Markets build on rally even as energy stocks tumble
Stocks recorded solid gains in November, building on the rally that began in the middle of October. The large-cap Standard & Poor's 500 Index and Dow Jones Industrial Average managed a series of new highs during the month, but their greater weighting in the poorly performing energy sector caused them to trail the technology-heavy Nasdaq Composite. Smaller-cap stocks lagged, with the Russell 2000 Index eking out a slim gain thanks to dividend payments. Consumer discretionary, consumer staples, and information technology stocks performed best within the S&P 500 Index. All other segments managed gains except energy, which tumbled over 8%. Growth stocks handily outpaced value shares across all market capitalizations.
|MSCI Indexes||November 2014||Year-to-Date|
|S&P 500 Index||2.69||13.98|
|S&P MidCap 400 Index||1.85||8.87|
|Russell 2000 Index||0.09||1.99|
Past performance cannot guarantee future results. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.
U.S. economy appears to be firing on all cylinders but one
Signs that the U.S. economy continued to gather strength in the fall boosted investor sentiment. The most welcome indicator may have been good news on the labor market which, according to some measures, appeared to be improving at the fastest rate since the 1990s. The Labor Department announced that the economy had added more than 200,000 jobs in October, its ninth consecutive gain at such a level and the best streak of performance in two decades. The four-week average of weekly jobless claims also reached its most favorable level since 2000. Better income prospects were reflected in improved retail sales, which boosted consumer discretionary and consumer staples shares, as well as a rise in consumer confidence. With the manufacturing sector also remaining robust, the housing sector appeared to be the only cylinder in the economic engine that was not firing reliably. While existing home sales and building permits rose, pending sales declined, and builders broke ground on fewer new units. Growth in home prices also appeared to be moderating.
Growth stalled overseas, but investors welcome stimulus response
The economic outlook overseas was much more subdued, but investors appeared to focus on hopes of a turnaround. European shares climbed on a few occasions after European Central Bank President Mario Draghi promised further action to boost inflation expectations and consumption in the region. Japan announced a surprise contraction in its economy in the third quarter. Japanese stocks fell on the news, but U.S. stocks appeared to receive a boost from the Japanese government's announcement that it was postponing a hike in the consumption tax in response. Finally, China sparked a rally in U.S. and other global markets with a surprise cut in interest rates—its first in over two years. T. Rowe Price's Hong Kong-based managers and analysts expect the Chinese economy to slow in 2015 as it tries to pivot toward domestic growth, but they believe that policymakers will successfully avoid the "hard landing" of an abrupt slowdown. They also believe that growth elsewhere in the region will pick up in 2015, particularly in countries that have elected reform-minded leaders.
OPEC inaction contributes to falling oil prices...
Perhaps the most important global economic story of the month, however, was the steep drop in oil prices. Energy stocks followed oil prices lower throughout much of November, but both plunged on November 28, following a Thanksgiving-day announcement that Organization of the Petroleum Exporting Countries (OPEC) ministers had been unable to agree on production cuts to curb the decline. The dramatic increase in U.S. shale oil production in recent years has been one factor in rising global supply, but T. Rowe Price managers and analysts have kept a close eye on growing production in overseas markets as well. The high prices in the last decade provoked massive investment in new on- and off-shore fields, which is likely to keep the price of oil under pressure for the foreseeable future. They are seeing some opportunities in well-positioned companies due to the recent declines in energy stocks, however.
...But supply-driven drop in oil prices should be a boon to the overall economy
Indeed, the broader implications of lower oil prices for the market are much more favorable. T. Rowe Price Chief Economist Alan Levenson notes that a supply-based decline in oil prices—as opposed to one driven by slowing economic growth and shrinking demand, as occurred in 2008—should provide a notable boost to households' disposable income. In fact, Wal-Mart reported early in the month that lower gasoline prices had helped its lower-income customers and contributed to the discount giant's first sales increase in two years. Hopes for a better holiday shopping season in general helped the market as the month ended and investors awaited data on spending over the "Black Friday" weekend.
Treasury yields continue to decrease
U.S. Treasuries rallied in November despite U.S. economic data that showed a generally strong rebound in the labor market and healthier growth. The yield on the 10-year Treasury note continued to defy expectations by decreasing to 2.17% at the end of the month, while the 30-year Treasury yield finished at 2.89%. The unemployment rate fell to 5.8% as of October, down from 5.9% in September. The Commerce Department reported that U.S. gross domestic product (GDP) grew at a 3.9% annualized rate in the third quarter, up from its earlier 3.5% estimate. T. Rowe Price Chief Economist Alan Levenson expects GDP growth of about 3% over the next few quarters, and he anticipates an initial rate increase from the Federal Reserve in mid-2015.
