive solutions.

First, as many of you know, we have been skeptical of the Euro framework principally because there is no currency adjustment provision for individual countries, each heterogeneous in the extreme, to deal with the consequences of the business cycle on each country’s competitive position and balance sheet condition. That is to say, in the European Monetary Union (EMU), a member country under stress cannot devalue its currency, which is often the most expedient way to deal with an economic imbalance. Consequently, we maintained that the EMU, in the long term, would not last in
its present form.

In the near term, much will be done to preserve the Euro currency. Here are some of the possibilities:

-The European Central Bank (ECB) would refund maturing sovereign debt by, essentially, printing money. The U.S. Federal Reserve Bank (FRB) may participate in the refunding operation. It would be executed through the European banks to ensure their stability. This option would not solve the EMU structural problems and it presents a long-term inflation issue. At best, it would be a short-term solution. Our guess is that this option, or a variation of it, ultimately, will be adopted.
-An option that addresses the structural deficiency of the European Union would include, first, ensuring the stability of the major European banks to prevent a private credit crisis, similar to the U.S. experience in 2008. Refunding operations of the member countries would be accompanied by significant fiscal reforms, with help and monitoring by the International Monetary Fund but without ECB subsidy. This option is likely to produce collateral damage and some European Union dropouts. In our view, it is the best long-term solution with the least pain and a credible likelihood of a permanent fix.
-The option to abandon the Euro in a rapid system conversion, similar to the economic conversions done successfully in Chile and tragically in the Soviet Union, would be too disruptive and potentially dangerous, in our view.

As noted in our October report, the developed world has too much debt, made too many promises, and has insufficient revenue to meet its obligations. As Jeremy Grantham notes, we are witnessing “…financial incompetence on a scale hitherto undreamed of, and decreased effectiveness of government, particularly in its ability or even willingness
to concern itself with long-term issues.”

Investment Strategy
Relative to other choices, equities are particularly attractive. Specifically, large cap multinational companies with solid balance sheets, seasoned management, focus, and in front of secular worldwide trends are uniquely situated to achieve superior long-term performance. We have an extensive buy list of these (and other smaller companies with some of the same characteristics) that are in client portfolios and which continue to be purchased selectively. We expect to add to these stocks at even more compelling prices than exist at this moment. For those who can withstand what may be an extended period of unusual volatility, we believe patience
will be well-rewarded.

We find other investments less attractive, however specific allocations are consistent with the circumstances of each client:
-Short-term instruments – Yields on money market and short-term maturities are near zero. The FRB is expected to maintain this low rate well into 2013 and perhaps longer. We use this asset class for safety, liquidity and to build a reserve for future purchases.
-Long-term bonds – We expect interest rates on Government long-term bonds to be kept artificially low. (Interest rates on non-Government debt will adjust lower to reflect the Government rates.) When Government bond rates are below the rate of inflation, as they are now, investors receive a negative real return which is advantageous only to the Government as it repays debt with cheaper dollars. When interest rates rise, as they surely will, investors of long duration bonds will suffer an additional significant capital loss.
-Commodities – With few exceptions, commodities are unattractive because demand worldwide will be weak. The exceptions are important: wide demand-supply disequilibrium in certain commodities, long-term, argues for maintaining positions even in protracted weak periods. Our vehicles of choice are large producing companies with seasoned management, experience managing through cycles, good balance sheets, and deep reserves.

-Real estate – We expect most markets and classes of real estate to be under pressure. Weak income (personal and later corporate, noted below), technological changes in the workplace and changing retail buying patterns will have an increasing adverse impact on real estate returns. When occupancy levels and pricing are weak, depreciation will be recognized more as a real cost than a tax deduction.

Excluding art, collectibles, tulips and other illiquid markets, we are left with equities, which, as noted, are particularly well situated. Actually, too well situated; current record profit margins are not sustainable with incomes and economic growth weakening. When profit margin contraction becomes apparent, probably when economies are bottoming, the time will be about right to step up equity purchases.

Best for the New Year.

P.S. We recognize that this is an unusually technical letter written for a complicated period. We encourage calls to discuss.