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  • April 22, 2013

    David Giroux David Giroux, portfolio manager of the T. Rowe Price Capital Appreciation Fund.

    During the first quarter of 2013, U.S. equity markets were finally able to recover all the ground lost since the 2008-2009 financial crisis, while bond yields continued to compress as the Federal Reserve persisted in its asset purchase plans. So what's next for the U.S. markets? We checked with David Giroux, who has been with T. Rowe Price for 14 years and has managed the Capital Appreciation Fund since 2006. In a recent interview, he offered his take on the recent environment and current outlook for U.S. markets.

    Differences Between the Pre-Crisis Economy and Today

    Despite a string of fiscal crises in the U.S. and Europe, U.S. equities have been enjoying a steady bull market for most of the past four years. Investors are weary of the crisis cycle and have come back into equity markets, lifting valuations. Giroux says that strong corporate profits are encouraging investors. But while many major market indexes are back at late-2007 levels, the economic landscape is quite different in many ways.

    Prior to the financial crisis, consumers' debt load was high. Today, personal debt has been trimmed dramatically. Likewise, companies then were highly leveraged but today are sitting on large cash reserves and are financially stronger. Conversely, federal government debt levels have spiraled, and the Federal Reserve has significantly expanded its balance sheet. Giroux argues that this does not necessarily put us in a position that is less risky than in 2007, just one with different risks.

    There is still a need for the U.S. to shore up its fiscal policy—a need that has been repeatedly deferred by bickering in Washington. For corporations, policy uncertainty has been a strong impediment to deciding where and how to deploy their built-up capital. In the meantime, corporate profits have benefited from cost-cutting and other efficiency gains, but this benefit has already begun to slow.

    Despite Slowing Corporate Earnings Growth, Stocks Have Risen Amid Low Interest Rates

    Over the last six months or so, the pace of corporate earnings growth has slowed from strong double digits to mid-single digits, a pattern forecast to continue through 2013. Companies have pretty much reached the limit in their ability to grow profit margins through cutting costs and now must increase sales, which is difficult in a worldwide economic slowdown. However, equity markets have reached all-time highs even as profit growth has slowed.

    Giroux says much of this is due to the fact that investors seeking higher yields and attractive returns have few options other than to invest in equities. For example, many investment-grade bonds have yields below 3%. On their own, equities do not seem to be especially attractive, but in a low-yield fixed income environment, they appear more compelling than many alternatives.

    With Exceptions, the Risk/Reward Trade-Off of Most Bond Sectors Is Unfavorable

    Giroux also keeps an eye on the fixed income market, where yields have compressed to historic lows. Indeed, the risk/reward trade-off of traditional bonds has become unfavorable. If interest rates stay suppressed, there is not much money to be made; but if rates rise, the investor could experience significant losses.

    This has reduced the overall attractiveness of bonds, but Giroux notes a few exceptions. Many corporate bonds are offering yields above 3%, for example. A less conventional option has been floating rate loans, also known as leveraged loans. These securities tend to be at the top of a company's capital structure, so even if the issuing company declares bankruptcy, there is little risk of losing your principal. On the plus side, these securities can generate attractive levels of income and, because of the floating rate feature, they can provide a hedge against rising interest rates.

    The views are as of April 4, 2013 and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

    Stocks and sectors may not perform in line with the managers' expectations. The value approach carries the risk that the market will not recognize a security's intrinsic value for a long time, or that a stock judged to be undervalued may actually be appropriately priced. Small companies tend to have less experienced management, unpredictable earnings growth, and limited product lines, which can cause their share prices to fluctuate more than those of larger firms. Funds that invest overseas generally carry more risk than funds that invest strictly in U.S. assets, due to factors such as currency risk, geographic risk and emerging markets risk. Because of the concentration in rapidly developing economies, investing in emerging markets involves a high degree of risk. Bonds are subject to credit risk and interest rate risk. High yield bonds and floating rate (or "leveraged") loans have a greater risk of default than higher quality bonds. Floating rate loans are usually considered speculative and involve a greater risk of default and price decline than higher rated bonds. Investors should note that if interest rates rise significantly from current levels, bond returns are likely to decline. Diversification cannot assure a profit or protect against loss in a declining market.

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