Record-low yields on German government bonds
The extremely low yields on other high-quality sovereign bonds probably contributed to gains in Treasuries by making their rates look attractive in relative terms. For example, the yield on 10-year German government bonds dropped below 0.7% for the first time ever at the end of November. Mario Draghi, the president of the European Central Bank (ECB), periodically made comments about the ECB potentially expanding its bond purchase program to include eurozone sovereign debt, helping fuel the rally. Economic growth and inflation in the eurozone are still uncomfortably low—the November year-over-year inflation reading of 0.3% was a five-year low.
Ongoing U.S. dollar strength
Japan's economy unexpectedly contracted in the third quarter even as the Bank of Japan increased the size of its quantitative easing program to try to boost growth. With the Fed preparing to raise rates while the ECB and the Bank of Japan become even more accommodative, the U.S. dollar strengthened against the euro and most other currencies. This dragged down the returns of many locally denominated bonds for U.S. investors. We think that the dollar's gains will continue as a result of the ongoing divergence in monetary policy between the Fed and other developed market central banks.
|Barclays U.S. Aggregate Bond Index||0.71%||5.87%|
|Credit Suisse High Yield Index||-0.81||3.64|
|Barclays Municipal Bond Index||0.17||8.50|
|Barclays Global Aggregate Ex-U.S. Dollar Bond Index||-1.13||-1.90|
|J.P. Morgan Emerging Markets Bond Index Global Diversified||0.09||9.97|
|Barclays U.S. Mortgage Backed Securities Index||0.65||5.92|
Oil price decline accelerates, hurting high yield bonds
Near the end of the month, the members of the Organization of the Petroleum Exporting Countries (OPEC) decided to leave their oil production goals unchanged, exacerbating the recent sharp decline in crude oil prices. Because bonds from energy-related issuers account for a large proportion of most high yield indexes, the drop in oil prices pulled high yield market returns into negative territory. For most of the month, the selling pressure on high yield bonds from companies that rely on oil revenue was most acute on lower-quality securities within the noninvestment-grade universe; however, even higher-quality energy-related bonds lost ground after the OPEC meeting.
Glut of new issues weighs on investment-grade corporate bonds
Credit spreads, which measure the additional yield above that of a comparable-maturity Treasury security that investors demand for holding a bond with credit risk, widened in the investment-grade corporate bond market amid a rush of new issuance. While demand for new issues has generally been strong, investors in the secondary market have required wider credit spreads. In one of the higher-profile new issues, Chinese e-commerce giant Alibaba Group Holding sold $8 billion in dollar-denominated bonds in a heavily oversubscribed offering.
Country-specific volatility in emerging markets debt
Emerging markets bonds denominated in U.S. dollars generated a slight overall gain, but country-specific returns were volatile. The returns of locally denominated emerging markets debt for U.S. investors suffered from the strength of the dollar. China's central bank unexpectedly cut its benchmark lending rates for the first time in over two years, which helped lift sentiment about the debt of other developing countries in Asia. A scandal involving allegations of money laundering and graft at Brazilian state-controlled oil company Petrobras contributed to elevated volatility in the country's bonds.
|Maturity||October 31, 2014||November 30, 2014|
Detroit restructures its debt
Municipal bonds extended their stretch of monthly gains but lagged Treasuries amid an uptick in new municipal supply. In Detroit, a federal judge approved a plan that will allow the city, a major municipal debt issuer, to exit bankruptcy. Although the relatively quick resolution of proceedings helped remove a negative overhang from the municipal market, our analysts remain concerned by the extent to which Detroit bondholder recoveries were diluted in favor of the city's retirement liabilities. This may set an unfortunate precedent for future municipal bankruptcies.
MBS gain despite increase in issuance
Mortgage-backed securities (MBS) benefited from trading in lockstep with Treasuries. The MBS market overcame the end of the Fed's purchases last month and a sizable increase in new MBS origination to post healthy gains. Year-to-date issuance of asset-backed securities (ABS) has already made 2014 the busiest year for new ABS deals since 2007, with bonds backed by auto loans, credit card receivables, and nontraditional collateral accounting for the bulk of the higher volume.
TIPS and some local emerging markets bonds offer value
While the environment of very low interest rates has made relative value difficult to find within fixed income, we think that the recent selling pressure on Treasury inflation protected securities (TIPS) has created some buying opportunities. TIPS now offer considerably more upside potential relative to conventional, non-inflation indexed Treasuries and our inflation expectations. Locally denominated bonds of some emerging markets also offer compelling relative value, but we are cautious about risk and volatility in the currencies of developing countries.
