This is a quarterly update of economic conditions and investment strategy.
The U.S. economic recovery continues, with a strong fourth quarter GDP increase of 5.6%, up from the previous quarter’s 2.2% increase. The fourth quarter was the first evidence of real growth since the recession began in 2008. While the third quarter’s increase of 2.2% was substantially aided by auto sales (“cash for clunkers”), the fourth quarter GDP was driven by rebuilding inventory, and an increase in exports, personal consumption, and nonresidential fixed investment.
A sustained recovery requires job creation. While recently released data show an increase of 162,000 jobs in March, the best data in three years, 48,000 of these jobs were temporary Federal hiring for census data collection. Unemployment continues at 9.7% and will drop only with a sustained period of job creation at a clip of over 200,000 per month. In the fourth quarter of 2008 and the first quarter of 2009, job losses were massive—more than 600,000 per month.
Job increases are unlikely to be found in sectors traditionally associated with recoveries, such as, financial services and housing, which suffered the worst losses. State and local governments are dealing with severe short and long term structural problems and face further furloughs and layoffs. Healthcare may see an increase in employment with the broader access driven by recent legislation, but our best hope for job creation is for a long-awaited increase in manufacturing jobs, assisted by investment in new technologies and by a lower U.S. dollar.
Additional help in the form of Federal stimulus spending seems unlikely. Massive Federal deficits mean the most likely Federal role will be a monetary one in the form of low short-term interest rates to provide continued assistance to the banking, housing and other credit-dependent sectors. Fiscal problems at the State and local level—a recent report from the Pew Center cited a $1 trillion shortfall in retiree pension and health care funding for municipalities—largely restrict stimulus from this sector.
Recent increases in yields of the ten year U.S. Treasury, a benchmark rate not controlled by the Fed, signal international unease with our high debt levels. In the absence of a creditable deficit reduction program, foreign buyers will demand higher interest rates as compensation for the higher currency risk of increasingly large deficit refunding.
Roughly half of Chevy Chase Trust client assets are held in fixed income instruments, including municipal and corporate bonds, U.S. Agency and Treasury instruments, and lesser amounts in preferred stocks, non-U.S. sovereigns, and other investments held for shorter-term strategic reasons. Given the importance of fixed income investments to financial stability, as well as to
equity valuations, we pay close attention to all factors that govern their valuations. These include: the shape of the yield curve, that is, the spread of interest rates between short and long-term bonds; duration of bond portfolios; and market expectations for changes in interest rates, including the causes of such changes, e.g., change in the rate of inflation, or in expectations of inflation, or change in the willingness of foreign buyers to own our debt.
More than ever, monitoring the fixed income markets will be critical to portfolio performance. For the twelve months ending, U.S. stock mutual funds saw outflows of $30 billion, while a stunning $395 billion in new monies were added to the fixed income sector. This occurred during a period of significant stock market recovery and historical low yields in the fixed income sector. In other words, investors ignored low valuations in the equity market and bought heavily in what is likely a fully valued fixed income market.
This massive flight to the perceived safety of fixed income investments could whiplash these investors. We view long-term bond funds as especially vulnerable to a rise in interest rates.
Interest rates, as measured by the ten year U.S. Treasury, are near 4%. With the Fed maintaining short term rates near zero, the spread—or difference—between short and long rates is at a near record level. Our view, for the near term, is that any of three events could raise rates: a renewed fear of inflation; a real uptick in inflation; and/or a massive supply of bonds that overwhelms demand. If we get more than one of these, rates could be much higher. We are maintaining durations, or average maturities, at short term levels even with low short term rates. There will be a time to emphasize longer term bonds, but we do not believe that it is now.
Our equity portfolios continue to generate positive returns. We have replaced lost bond income in many cases with stock of U.S. and foreign companies that pay high dividends and also offer attractive growth prospects. We also have strong positions in energy: the proposed opening of new offshore areas for drilling is quite limited, requires much new infrastructure investment, and, in any case, will not pay off until 2020. In the meantime, economic recovery will put pressure on prices as excess capacity is used. We like pipelines that will transport the new natural gas supplies as this source of energy gains wider acceptance.
We continue to pay close attention to food and water issues. Global food demand is expected to increase 50% during the next 20 years. Research projects the need for an additional 2.5 billion hectares of cultivable land to meet this demand but only 750 million hectares will be available. In our view, advances in seed technologies are critical in mitigating this gap. Water has its own set of problems which we will discuss in future updates.
In short, there are many opportunities for thoughtful investments, especially under challenging conditions.
Chevy Chase Trust, April 2010