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Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: Second Quarter, 2007

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

Economic Conditions

First quarter, 2007 GDP increased at an annual rate of 0.7%, down from the previous quarter’s 2.5% annual rate, and the lowest quarterly increase in four years. Corporate investment slowed and the housing slump continued. However, as an offset, consumers continued to spend. For the second quarter, preliminary data indicate that consumer spending and low unemployment are keeping GDP activity in positive territory.

As expected, the Federal Reserve Board kept short-term interest rates at 5.25%, despite slowing economic growth. Inflation data, especially core inflation, are the Fed’s main focus. While core inflation is 2.7%(excludes energy and food), energy costs have increased nearly 5% and food price inflation is 3.9%. With these trends firmly in place, and the likelihood that the latter will spill into the core data, expectations are low for a near term cut in interest rates.

As noted in previous letters, increases in food prices have our attention. We believe the official food inflation rate of 3.9% is headed higher, a view supported by increases in grain prices such as corn and wheat, among others. This story is similar to that of oil and base metals—steady increase in demand from overseas without significant increases in production—exacerbated by new demand for the production of ethanol. The result: during the past two years, a doubling in corn prices, a 50% increase in soybean prices, and
significant price increases in other grains and foodstuffs.

The primary use for corn and other “coarse grains” is feedstock for poultry, beef, and other livestock. Consequently, we are seeing significant increases in meat, milk, cheese and other food prices.

As long as China, India, and the other developing countries prosper, their changing diets will result in increased consumption of meat, poultry, and dairy products. This incremental demand, along with the recent ethanol boom, puts pressure on the global food production system. The U.S. Department of Agriculture estimates that nearly 20% of current U.S. corn production will be diverted to ethanol production, a figure certain to rise with construction of new ethanol production plants. The law of unintended consequences is at work: meeting the needs of the developed world plusa nascent biofuels industry results in historically
high grain prices (and new water problems too—another story).

The challenges are substantial, as are the investment implications and opportunities.

Investment Strategy

Our portfolios continue to perform well ahead of the S&P 500 as we continue to position them in line with our major themes: energy and other natural resources; stress on the global food supply chain; the need to provide clean water to both the developed and developing world; and the opportunities and challenges of an aging population.

In each of these areas we invest in companies with unique technology, resources, or other competitive advantages. Often these are foreign companies; our flexibility in following companies and economies world-wide has been one of the keys to our success the past decade.

Specific to food production, we are finding opportunities in companies that produce seeds, protect crops, and distribute production. We have not invested in companies involved in ethanol production. While biofuels are likely to play an ongoing role in meeting energy needs, we do not believe the first generation of biofuels is the right answer.

We continue to expect long-term interest rates to increase. This has implications for both stock and bond portfolios. While higher rates may not, by themselves, greatly impede economic growth, the path to higher levels may be disruptive. For this reason, we continue to put less emphasis on financial stocks that are more at risk from this shift. Also, our bond portfolios continue to be geared to shorter maturities and top quality instruments. A recent hedge fund debacle with mortgage securities is unlikely to be a one-time event, and we are not taking chances with our fixed rate instruments.

Finally, active investment management for our taxable accounts periodically requires portfolio pruning to reduce risk, correct excess valuations, rebalance between asset classes and setors, and free up funds for new opportunities. While we are focused on tax efficiency, we will not let tax avoidance override prudence. For long-standing clients this is likely to be a year of higher capital gains. In the first half, 2007, a number of our companies merged or were purchased, triggering an automatic tax event. We will keep you apprised as
the year progresses.

Have a pleasant summer.

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