Thematic Investing involves capitalizing on powerful secular trends, disruptive ideas, innovations and economic forces that are constantly reshaping the world. Thematic investing builds portfolios of companies positioned to exploit these transformational changes and, just as importantly, avoids companies that will be disrupted by creative destruction.
“The strong basis for stock selection comes from whittling down the thousands of public securities around the world to a manageable group- identified through our thematic research. This screening process is perhaps the most important part of investing.”
Amy Raskin, Chief Investment Officer
News & Noteworthy
- Washingtonian Magazine | Top Wealth Adviser Hall of Fame Posted in: Noteworthy, People - January 31, 2023 - Chevy Chase Trust's Michael Gildenhorn, Director of Portfolio Management, has been selected by Washingtonian Magazine to receive their “lifetime achievement” award for local financial experts.
January 31, 2023 – Consistency pays off for Chevy Chase Trust’s Michael Gildenhorn, Director of Portfolio Management, who appears on the short list of Washingtonian Magazine’s “lifetime achievement” awardees for repeatedly making its “Top Financial Advisers” list. Read more to learn about the selection process.
- Globalization: Evolving, Not Ending Posted in: Insights, Noteworthy - 1/20/23: We don’t often publish our research, especially after concluding that the topic in question should not become a theme in client portfolios. However, given the extensive press this subject has generated, we thought it appropriate to share our perspective.
A Post-Pandemic Assessment of Globalized Production
January 20, 2023 – During the early months of the Covid pandemic, international trade slowed sharply. Goods as simple as medical masks and as complex as advanced semiconductors became impossible to find, speeding the disease’s spread and amplifying its dire economic consequences. The pandemic tattered the web of intricate supply chains woven over the past 30 years, exposing the fragility of a globalized economy that depends upon them.
Many pundits now argue that the great wave of globalization that began more than 30 years ago is ending. They contend that both potential natural disasters and developing geopolitical tensions make it too risky to rely on global trade and production, so governments will require local production of many goods in the name of national security and companies will seek to improve resiliency in their supply chains by bringing production back home.
We disagree. Our research suggests that global production and trade are unlikely to shrink dramatically. Yes, governments are requiring more domestic production of critical goods and their components. But the world needs trade, because energy, food, and other critical or desirable goods can’t be produced everywhere, and many goods that can be produced in many places are most economically produced in just a few.
Already the dollar value of global trade has bounced back sharply from its pandemic-related drop to set an all-time high of over $22 trillion (Exhibit 1). Even if half the recent increase was due to inventory rebuilding, global trade would still be setting new records.
Exhibit 1: Global Value of Trade in Goods (1948 – 2021), Trillions
Source: UN Conference on Trade and Development
Predictions that production will simply “come home” are just too sweeping and vague. They ignore the myriad factors that drive production decisions, such as proximity to major markets, tax rates, regulatory burdens, labor costs, access to commodities and components, proximity to partners and shipping costs. As with many aspects of business, the devil is in the details. While change will come, it is likely to occur gradually.
For the most part, when pundits predict that production will come home, they are talking about moving manufacturing from China to the U.S. or other developed countries. China became the world’s factory for reasons that evolved over the past two decades. While some of those reasons are indeed reversing, many remain compelling.
Cost Advantages in Labor and Energy
When China joined the World Trade Organization in 2001, it had two key advantages: cheap labor and cheap energy. China had a population greater than 1.2 billion and an annual GDP per capita below $1,000 a year. Chinese leaders were eager to create jobs that would improve living standards. At the time, China also had abundant low-cost coal and few environmental restrictions on burning it.
China welcomed global firms, wooing them with promises of massive infrastructure investments. They honored these commitments quickly by building roads, rails, ports and factories as good, if not better, than other countries. For nearly two decades, China’s gross fixed capital formation as a percent of GDP was far higher than most trading partners (Exhibit 2).
Exhibit 2: Gross Fixed Capital Formation as a Percent of GDP
Source: The World Bank
China’s massive fixed-asset investments made it easy for firms to move supplies around the country and to its modernized coastal ports. Between 2001 and 2020, export volumes increased eight-fold. China is now the world’s largest exporter, with cargo volumes only 2% smaller than the total for the entire developed world.
Today, China manufactures almost $5 trillion of goods each year, roughly 30% of the global total. The country also has dominant market share in many critical inputs (Exhibit 3). China produces 56% of global cement, 53% of its steel and 30% of its plastic
Exhibit 3: Share of Crude Steel Production, Percent
Source: World Steel Association
Massive Manufacturing Clusters
As China’s share of global manufacturing grew, manufacturing clusters formed for distinct industries. Each cluster is composed of interconnected businesses in a geographic region, with each business benefiting from the others’ growth. Clustering provides a host of economic advantages as specialized workforces and institutions develop, providing qualified labor and opportunities for innovation. With everything close at hand, transporting inputs takes little time or money, and communicating inventory or production adjustments is easy.
