NOTEWORTHY

Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: First Quarter, 2007

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

Economic Conditions

Fourth quarter, 2006 GDP increased at an annual rate of 2.2%, down from the previous quarter of 2.6%, and the third consecutive quarter of decelerating U.S. economic growth. Weak housing and auto production will continue this trend. Indeed, by the end of 2007, a recession is possible, as the cumulative effects of mortgage foreclosures, high inventories of unsold homes, lackluster business investment and weak orders in the manufacturing sector are more fully felt.

Despite this somewhat gloomy forecast, we do not expect the Federal Reserve Board (FRB) to reduce short-term interest rates to promote growth, at least in the next few quarters. In our view, the FRB will focus on inflation data, and the view here is not bright. “Core inflation” of 2.7 percent is much higher than the FRB target range of 1-2 percent, and the consumer price index has increased at an annual rate of 4 percent in the last three months. Moreover, productivity improvement is slowing. Good productivity performance in recent years has positively affected the standard of living in the United States by helping to keep prices stable, despite slow growth in wages.

Beyond the next year or so, we forecast a significant increase in long-term interest rates to meet U.S. refunding requirements, a consequence of the growth in defense expenditures, and entitlement liabilities from pending baby boomer retirements. Even if domestic budget balances improve through tax increases, our international account deficits are likely to exert significant upward pressure on interest rates in the United States. Given our view, we have reduced and will continue to reduce equity holdings that are particularly sensitive to interest rates.

Investment Strategy

Our highest priorities are: (1) energy and other natural resources in politically safe areas; (2) water resources – production, processing, transportation, and purification; (3) food production (highly interdependent with (1) and (2)), especially relating to new methodologies in growing patterns and seed formulation; (4) select large capitalization corporations, a relatively undervalued asset class, especially those associated with  infrastructure improvement and financial services, and (5) health related companies that are likely to benefit from the aging populations of the U.S., Europe, Japan, China and some other countries. For each of the above, other investment attributes being equal, we will continue to focus on high quality foreign companies denominated in currencies we believe are likely to appreciate against the dollar. We expect U.S. dollar weakness even in an environment of higher domestic interest rates.

We continue to emphasize energy because of the declining rate of major new oil discoveries, political instability, the reservoir decline rate of existing fields that we believe is not fully recognized in the market, and substantial growth in demand, particularly in Asia. In addition, we do not believe that alternative energies will diminish demand for fossil fuels for the foreseeable future.

We like water resources because we expect water scarcity will be one of the most important domestic and international issues in coming decades. The supply of fresh water is declining in most major population areas and water is being diverted to cities at the expense of farm communities. This reduces productive farm land already under pressure in some places as a result of reallocation to alternative energy crops. This is an example of the interdependencies noted above, and the result is a need to import food by some countries heretofore food independent. This puts pressure on food prices world-wide. In addition, global warming adds additional pressures because it further reduces plantings and increases plant disease and insects. This is why we are particularly interested in modified seed research.

Large capitalization corporations, that is to say, big companies, are attractive relative to mid and small capitalization corporations. Some are also attractive on an absolute basis and many are well positioned to handle a weaker economy. Also, we like a few for their diversified currency exposures.

The health industry faces tremendous policy, financial and public relations pressures. This has greatly reduced some stock valuations, i.e., their prices relative to earnings, assets, etc. We believe a few of these companies are very attractive. In the end, demographic changes will massively increase demand for drug and other therapies, and established high quality health care companies will benefit.

With regard to bonds, we are emphasizing short-term durations and high quality. As noted, we expect long rates to move higher and, in any case, there is little benefit, but much risk in extending maturities or compromising quality. We will purchase high quality foreign bonds again, which have produced excellent results for clients in the past, but this is not the right time because we believe any currency gain would be more than offset by the value loss resulting from rising interest rates.

We appreciate your kind words and many referrals and will continue to work hard to maintain your confidence.

Phil Tucker, Bill Lauer, Tom Frank, Terry McCubbin, John Edwards, Ed Dobranetski