Chevy Chase Trust BLOG

Investment Update: Fourth Quarter, 2011

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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.

Chevy Chase Trust Sponsors A Guide to Giving

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At Chevy Chase Trust, we believe some of the best returns come from investing in people and communities. Many of our staff members volunteer and serve on the boards of local not-for-profit organizations. As a company, we support Smart Sacks, an initiative through Manna Food Center to provide school children with back packs of food for weekends when they do not receive school meals. That’s why we proudly sponsored the “Guide to Giving” featured in Bethesda Magazine’s November/ December 2011 philanthropy issue.

 

The “Guide to Giving” highlights 50 nonprofit organizations in Montgomery County that are working hard to improve the lives of low-income children, families and seniors in the area. Many of those in need will receive funding from the Sharing Montgomery Fund, a pooled fund established by the Community Foundation for Montgomery County. To learn more about the Sharing Montgomery Fund, go to CFMC. For information on the “Guide to Giving”, please click here.

Post Holiday Review

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It was a “turkey” of a week, with the S&P down 4.7%, its worst Thanksgiving trading week since 1932. Global equity markets continued to show weakness.  The Dow is at its lowest level in six weeks.  Stocks fell for a tenth day, the longest losing streak since July 2008, and the euro extended losses as the burden of government debt grew around the world.

Like the “tryptophan” post-Thanksgiving dinner blues, huge debt and spending levels in countries like Greece and Italy have come home to roost as the party ends.  The euro zone crisis continued to escalate.  Bond yields for Euro countries are at unsustainable levels with Italian and Spanish borrowing costs rising above 7% (Italy borrowed 2 year money at 7.82% and six month debt is at 6.52%, nearly double borrowing costs from one month prior.)  Additionally, last week we saw a chink in the armor as Germany was able to sell 60% of 10 year Bunds it issued at auction.  The fear is that contagion continues to spread and is now infecting even German borrowing capabilities.  However, German borrowing rates were still very low (1.98%), and may have contributed to lack of interest in the auction.  The cost of insuring European sovereign bonds against default rose to a record.  Flight to quality intensified and US borrowing rates fell; despite our own problems, US Treasuries are still seen as a safe haven and 10 year Treasury rates fell to 1.95% (up to 2.07% Monday morning based on equity strength.)  Interestingly, the yield on German 10 year Bunds rose above 10 year US Treasuries for the first time in two years.  There is now significant discussion about the possibility of an end of the “Euro.”   The Euro slid for a fourth week, the longest losing streak against the US dollar in 18 months.  The Euro now trades at $1.32, a seven week low.  Merkel has rejected calls for joint Euro area borrowing and an expanded role for the ECB.  There is a widespread belief that Euro officials may not be able to act uniformly and handle the mounting crisis.

“Black Friday” Early estimates show “Black Friday” sales up 6.6% from 2010 to a record $11.4 billion.  It will be interesting to see how sales trends continue and whether expanded sales hours were the sole contributor to gains.

Still “Hungary” after a huge debt indulgence?  Moody’s Investors Service cut Hungary’s debt to junk.  Hungary lost its investment-grade rating as Moody’s cited risks to budget-deficit and public debt targets. The foreign and local currency bond ratings were cut one step to Ba1 from Baa3.

The Economy

Orders for durable goods (equipment meant to last 3 years) fell .7% in October after falling 1.5% in September (twice the originally reported number.)  Demand for aircraft and business equipment slowed as the declining global economy threatens purchases of US goods.

US Ratings- The “supercommittee” wasn’t so “super,” but S.&P reaffirmed that it would keep the US credit rating at AA+.  ​The panel’s inability to agree on $1.2 trillion in budget cuts has also stoked doubts about U.S. lawmakers’ ability to overcome partisan gridlock and safeguard the nation’s fiscal health. Moody’s reaffirmed its AAA rating with a negative outlook and Fitch Ratings said in August that a supercommittee failure would probably result in a “negative rating action,” likely a revision of its outlook to negative.​

US GDP- We are still very focused on US growth trends and our ability to weather the Euro assault.  In an initial sign of some of the Euro drag, the US economy showed real GDP growth for the 3rd Q revised down to 2% from an initial estimate of 2.5%.  Inventories fell in the quarter and were not fully restocked, capital expenditures were also revised lower.  However, gains in retail sales, manufacturing and housing, combined with the mentioned lean inventories, raise the odds that 4th Q and early 2012 GDP may have some tailwinds.

Previously owned home sales unexpectedly rose in October by 1.4% to a nearly 5 million annual rate.  Falling prices may be luring buyers into the market.  The median price of a house fell by 4.7% and the number of homes on the market was the lowest for any October since 2005.  Borrowing costs near record lows are also helping homebuyers.