Many clusters dominate their global industry. The cluster in Danyang County produces 40% of global eyewear, while 90% of the global lighting industry can be traced back to Guangdong Province. Home to some of China’s most innovative cities, like Shenzhen and Guangzhou, Guangdong Province also accounts for one-third of global consumer electronics output.
Clustering isn’t a new concept. Much of the global auto industry, including parts and steel, clustered in or near Detroit beginning at the turn of the 20th century. But China’s clusters are much larger. By mid-century, about 200,000 people were employed by the auto cluster in the Detroit area. Today, the consumer electronics cluster in Shenzhen employs over 2 million people.
As manufacturing migrated to China and the Chinese economy developed, wages rose rapidly. Cheap labor is no longer China’s advantage. Adjusted for productivity, China’s cost of labor is now higher than Japan’s. Cheap energy is also a less compelling advantage today. Pollution is a major concern for Chinese citizens, and the country has pledged to reach peak CO2 emissions before 2030 and achieve carbon neutrality before 2060.
But the advantages of China’s clusters are hard to beat, anchoring manufacturing there. Moving production to locations with cheaper labor would mean at least temporarily ceding the efficiencies that clustering provides. In many cases, it would also be prohibitively expensive. Relocating production to the U.S. would require not only building new factories that produce those goods, but also new plants to produce the concrete, steel and plastic needed for their manufacture. All this would cost billions of dollars and require decades of concerted effort.
There is little evidence of this happening en masse to date. Perhaps it will over time, but it likely won’t be quick. After all, the Detroit automotive production cluster that developed in the early 20th century and peaked in 1958 remained dominant well into the 1980s, despite U.S. automakers’ loss of global industry share and increased reliance on offshore factories with lower labor costs. Today, the benefits of the region’s specialized production cluster remain visible. Michigan is still the largest exporter of transportation equipment in the U.S., and 96% of the largest automotive suppliers in North America have a presence in the state. Sixty of them are headquartered there.
Supply Chains Will Continue to Evolve
Corporate leaders have told us they’re not moving production away from their current Chinese factories any time soon, citing their economic efficiency and the high cost of relocation. But some have said they’re not building more plants in China. Production growth will occur elsewhere. The massive scale that makes clusters efficient also creates vulnerability to epidemics, natural disasters, and political risk, they note. To western business leaders, many of China’s actions in recent years appear less predictable, adding risk to future investments they may contemplate.
One strategy many firms are pursuing is called “China+1,” where they continue to manufacture or source goods in China, while building additional capacity elsewhere. But until Chinese clusters can be replicated elsewhere, their new factories will likely have to source critical components from suppliers located in China.
Managers must continually weigh a host of factors that differ by industry and company, and that change through time. Two consumer giants, Nike and Apple, illustrate the complexity of building resilient, cost-effective supply chains and their natural evolution over time.
NIKE: Chasing Low Wages
Nike was founded in Eugene, Oregon, in January 1964. With labor a significant portion of production cost for footwear, Nike started locating manufacturing in Japan the same year to take advantage of the low cost of labor in the still war-ravaged nation. As the Japanese economy rebounded in the 1970s, wages there rose, leading Nike to move manufacturing to South Korea and Taiwan. Rising wages in those countries eventually spurred Nike to seek yet another manufacturing base. In 1981, Nike opened its first factory in China. It continued to grow its manufacturing presence there throughout the 1990s. Inevitably, wages in China also began to rise, so in 1996 Nike opened its first factory in Vietnam. By 2012, Nike’s sneaker production in Vietnam equaled its production in China, with 30% in each country. By 2017, Nike’s sneaker production in Vietnam outstripped its Chinese production, 44% to 19%.
While lower wages prompted greater production in Vietnam than China, it seems that Nike cannot entirely quit China. Nike still maintains 104 factories with 123,000 employees in China, versus 114 factories with 537,000 employees in Vietnam. It gets about 30% of its materials from China, versus 23% from Vietnam. Of course, China is a significantly larger end market for Nike than Vietnam: In 2017, Nike sold 17% of its global sneaker output in China. But revenue is clearly not Nike’s main consideration when deciding where to locate production. While one-third of Nike revenues come from the U.S., only 6% of Nike’s factories and fewer than 5,000 employees are in the U.S., and none of its materials originate in its “home country.”
APPLE: Leaning on Clustering
Manufacturing electronics is more complicated than manufacturing shoes and clothes. The benefits of clustering are also greater, due to the larger number of components involved. Apple’s iPhone 12 has more than 178 components, made by a vast network of suppliers. For example, Sony makes the camera sensors, Bosch the accelerometers, and Corning the glass screens. All three have factories in China, as well as other countries, including their home countries of Japan, Germany and the U.S., respectively.
But regardless of where their components come from, all iPhone 12s are assembled in China, by Foxconn, Apple’s largest partner. Foxconn has more than 350,000 people at its assembly site in Zhengzhou, which can churn out more than half a million iPhones a day.
