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Chevy Chase Trust - Investment Update, Fourth Quarter 2018

Investment Update: Third Quarter, 2010

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

Economic Conditions

There were numerous reminders in the third quarter of a sluggish, uneven economic recovery. The most recent Government estimate of second quarter real GDP showed a deceleration to 1.7% growth from the first quarter’s 3.7% annual rate. Most estimates of third quarter GDP indicate another positive but lackluster quarter as the tailwind of Government stimulus weakens.

The current growth rate is not strong enough to bring down a persistently high unemployment rate that has topped 9% for 17 consecutive months. Nor have conditions in the housing market improved enough to take the pressure off those with little or no equity in their homes and those struggling to make mortgage payments. RealtyTrac estimates that 25% of outstanding mortgages are underwater with a record 1.2 million repossessions this year, up from just under 1 million in 2009. It is difficult to forecast robust economic growth without a significant improvement in residential housing.

While the balance sheets of U.S. households have yet to recover from the the financial crisis and ensuing recession (U.S. household net-worth is well below its 2006 peak), corporate profits have returned to pre-crisis levels. This incongruous outcome results from corporate cost cutting, favorable borrowing rates, and growth in international markets, rather than buoyant consumer spending at home. Thus, companies have been hesitant to reinvest in their U.S. operations or hire new workers.

An increase in hiring hinges on corporate confidence in a sustained recovery and a clearer notion of tax policy. Corporations have ample cash and ample ability to borrow at near-zero (after tax) interest rates, but the aforementioned concerns, in addition to regulatory uncertainty (health care

implementation, financial reforms), are delaying the typical post-recession hiring cycle. Given that a large percentage of lost jobs were in sectors that may not recover for years, or may remain at lower employment levels (financial services, home construction), the eventual pick-up in jobs will need to come from sectors spurred by new technologies and innovations.

The twin pressures from weak job and housing markets continue to depress consumer sentiment; consequently, we, along with most everyone else, see subdued growth for the remainder of 2010 and into 2011.

Investment Strategy

Notwithstanding our cautious U.S. economic outlook, our portfolios are performing well, aided by long-standing positions in resources, precious metals, and foreign securities. Newer positions in multi-national consumer companies have also contributed positively.

We are benefitting from the unfolding of two investment themes that we have researched and studied for a number of years; the growth and increasing prosperity of the middle class in the developing world; and the (closely related) prospect for scarcity of vital natural resources such as water, arable land and hydrocarbon deposits.

The World Bank estimates that the global middle class will grow from 430 million people in 2000 to 1.2 billion in 2030 with China and India accounting for two-thirds of the increase. Despite weakened demand for their exports from the developed world, growth rates in most major emerging markets continue to be robust with India and China expected to grow GDP 8.2%

and 9.5% respectively in 2010. We have positioned portfolios to take advantage of this trend through investments in multinational firms with significant and growing exposure to developing market consumers as well as in select foreign firms that are well-positioned to serve their local markets. While there will be set-backs and occasional crises among the developing countries—just as U.S. economic history is rife with periodic panics and recessions—we believe in a secular multidecade trend that is fundamentally reshaping global markets.

As urbanization and industrialization continue at a rapid pace in the developing world, there is increasing pressure on the global supply of key natural resources. Previous recessions have been accompanied by corresponding weakness in raw material prices. However, in the current environment, commodity prices have recovered much more rapidly and to higher levels than experienced in past expansions despite anemic growth rates in the U.S., Europe and Japan. We continue to maintain outsized exposure to energy and resource firms with long-lived reserves in politically stable environments.

Recent developments in global currency markets reinforce our case for exposure to hard assets. Many of the major economic powers are either openly or surreptitiously attempting to boost exports through relative currency weakness. Given their internal problems, many governments are strongly incentivized to continue this geo-strategic game of competitive currency devaluation. As currency debasement is coupled with the likelihood of additional stimulus measures, we think the potential for future inflation is heightened. Exposure to commodities is likely to serve as an effective hedge against such a development.

Bond portfolios are being impacted by historically-low interest rates, the result of intervention by the Federal Reserve and the Treasury, as well as the expectation of low growth and low inflation in the immediate future. In fact, deflation concerns have become widespread. While low rates may persist for some time, we do not think that time is indefinite, and we believe that deflation risks are outweighed by the certainty of serious capital loss to long-term bond holders when rates increase. We continue to look for opportunities to enhance income generation without extending portfolio durations. We enjoy discussing these and other ideas with clients and friends.

Chevy Chase Trust, October 2010