Munis- low rates are helping municipal issuers.  Many states and municipalities are saving significant money by repaying higher cost debt.   About 43% of sales in 2011 have been to refund previously issued debt.

The week ahead- This week we will be watching EU leaders at a White House summit, October new home sales, Conference Board Consumer Confidence index, the Fed Beige Book and Friday’s unemployment number for November.

 

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This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more:  Post Holiday Market Review | Washington Business Journal

The Good, the Bad and the Ugly: A Look at Last Week’s Economic News

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Here’s a quick rundown of what happened last week in what we like to divide up in three categories we can all relate to: The Good, The Bad and The Ugly.

Good- New home starts were in line and construction permits climbed in October.   Construction permits climbed to the highest level since March 2010, housing starts are on a 628,000 annual pace (stronger than economists’ forecast.)  Housing may become less of a drag in quarters to come.  Mortgage rates near record lows and a continued reduction in inventory seem to be helping the markets.

Good- Retail sales in October were up a strong +0.5% vs +1.1% in September.  This gives the economy a bit of steam heading into holiday season.  Apple was a driver of the growth with iPhone sales.

Good- Empire State (NY) manufacturing index
in November increased to -0.6 vs -8.5 in October.  This has great import because it is the first positive movement since May.  Measures of shipments and employee workweek improved.

Good- Weekly unemployment insurance claims fell last week by 5,000 to 388,000, the lowest level since April.  The number of people on unemployment fell to a 3 year low.

Good- the Conference Board Index of Leading Indicators rose .9% in October, the largest increase since February.   The October rebound in the leading index reflected positive contributions from building permits, the spread between short-term and long-term interest rates, a rising stock market and a slightly better employment reading.

Good- GDP- many economists are raising their projections to over 3% for 4th Q GDP.

Good/Bad-  CPI (inflation) was down .1%, up .1% excluding  food and energy.  In October, gas prices were down 3.1%.  However, year over year, inflation is at 3.5%.  Without food and energy, inflation is not a big concern. However, that doesn’t help the average consumer who spends significant dollars on food and energy.  Groceries are up 6.2% over the past year. The cost of your average Thanksgiving dinner is up 13% from last year.  Enjoy your turkey, you’re paying more for it! 

Bad-Europe: it’s not good when stories are floated over a possible breakup of the European Union.  We don’t see it happening, but it is a clear indication of the fear of contagion that many European countries are experiencing.

Ugly (really ugly)- The US congressional supercommitee appears to have failed to reach a consensus prior to the November 23 deadline. News sources are reporting that members are searching for the best way to release this news to the public and then get out of town.  There are serious concerns that the year end expiration of a 2 percent cut in employee payroll taxes and extended unemployment benefits may curtail US growth by as much as 2% next near.  It remains to be seen what the long term effects and solution might look like.  Forced cuts totaling $1.2 trillion will begin in 2013.  The lack of an agreement is most likely to add volatility to an already spooked equity market.

Markets- It was a rough week for global equity markets.  Volatility returned and all markets suffered.
Dow down 2.9%, Nasdaq down 4%, S&P down 3.8%, gold down 3.5%, crude oil down 1.6% to $97 after having risen to over $100 earlier in the week and US 10 yr Treasuries still near record lows at 2.00%.

Dividend stocks continue to be in favor.  Utility stocks were the best performing sector in the S&P for the first time in over 10 years.  While utilities are the only S&P sector with lower earnings forecasts in 2012, consumer demand for their higher dividend has pushed the sector higher.

We are expecting a heavy calendar this week for US Treasury issuance, over $100B.  The size, combined with supercommittee concerns and a shorter Thanksgiving week may put pressure on Treasuries (yields up.)

The markets will all be focused on numerous data releases prior to Thanksgiving.  Data on existing home sales will be released Monday, initial jobless claims report along with orders for durable goods and the final reading on consumer sentiment on Wednesday.

 

Happy Thanksgiving.

 

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This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more:  The good, the bad and the ugly: A look at last week’s economic news | Washington Business Journal

Market Updates: Tricks and Treats

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After a scary third quarter in the global financial markets, U.S. equity markets are poised for the largest monthly rally since October 1974. The recent rally has put the treat back in ‘trick or treat’. Why the strength? Continued resilience in the U.S. economic numbers along with fairly good company profit numbers. But, it still all comes down to Europe. After months of extreme fear, investors began to anticipate and were relying on a comprehensive assistance plan from Europe. Finally last Thursday, European leaders reached agreement on an improved EU bailout/assistance plan. EU leaders agreed to restructure Greek debt (50 percent write-downs), boost bank capital and leverage a government-backed bailout fund of 1 trillion Euros. But still, the devil is in the details and many are afraid the measures do not go far enough or that there are more skeletons in the Euro closets.