Since Apple and Foxconn established their presence in Zhengzhou, the region has become the world’s largest production center for mobile phones, with suppliers and adjacent businesses in the suburbs. Zhengzhou is now referred to as “iPhone City” by locals. The clustering of suppliers around the factory allows Apple to quickly make adjustments if volumes or specifications change. Despite the rising cost of labor in China, the cluster makes China essential to Apple’s supply chain. Since launching the first iPhone in 2007 from a Foxconn assembly site in China, every Apple product has been assembled in China initially.
Apple has diversified production to other countries after initial launch. One year after launching its cheapest model, the iPhone SE, in China in 2016, Apple announced that a partner would produce the phone in India, with the goal of capturing share in that country’s 1.4 billion-strong domestic market. However, Apple’s Indian factory remains highly reliant on China for critical iPhone components.
The National Security Issue
National security is another frequently cited reason to bring production home for critical products (such as medical masks) and technologies (such as advanced semiconductors). But such endeavors are complicated and costly. The U.S. recently cited national security concerns to justify $280 billion in economic support for domestic production of semiconductors in the CHIPS and Science Act, passed in August 2022. It would take scores of large-scale initiatives like this to alter the landscape of global trade. We are unlikely to see these. Deficit and debt levels are already high in many countries, and governments face a wide array of demands for funds from disparate sources, including military spending, climate change initiatives, and support for aging populations.
The headlines predicting a sharp decline in globalized production are wrong, for many reasons. They don’t capture the many, intricate factors that global firms weigh when determining where to locate production or source supplies. While the disruptions caused by Covid and the war in Ukraine have taught companies that resilient supply chains are important, resiliency doesn’t necessarily mean bringing production home.
Except in a small number of industries designated as crucial for national security—such as batteries and semiconductors—there is little evidence that companies are moving production back to the U.S. or other highly developed markets. The costs of production in many instances are significantly higher, and access to commodities and other inputs can be scarce. Instead, resiliency concerns may simply cause companies to hold more inventory and build slack into “Just in Time” production models.
They will also diversify their sources of production and supply, in various ways. Some global firms may decide to invest more in countries close to large markets. If so, Mexico would likely benefit from its proximity to the U.S., and Morocco and Turkey from their proximity to Europe. Other global firms may move production from China to countries with very low wages, such as Vietnam, India, Indonesia, and Bangladesh, which are already gaining share in apparel and other industries. Overall, firms will generally favor countries with more reliable infrastructure and more stable political, economic and legal systems.
While firms may seek new manufacturing locations, China is likely to remain pivotal to the global economy for the foreseeable future because it would take massive investment and many years to replicate China’s efficient production, complex industrial clusters and unparalleled infrastructure. Access to China’s vast population and economy is also an important consideration for many.
There are two potential developments that could make us change our minds:
- A rapid increase in non-automotive sector industrial automation
Automation technology has materially improved over the past decade and costs of implementation have declined. But, until very recently, most management teams have not fully embraced this new technology. Recent labor shortages and healthy corporate balance sheets may eventually lead to more widespread adoption of automated solutions and spur a substitution of capital for labor. If this happens, the calculus regarding where to locate manufacturing facilities would change, and developed markets could be advantaged. This is a focus of ongoing research at our firm.
- Greatly intensified geopolitical tension with China
In recent years, China has adopted a more aggressive posture with other governments, while remaining quite accommodating to global firms. If China becomes more aggressive or unpredictable, either on the world stage or domestically, some nations may decide it’s in their national interest to require production of basic goods such as steel at home or in friendly countries. If China becomes less accommodative or predictable for companies, relocations will likely speed up, even if governments don’t require it.
Since the end of World War II, firms have found efficiencies in locating manufacturing where it’s most cost effective. Barring massive change in national policy viewed as permanent, or a huge breakthrough in automation, few companies are likely to abruptly change where they locate production. Instead, most companies will continue to optimize production over time. Even if all the stars align, it will likely take decades to complete major shifts in industrial hubs, just like it took decades to build China’s dominant position.
Supply chains will evolve as political winds continue to shift and the cost of labor and energy fluctuate. In the near term, global production is unlikely to return to the extreme efficiencies of the pre-Covid period. The quest for resiliency will boost the cost of production, likely resulting in higher prices for consumers and margin pressure for global firms. Nonetheless, production is unlikely to just “come home.”
