NOTEWORTHY

Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: Second Quarter, 2008

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

Economic Conditions

We see a very slow growing U.S. economy, not withstanding the brief stimulus of the tax rebate. Weakness in housing, autos, retail, and travel are likely to dampen economic growth well into 2009 and perhaps longer.

Unemployment has reached 5.5%; income growth has slow ed; and cost pressures on consumers — for energy, food, medical services – greatly reduce consumer purchasing power. Unfortunately, the poor state of consumer balance sheets, the virtual shutting down of the home equity bank, and tightened lending standards remove previously exploited financial backstops. In short, no quick rebound; the return to a healthy level of economic growth is likely to be a protracted affair.

Policymakers recognize the fragile state of the U.S. economy although this is not expressed forthrightly. One need only observe a few key interest rates, e.g., the two year treasury at about 3% and the Federal funds target rate of 2%, both significantly under the current rate of inflation. Interest rates at these levels have a longterm inflationary impact. Their presence, i.e., the acceptance of negative real interest rates, is an important indicator of policymakers’ belief that the economy is very fragile and inflation is less of a priority.

Longer-term Considerations

Domestic economic growth will be under considerable pressure as we belatedly come to terms with our Government budget problems and our trade deficit. The Federal budget deficit, before addressing the entitlement programs, is in a structural deficit. Financing the entitlement programs, especially Medicare, will be a Herculean task, even with cutbacks in benefits. State government contingent liabilities for pension plans and other obligations also present major financing problems.

The trade deficit is equally as challenging as the budget deficits. The rise in the price of energy is causing one of the greatest transfers of wealth in economic history, in this case from oil consuming countries to the producers – about $600 billion annually from the U.S. alone. Strong actions will be needed; no country can withstand the magnitude of this size drain very long. If meaningful measures are not taken, the consequent drop in the U.S. standard of living may be the least of our worries.

Ultimately, the transfer of wealth is very likely to result in significant inflation in many of the exporting countries caused by their poor allocations of capital. The beginning of this process is evident, e.g., in Russia and some of the Persian Gulf states. As the inflation momentum grows, the relative values in other countries will become attractive eventually leading to outflows from the producers. This phenomenon, David Hume’s “price specie flow mechanism”, may repeat the experience of Spain as it dealt (very poorly) with the wealth of the Inca empire. However, it can be a long process.

Investment Strategy

The economic climate and our projection of future events suggest strongly to us: (1) continuation of a global orientation, and (2) a conservative investment posture emphasizing, for equities, secular trends that are likely to be strong regardless of economic conditions.

We have featured foreign securities for many years, indeed, since inception. We believe foreign exposure will be increasingly important because geographic availability of resources (human and material) and changes in currency value will be larger factors of production than in the past. It may not be enough to be a world class company; it may be better to be a runner up with access to a natural resource. Financing production, always dependent on interest rates, will be more affected by strength in currency; that is to say, a weak currency caused by a massive trade deficit may require a sharp rise in interest rates to attract foreign capital, placing a burden on the domestic producer.

The secular trends that we have reported to you continue to be high on our investment overweight list. These include energy, food production, water, infrastructure including electrical generation, and healthcare. We continue to be underweight in financials maintaining positions in those addressing the retirement needs of aging populations and high savings rates overseas.

Energy is the most controversial of the aforementioned; everyone has a view. Here is ours: prices may drop in the short-term due to planned increases in OPEC production of light sweet crude and a fall off in demand caused by the sluggish economies and the high price of the commodity. Long-term, beyond 2010, supply limitations will be a very important consideration and prices will head higher on a secular path.

So why hold energy producers now? One reason is that energy companies would be very profitable even at much lower prices than those in the current and futures market. Also, many factors beyond supply-demand affect prices, e.g. politics, wars, storms, production delays, etc. We believe that in order for prices to drop significantly and for more than a brief period, spare capacity or inventory levels must reach high and sustained levels. This would result from a significant decrease in global demand; a large increase in the growth of capacity; a reversal in the depletion rate of existing fields; or a meaningful combination of the above. We do not see evidence of this taking place; indeed, we see the opposite, increased depletion of existing fields (e.g., the Cantarell field in Mexico and reports of declines in some Saudi reservoirs), and growing internal use by the exporting nations. Consequently, we remain overweight in the energy sector, especially Canadian oil and gas exploration and oil sands companies.

There are other areas of current investment emphasis. Provision for new water supplies will be widely recognized as a need that can no longer be postponed. It will advance on the priority lists of most nations as food production increasingly fails to meet global needs. The frequency of power failures and shortages is likely to increase dramatically in the developed and developing economies. Electric–based transportation may add to the demand for electric generation. The U.S. transmission system will require substantial investment to update for current needs and much more to meet projected needs. Separately, the increase in private generation, the result of serial power failures in the U.S. and abroad, will put additional pressures on energy supplies.

This is our investment framework and areas of concentration. Investment strategy will continue to be formulated using a shifting allocation of bonds, stocks, and other instruments that have served us so well during weak and strong markets.

Have a pleasant summer.

Phil Tucker, Eric Kraus, Tom Frank, Sneha Mansukhani, John Edwards, Kathleen McGill, Ed Dobranetski