In the days following Halloween this week, look for news out of the G20 summit, the employment numbers on Friday and ISM reports on service and manufacturing. Over the next 4 weeks, look for news from the super-committee charged with finding $1.2 trillion in U.S. budget savings by their Nov. 23 deadline.

The treat: University of Michigan consumer confidence reading unexpectedly rose in October to 60.9 from 59.4 in September. The forecasts had been in the 58 range. Consumer spending makes up the largest piece of the US economy and it is likely that the improving equity markets and lower gas prices have fueled this improvement.

The trick: There is more than one confidence study. The New York-based Conference Board’s household sentiment index slumped to 39.8 in October, the lowest level since March 2009. So, who to believe?

When you feel good about things, you are more likely to spend money. In September, even with steep equity declines, the consumer spent more dollars. Purchases increased by .6% after a .2% increase in August and with incomes rising less than projected, the consumer’s saving rate fell to the lowest level in nearly 4 years.

Will the consumer buy a home? It seems like they will, if the price is right. New home sales rose 5.7 percent in September as discounted prices lured buyers in some parts of the U.S. The median new home sale price was down 10 percent from September 2010. The S&P/Case-Shiller index of property values in 20 cities fell 3.8 percent from August 2010.

GDP: The value of all goods and services produced rose at a 2.5 percent annual rate, up from a 1.3 percent gain in the second quarter. Helping to ease the fear of a double dip recession, this fast pace has been fueled by consumer spending and business investment.

Durable goods: GDP and durable goods orders typically go hand in hand. Durable Goods orders excluding transportation (airplanes and autos) climbed 1.7 percent, well above estimates of .4 percent. This was the largest increase in six months and is providing strong support for GDP and consumer confidence.

Munis: Munis are still cheap relative to Treasuries, but with a recent back up in 10-year T rates, the ratios are not quite as attractive (still over 100 percent though.) Credit confidence in muni issuers has remained strong, despite one off credit headlines such as Harrisburg PA. One stat helping muni credits is the level of tax collections at the state and local levels. U.S. state tax collections are heading for their seventh-straight Q of growth, according to preliminary data released by the Nelson A. Rockefeller Institute of Government. For the fiscal year ended June 30 (used by 46 states), revenue rose by 8.4%, the biggest annual gain since 2005. However, projections are for weaker growth in the next fiscal year.

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This post was originally published in the Washington Business Journal’s WBJBizBeat Blog. Read more:  Market Updates: Tricks and Treats | Washington Business Journal

East Meets West: Integrating Traditional Medicines with Evidence-Based Alternatives

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One in three American adults integrates at least one complementary or alternative medicine practice into their lifestyle, such as using herbs or supplements, visiting an acupuncturist, or practicing yoga, Tai Chi, or meditation. Do they know something we don’t?

On September 27, 2011, Chevy Chase Trust collaborated with Bethesda Magazine, Round House Theatre, and Georgetown University’s finest scientists to discuss whether now is the time to give complementary and conventional medicine co-starring roles in the American health care system.  Listen to the discussion and/or view the transcript below.

 

Welcome, introduction, and history associated with Georgetown’s decision to offer a Master’s Degree program in Complementary and Alternative Medicine (CAM). 

 

What are the definitions of complementary medicine, alternative medicine, and conventional medicine? 

 

Are these ancient medicines based on scientific evidence at all, or is their reputation really anecdotal in nature, passed down through the generations? 

What is the mind-body connection? What are your recommendations for stress reduction?

 

 

What is the definition of “good” nutrition? Does it mean consuming specially grown or specially prepared foods?

 

What are your recommendations for herbal medicines? What are your recommendations for nutritional supplements? 

 

 

Do any of you all know of any remedies that can be used to help with autoimmune diseases, such as Meniere’s disease? 

 

 

Is it true that there are some complementary and alternative medicine (CAM) procedures that are covered by Medicare and/or insurance?

 

 What does the complementary and alternative medicine (CAM) community do for conditions and/or diseases that are genetically linked?

 

 

What roles do low-carb diets play in chronic? Also, what are the risks and benefits of soy products and diets for health and disease?

 

 

What treatment options are available for the epigenetic mutations that contribute to inherited forms breast cancer?

 

Closing remarks.

 

The contents of this transcript are for informational purposes only. The content is not intended to be a substitute for professional medical advice, diagnosis, or treatment. Always seek the advice of your physician or other qualified health provider with any questions you may have regarding a medical condition. If you think you may have a medical emergency, call your doctor or 911 immediately. Chevy Chase Trust Company does not recommend or endorse any specific tests, physicians, products, procedures, opinions, or other information that may be mentioned in this transcript.