This commentary is for informational purposes only. The information set forth herein is of a general nature and does not address the circumstances of any particular individual or entity. You should not construe any information herein as legal, tax, investment, financial or other advice. Nothing contained herein constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments.This commentary includes forward-looking statements, and actual results could differ materially from the views expressed. Clients with different investment objectives, allocation targets, tax considerations, brokers, account sizes, historical basis in the applicable securities or other considerations will typically be subject to differing investment allocation decisions, including the timing of purchases and sales of specific securities, all of which cause clients to achieve different investment returns. Past performance is not indicative of future results, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable, equal any historical performance level(s), be suitable for the portfolio or individual situation of any particular client, or otherwise prove successful. Investing involves risks, including the risk of loss of principal. The level of risk in a client’s portfolio will correspond to the risks of the underlying securities or other assets, which may decrease, sometimes rapidly or unpredictably, due to real or perceived adverse economic, political, or regulatory conditions, recessions, inflation, changes in interest or currency rates, lack of liquidity in the bond markets, the spread of infectious illness or other public health issues, armed conflict, trade disputes, sanctions or other government actions, or other general market conditions or factors. Actively managed portfolios are subject to management risk, which involves the chance that security selection or focus on securities in a particular style, market sector or group of companies will cause a portfolio to incur losses or underperform relative to benchmarks or other portfolios with a similar investment objectives. Foreign investing involves special risks, including the potential for greater volatility and political, economic and currency risks. Please refer to Chevy Chase Trust’s Form ADV Part 2 Brochure, a copy of which is available upon request, for a more detailed description of the risks associated with Chevy Chase Trust’s investment strategy. The recipient assumes sole responsibility of evaluating the merits and risks associated with the use of any information herein before making any decisions based on such information.
- Bethesda’s Chevy Chase Trust Opens First Northern Virginia Office Posted in: Latest News, Noteworthy, People - We are proud to announce the opening of our new office in Tysons Virginia. Read the Washington Business Journal article about their recent interview with Jeff Whitaker, CEO.
- Fourth Quarter, 2022 Posted in: Noteworthy - On the heels of 2022’s market turmoil, we see opportunity emerging in many quarters. Being nimble and discerning may be more important than ever. Read our Q4 Investment Update to learn more about our steadfast commitment to our thematic investment approach.
January 9, 2023 – During 2022 the financial markets faced an extraordinary confluence of challenging events. Inflation hit its highest level in four decades. Interest rates rose at an unprecedented pace. War broke out in Europe. And China continued to impose pandemic-related lockdowns that hobbled its economy.
Against this backdrop, U.S. equities and bonds were both down sharply, making 2022 among the worst years for investors in a century (Exhibit 1). During 2022 the S&P 500 generated a loss of 18.1%, and the Bloomberg Aggregate bond index lost 13.0%.
Exhibit 1: U.S. Equity and 10-Year Bond Annual Total Returns (1872-2022)
Source: CLSA, Refinitiv, Robert Shiller – Yale University, Department of Economics
While market performance in 2022 was disappointing, it is important to view it in context. Over the prior three years, the S&P 500 rose over 90%, and with dividends, returned over 100%, while the Bloomberg Aggregate returned 15%. In 2022 the equity index gave up a small portion of its gains from 2019 through 2021, and the bond index settled back to its level at the beginning of 2019.
Inflation at the Root of It All
The 2022 decline in the financial markets was driven in large part by the U.S. Federal Reserve’s rapid about-face on inflation. At the start of the year, the Fed saw inflation as “transitory,” and thought that only a modest interest rate increase was needed to tame it. At the end of 2021, a majority of Fed Governors expected the Fed Funds Rate to end 2022 at only 0.9%. Just a few months later, persistent high inflation led the Fed to completely change its position and embark on a series of large rate hikes. By the end of 2022, the Fed Funds Rate had climbed to 4.25%-4.50%, and 17 of the 19 Fed Governors expected it to rise above 5.00% in the first half of 2023.
At Chevy Chase Trust, we began to think differently about inflation earlier than many. In mid-2020, as the Federal government distributed massive pandemic-related stimulus, we recognized that the low-inflation paradigm of the prior two decades was ending.
To properly assess inflation’s likely evolution, we developed a new inflation framework that explicitly separated the shorter-term, cyclical drivers of inflation on which most of the market focuses, from the longer-term, secular drivers of inflation that we believe will have a more profound impact over time. This work led us to add the End of Disinflationary Tailwinds theme to our Thematic Equity portfolios a few months later.
We first published our inflation matrices in our Investment Update — July 2021, and we have continued to refine our analysis since then.
Our view on long-term, secular inflation remains largely unchanged (Exhibit 2).
Exhibit 2: Chevy Chase Trust Long-Term Inflation Matrix
(1) 2011 and 2021 calculated as of end of Q2 2021.
(2) Driver added in May 2022.
(3) 2011-2022 average annual CPI, and Chevy Chase Trust forecasts for average annual CPI for 2021-2031 and 2023-2033.
However, our short-term inflation matrix has changed dramatically (Exhibit 3).
Exhibit 3: Chevy Chase Trust Short-Term Inflation Matrix
(1) CPI data are average for 2011 and 2021 and Chevy Chase Trust projection for 2023.
We expect inflation to fall sharply over the next six to nine months, which should benefit both stocks and bonds. While we believe the Fed will remain hawkish to keep long-term inflation expectations anchored, inflation has already started to come down, and we expect its decline will continue. We wouldn’t be surprised to see inflation fall below the Fed’s current 2% target in the second half of 2023, before eventually moving up to the rates suggested by our long-term matrix.
A Mild Recession Probably Lies Ahead
Economic concerns are shifting from inflation to recession because the Fed has raised interest rates so much that the current inflationary fire is running out of fuel. Classic indicators all suggest that an economic slowdown lies ahead for the developed world. But our sense is that consumers flush with cash will delay its onset, and a broadly sound private sector will muffle its severity. Neither households nor businesses are over-extended, and regulation has converted banks from accelerants of recession to firebreaks.
Four factors should delay the onset and reduce the severity of a U.S. recession.
- Job openings remain elevated across all industry groups. In November, there were 1.7 job openings per unemployed worker, nearly 50% higher than in December 2019. Most workers who lose their jobs should have little difficulty finding new ones. The ongoing scarcity of labor suggests businesses may be reluctant to shed as many jobs in a recession as they might have otherwise. Joblessness is unlikely to rise sharply.
- Adjusted for inflation, disposable personal income rebounded in the third quarter of 2022, after declining for five quarters. We expect the uptrend to continue into 2023, because inflation-adjusted wages rarely decline when unemployment is low. As inflation falls, real wage growth will likely turn positive, even if nominal wage growth slows.
- Although U.S. households have spent much of their stimulus payments, consumers still have roughly $1.5 trillion more in savings than they did before the pandemic, the equivalent of 5.8% of U.S. annual GDP.
- While business surveys about expected capital investment point to some softness ahead, the decline is unlikely to be dramatic. Capital spending is already very low compared to historical norms, and the average age of nonresidential capital stock is higher than at any point in almost 60 years. We also expect businesses to increase capital investment to address the longer-term labor shortage that many large economies face.
Our portfolios have migrated to reflect our current outlook: near-term declines in inflation, a delayed and mild recession, followed by inflation and interest rates that will be higher than those seen during the past two decades. We expect bonds to be less correlated with equities than they were in 2022. This should provide more diversification benefit if a recession proves deeper than we expect.
In our Thematic Equity portfolios, we have trimmed positions in our End of Disinflationary Tailwinds theme, which performed well in 2022. Although we still like their longer-term prospects, we think these stocks may underperform in the short-term as inflation declines. We used the proceeds of these sales to add to positions in both our Dawn of Heterogenous Computing and Next-Generation Automation and Supply Chain Transformation themes. Many of our positions in these two themes fell considerably in 2022, partially reversing gains from prior years. We believe current prices represent an attractive entry point for these companies, which are also likely to rise if inflation declines early in the year, as we expect.
We also continued to trim our positions in the largest Growth stocks, including Apple, Microsoft, Google and Amazon. Despite stock price drops in 2022 that ranged from 26% to 49%, we believe these companies are still viewed too optimistically. Our research suggests that during the pandemic, each of these companies had gains in sales and earnings that would otherwise have taken several more years to achieve. In comparison to those massive gains, near-term results may look mediocre, at best (Exhibit 4).
Exhibit 4: Past and Estimated Future Sales Growth of Tech Leaders vs. S&P 500
Compound Annual Growth Rate
Source: Goldman Sachs Global Investment Research, FactSet
Market leadership often shifts in bear markets. We believe that once a bear market starts, investors should focus on identifying the next winning trend, rather than trying to time a reentry into the prior bull market trends that may now be defunct. We believe many of our current themes are well-positioned for this new era of market leadership, given the powerful secular changes they exploit. We are particularly optimistic about opportunities in our Next-Generation Automation and Supply Chain Transformation, Advent of Molecular Medicine, and End of Disinflationary Tailwinds themes.
We have also begun to increase positions in non-U.S. markets, particularly European stocks, which remain at a historic discount to U.S. equities, reflecting what we deem to be undue pessimism about the outlook for Europe (see box).
We enter the New Year with ample – though guarded – optimism in the markets, where being nimble and discerning may be more important than ever. We believe this flexibility, paired with confidence in our Thematic approach will serve us well. Thank you for your continued trust.
Opportunity Knocks in Europe
Europe is less far along than the U.S. in its recovery from the pandemic. Wage growth there has been lackluster, and durable goods spending remains well below its pre-pandemic trend. Furthermore, European inflation largely stems from disruptions to energy supplies related to the war in Ukraine. Core inflation in Europe is far lower than in the U.S.
We think Europe’s outlook is better than it may seem. While energy supplies in Europe remain constrained, policymakers in the region reacted with uncharacteristic haste to replace Russia as their source of gas supplies. Germany completed the construction of its first floating liquid natural gas terminal in late 2022 and aims to have five floating units operating by the end of 2023. New pipelines are also being constructed. Last Fall, gas started flowing from Norway to Poland.
In the meantime, efforts to conserve gas are proving less onerous than previously feared. In a recent ifo Institute survey, 75% of German companies reported that they were able to curb gas usage without cutting production.
Defying expectations of a big decline, euro-area industrial production remained resilient in 2022. European households have accumulated savings that can support spending until the energy shock subsides, and credit growth remains above pre-pandemic levels.
Europe doesn’t have to grow faster than the U.S. for European stocks to outperform. With valuations so depressed, just beating low expectations could power a strong rebound (Exhibit 5). We’re looking for attractive opportunities in Europe, particularly in Industrial, Energy and Consumer Discretionary stocks that are well positioned to capitalize on a European recovery; are well-aligned to our Increasing Wealth Concentration, Long- Term Covid Beneficiaries and End of Disinflationary Tailwinds themes; and trade at a discount to their U.S. peers.
Exhibit 5: European vs. U.S. Forward Equity Price-to-Earnings Multiples (1999-2022)
Source: IBES, Datastream, Barclays Research
This commentary is for informational purposes only. The information set forth herein is of a general nature and does not address the circumstances of any particular individual or entity. You should not construe any information herein as legal, tax, investment, financial or other advice. Nothing contained herein constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments. This commentary includes forward-looking statements, and actual results could differ materially from the views expressed. Clients with different investment objectives, allocation targets, tax considerations, brokers, account sizes, historical basis in the applicable securities or other considerations will typically be subject to differing investment allocation decisions, including the timing of purchases and sales of specific securities, all of which cause clients to achieve different investment returns. Past performance is not indicative of future results, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable, equal any historical performance level(s), be suitable for the portfolio or individual situation of any particular client, or otherwise prove successful. Investing involves risks, including the risk of loss of principal. The level of risk in a client’s portfolio will correspond to the risks of the underlying securities or other assets, which may decrease, sometimes rapidly or unpredictably, due to real or perceived adverse economic, political, or regulatory conditions, recessions, inflation, changes in interest or currency rates, lack of liquidity in the bond markets, the spread of infectious illness or other public health issues, armed conflict, trade disputes, sanctions or other government actions, or other general market conditions or factors. Actively managed portfolios are subject to management risk, which involves the chance that security selection or focus on securities in a particular style, market sector or group of companies will cause a portfolio to incur losses or underperform relative to benchmarks or other portfolios with a similar investment objectives. Foreign investing involves special risks, including the potential for greater volatility and political, economic and currency risks. Please refer to Chevy Chase Trust’s Form ADV Part 2 Brochure, a copy of which is available upon request, for a more detailed description of the risks associated with Chevy Chase Trust’s investment strategy. The recipient assumes sole responsibility of evaluating the merits and risks associated with the use of any information herein before making any decisions based on such information.
- Chevy Chase Trust | 2022 Account Information Posted in: Featured, Insights, Noteworthy - Details regarding the timing and availability of your Chevy Chase Trust account tax forms.
2022 Tax Documents
To allow you to plan for the preparation of your 2022 tax returns, we are providing a time table for the mailing of the official tax documents that Chevy Chase Trust is required to report to our clients and the Internal Revenue Service. Please note you will only receive the tax forms that are applicable to your account(s). Copies of your tax documents will also be available on Wealth Access.
Consult with your tax advisor to discuss the possibility of filing an extension with the IRS to obtain additional time to file your tax forms, particularly if you hold securities subject to income reallocation.
DOWNLOAD TAX DOCUMENTS TO TURBOTAX: Chevy Chase Trust is a TurboTax Import Partner. This means that you can import your Chevy Chase Trust 1099 forms directly into your tax return when you use TurboTax software. A TurboTax tracking code can be found on the front page of your tax statement. During the preparation of your return on the TurboTax software, you will select Chevy Chase Trust forms for import and will be prompted to enter your TurboTax tracking code from the front page of your tax statement and your social security number.
- Practical Planning Strategies | Presented by Laly Kassa & Elizabeth Kearns, Co-Heads of Planning Posted in: Events, Noteworthy, People, Video - 11/15/22: Learn about specific planning strategies to consider amid the temporarily elevated estate tax exemptions, the ongoing market volatility, and rising interest rates. Listen to “Practical Planning Strategies” presented by Laly Kassa and Elizabeth Kearns.
- Bethesda Magazine | Top Financial Professionals Posted in: Latest News, Noteworthy, People - As of October 25, 2022, Chevy Chase Trust is proud to announce that Larry Fisher, Deb Gandy, Michael Gildenhorn, Ashely Hall, Laly Kassa, Paula Landau, Wendy Moyers, Craig Pernick, Jast Sohi, and Marc Wishkoff have been voted as 2022 Top Financial Professionals by Bethesda Magazine.
As of October 25, 2022, Chevy Chase Trust is proud to announce that Larry Fisher, Deb Gandy, Michael Gildenhorn, Ashely Hall, Laly Kassa, Paula Landau, Wendy Moyers, Craig Pernick, Jast Sohi, and Marc Wishkoff have been voted as 2022 Top Financial Professionals by Bethesda Magazine.
View Bethesda Magazine rankings here.
- Bethesda Magazine | Women in Business 2022 Posted in: Featured, Noteworthy, People - September/October 2022 - Learn about the roles women play at Chevy Chase Trust in the Bethesda Magazine article.
Bethesda Magazine, September/October 2022 – With a majority of women in the senior ranks and in the firm overall, Chevy Chase Trust is proud to be a part of Bethesda Magazine’s Women in Business Profiles. Photographed from left to right are Paula Landau, Stacy Murchison, Blake Doyle, Elizabeth Kearns, Tina Kearns, Laly Kassa and Amy Raskin. Read the full article here.
- Chevy Chase Trust Ranks #8 on Forbes/SHOOK List of Top RIA Firms in 2022 Posted in: Featured, Latest News, Noteworthy - As of October 25, 2022 - Based on qualitative factors such as how a firm treats and serves its clients, and quantitative metrics including assets under management and retention rates, they chose us as a top-ranking firm. Read the Forbes article.
As of October 25, 2022, we are pleased to announce that Chevy Chase Trust ranked #8 nationally on the 2022 Forbes/SHOOK list of America’s Top RIA Firms. Based on qualitative factors such as how a firm treats and serves its clients, and quantitative metrics including assets under management and retention rates, they chose us as a top-ranking firm. Read the Forbes article here.
- Third Quarter, 2022 Posted in: Noteworthy - For the first time in more than four decades, both stocks and bonds have turned in negative results for three quarters in a row with capital destruction exceeding $17T. Learn about two substantial transitions behind the turmoil and why active management with a thematic approach may be the best bet for investors.
Financial markets continued to deliver wrenching results in the third quarter, as the Federal Reserve continued to raise short-term interest rates sharply to quell persistent high inflation. The S&P 500 returned -4.9% in the quarter for a -23.9% return year-to-date. The Barclay’s U.S. Aggregate Bond Index returned -4.8% for the quarter for a -14.6% return year-to-date.
Stocks and bonds rarely decline together. From 1976 through 2021, there were only four instances when U.S. stocks and bonds both delivered negative returns for two consecutive quarters. In 2022, for the first time in at least 45 years, both major asset classes delivered negative returns for three consecutive quarters.
The decline in both stocks and bonds this year has resulted in losses greater than those experienced during the Global Financial Crisis (GFC) of 2008-09. During the GFC, investors endured over $9 trillion of capital destruction in U.S. financial markets, with deep losses in equities and mortgage bonds partly offset by a rally in government bonds. This year capital destruction has exceeded $17 trillion.
Drawdown in U.S. Equity and Fixed-Income Market Capitalization1
(1) Measured using Bloomberg U.S. Exchange Market Capitalization Index for equities and U.S. Aggregate Index for fixed-income.
(2) October 9, 2007 – March 9, 2009
(3) December 31, 2021 – September 30, 2022
Source: Gavekal, Kevin Muir, Bloomberg
Two Transitions at Once
Financial markets are grappling with two significant transitions, one obvious, the other more subtle but quite powerful.
The first, more obvious transition, is from a time of massive liquidity injections, which the Federal Reserve and other central banks provided to support the global economy during the pandemic, to a time of more normal liquidity conditions. Many investors were stunned by the massive rally in the equity and fixed-income markets during the pandemic, when global economic activity ground to a near halt. The gains in financial markets were largely due to unprecedented fiscal and monetary stimulus at a time when money had nowhere else to go. This largesse also led to short-term inflation, as demand soared for physical goods, while factory and port closures impeded supplies.
Now, central banks are withdrawing much of that excess liquidity to quell inflation, and financial markets are responding accordingly. Despite this year’s decline, the S&P 500 closed the third quarter at the same level it was at during the fourth quarter of 2020 and above its pre-pandemic high.
The second transition is less sudden but is likely to have more profound long-term investment implications. After 40 years of nearly continuous disinflationary tailwinds that drove inflation and bond yields down to extremely low levels, we think the environment is reverting to more normal, cyclical inflation with associated higher interest rates and bond yields.
The End of Disinflationary Tailwinds is an important paradigm shift for investors. Decades of declining yields discouraged investors from owning bonds and pushed them toward riskier asset classes to try to earn “acceptable” returns. With the yield on the 10-year U.S. Treasury bond falling below 2.5% in March 2019 and then plunging to 0.5% after the pandemic hit, many investors adopted a “TINA” mindset – “There Is No Alternative” to equities.
Declining rates also made equities – particularly longer-duration Growth stocks – more attractive in their own right, by increasing the expected value of their future earnings.(1) Technology and communications stocks benefited most from this phenomenon, growing to represent 39% of the total market capitalization of the S&P 500 at the end of 2021. At the same time, the combined weight of six classic value sectors – Financials, Industrials, Energy, Materials, Real Estate and Utilities – shrank to just 29% of the index. Meanwhile, the combined weight of just seven stocks (Apple, Microsoft, Alphabet(2), Amazon, Tesla, Meta(3) and NVIDIA) grew from 3% in 2002 to 29% last year.
(1) For a more in-depth description of this phenomenon, please see the discussion of duration sensitivity in our September 20, 2022, Virtual Investments Symposium, by clicking here. (2) Parent company of Google. (3) Parent company of Facebook.
Sector and Company Concentration in the S&P 500
(1) Discretionary, Staples, Healthcare
(2) Financials, Industrials, Energy, Materials, Utilities, Real Estate
Source: FactSet, S&P 500, Chevy Chase Trust analysis. All data as of June 30, 2002, and December 31, 2021.
No Time to Be Passive
Knowingly or unknowingly, at the end of 2021, investors in passive S&P 500 index funds or ETFs were allocating about 39% of every dollar to the high-growth technology and communications sectors and 29% of every dollar to seven stocks that were equal in weight to the six classic Value sectors combined. Given these circumstances, buying the Index meant taking a high-risk, concentrated position in yesterday’s winners.
We still own some of these stocks for clients, but over the years we have reduced our positions in them. Recently, we have been selling into strength when we can, while paying attention to taxes. While it may be tempting to invest new money in the sectors and stocks that have outperformed over the last 20 years, we think it’s not wise for two reasons.
First, even after the drop in long-duration assets this year, massive amounts of capital are still invested in them. Mathematically, the more money is invested in an asset class, sector or security, the harder it is to earn a return on it. And these long-duration assets no longer enjoy a tailwind from falling interest rates.
Second, while Apple, Microsoft, Alphabet, Amazon, Tesla, Meta and NVIDIA are innovative companies that have delivered terrific sales and earnings growth, they can’t grow as rapidly forever. At some point, they will saturate their markets. Great innovations are often supplanted by newer and better ones, and competitors often take share with a better product or a lower price tag. The first Wang computer of 1972 was great in its time, but the IBM PC eventually displaced it. And IBM, once considered invincible, left the PC market long ago.
New Leaders Will Emerge
Equity markets have a long history of falling in love with certain groups of companies and projecting their past success into the future – often wrongly. In 1980, amid a global oil crisis, seven of the ten largest-cap stocks were oil companies. In 1990, eight of the ten largest stocks were Japanese. In 2000, seven of the ten were tech or telecom firms, while in 2010, amid China’s manufacturing rise and construction boom, seven were commodity related. Recently, eight have been Internet and tech related.
We think it’s reasonable to expect that few of the world’s largest stocks today will be on the top ten list a few years hence. But the stocks that attain that lofty position for the first time are likely to be among the best investments in the decade to come.
Stock Market Leadership Changes: Top Ten Companies Globally by Market Capitalization
Source: *Gavekal Research, +Bloomberg. Data as of January 1st of the year indicated.
Since 1926, the best-performing 4% of U.S. listed stocks accounted for the net gain of the entire U.S. stock market versus 1-month Treasury bills. Some cite this data to argue that investors should not pick stocks and should just passively own broad market indices, such as the S&P 500. We believe instead that it shows the importance of forward-looking active equity management, focused on selecting stocks with exceptional return potential. Our Thematic investment process is designed to do just that, by identifying changes that will lead to sustainable shifts in market dynamics and competitive advantages for companies in a wide range of industries.
Recent Thematic Development: Advent of Molecular Medicine
Our Thematic Equity Portfolios are invested today in six themes. In the midst of a turbulent year in the financial markets, we have seen important developments in many of the industries, technologies and operating companies in which we invest. These have strengthened our conviction in our themes. Recent advances in molecular medicine are a case in point.
In early October, Illumina, the leading provider of genomic sequencing equipment, unveiled a new product line that reduces the cost of sequencing a genome by almost two-thirds and the time by roughly half. The company also made the machines easier to use and more efficient. In the past, similar step-change improvements spurred large increases in demand. We expect the same to occur with this new product introduction.
In many respects, the genomic sequencing industry is evolving like personal computing. As the cost of computing declined and PCs became easier to use, more applications were developed, which led to even higher demand and usage, and even more applications. A similar “virtuous cycle of demand” is unfolding in genomic sequencing. As costs decline and sequencers become easier to use, more clinicians are prescribing genetic tests to detect specific diseases earlier and treat them more effectively. And as usage of genetic tests and treatments increases, more companies are bringing such products to market.
Cell and gene therapies are now being developed at record speeds. More than 2,000 clinical trials are underway globally. Scientists at the Centre for Biomedical Innovation expect 40 to 50 new gene therapies to be approved for clinical use by 2030, compared to the trickle today. We expect Illumina’s latest announcement to accelerate the pace of innovation in molecular medicine.
The S&P 500 has returned roughly 9.5% a year since the late 1920s, with zigs and zags along the way. After particularly steep increases, like the one from 2010 through 2021, U.S. equities often drop or move sideways for several years. We think the market may now be in one of these consolidation periods, and that broad equity market returns are likely to be below average for the next few years.
When the stock market no longer lifts all boats, investors need skilled, active management to sail into the wind in pursuit of attractive returns. As Thematic investors, this is what we do best.
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