Developed markets post gains while emerging markets struggle
Developed non-U.S. stock markets posted positive returns in November. However, the MSCI Europe, Australasia, and Far East (EAFE) Index, which measures the performance of developed non-U.S. markets, remains underwater for the year to date. The more modest gain for the MSCI All Country World ex USA Index reflects its allocation to emerging markets, which declined during the month. The large developed markets in Europe (Germany, France, and Spain) performed well, while the Asia-Pacific region was barely positive. Within the emerging markets universe, several European and Latin American countries suffered from the steep decline in oil prices. T. Rowe Price managers and analysts generally agree that energy prices have entered a multiyear down cycle, but they are finding opportunities in selected companies due to the steep declines in the energy sector.
The U.S. dollar continued to strengthen against most other currencies, which hurt the returns for dollar-based investors. The euro, pound, and yen all weakened versus the dollar in November. For the year-to-date period, the euro has declined more than 9%, the pound has fallen more than 5%, and the yen is off more than 11% versus the greenback. Within the EAFE index, growth stocks handily outperformed value shares, and large-caps outperformed small-caps. From a sector perspective, the EAFE's best performers were consumer discretionary, telecommunication services, and information technology. The only sector in the EAFE index to post a loss in November was energy, which fell 8.3%. Utilities and financials stocks were also weak but posted modest positive results for the month.
|MSCI Indexes||November 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||1.37%||-1.08%|
|All Country World ex-U.S.||0.74||0.14|
|All Country Asia ex-Japan||0.31||7.32|
|EM (Emerging Markets)||-1.05||2.88|
The prospect of more stimulus boosts European markets
The European Central Bank (ECB) president, Mario Draghi, has repeatedly said that the central bank would keep interest rates low for as long as it takes to push inflation up toward the 2% level, and investors welcomed the prospect of further measures to boost growth and inflation. The ECB reaffirmed its willingness to expand its stimulus plan, which is much like the Federal Reserve's recently completed quantitative easing program, to include purchases of asset-backed securities in addition to covered bank bonds. Designed to boost lending in the region, Draghi's plan is to expand the ECB's balance sheet by €1 trillion (approximately $1.24 trillion). Thus far, the ECB has not engaged in large-scale purchases of public sector assets. The European Union has trimmed its 2014 growth forecast to 0.8% from 1.2% and its estimate for 2015 to 1.1% from 1.7%. The eurozone's third-quarter gross domestic product growth was anemic at 0.2%.
Asian markets were flat for the month
The U.S. dollar is near a seven-year high versus the yen, and the dollar could continue to appreciate following the Bank of Japan's (BoJ) new stimulus measures. The Japanese economy has struggled since the sales tax increase in April. As a result of lower-than-expected inflation and a slowdown in household spending in the third quarter, the BoJ announced an expansion of its monetary base. The Japanese government also announced that the country's economy had contracted for a second consecutive quarter—crossing the commonly accepted threshold of being in recession. While Japanese stocks initially declined on the news, investors eventually warmed to the promise of further stimulus. Separately, the government affirmed that it was pushing back a consumption tax increase planned for next year. China surprised the markets and cut interest rates for the first time in two years. T. Rowe Price's Hong Kong-based managers and analysts expect the Chinese economy to slow in 2015 as the government tries to stimulate domestic growth, but they believe that policymakers will successfully avoid an abrupt slowdown. They also believe that growth elsewhere in the region will pick up in 2015, particularly in countries that have elected reform-minded leaders.
Non-U.S. stock valuations appear reasonable, but dollar strength is worrisome
T. Rowe Price portfolio managers remain optimistic about the environment for global equities in the intermediate and longer term, but their near-term outlook remains somewhat guarded. Overall, valuations in non-U.S. equity markets are neither excessive nor inexpensive. Although some individual stocks and sectors appear to be richly priced, there are opportunities for bottom-up stock selection. In Europe, earnings growth has been disappointing, and the dispute between Western powers and Russia over Ukraine has called into question the viability of near-term economic improvement. Dollar strength is likely to remain a key focus for eurozone investors, and growth forecasts have been ratcheted lower. In Japan, we believe domestic consumption and wage inflation need to be the next growth engine for a sustained recovery. Prime Minister Shinzo Abe has been pressing corporations to raise wages in order to support the Japanese consumer and reverse a 20-year cycle of wage and price deflation. Indications of durable economic improvements in Japan, together with corporate tax incentives, should also favor an increase in salaries.
We remain encouraged by the continued dispersion of returns within emerging markets. In 2013, we saw little disparity in the performance of emerging markets due to Fed tapering and currency concerns. In 2014, returns have been considerably more reflective of underlying fundamentals at the stock and country level—a positive and overdue development, in our view.
Emerging markets stocks decline on disappointing growth, oil price drop
Emerging markets stocks declined in November as signs of slowing growth worldwide and plunging oil prices weighed on big energy exporters. Many developing countries reported disappointing economic growth in the third quarter, forcing several of them to cut their full-year growth targets. Separately, the decision by the Organization of Petroleum Exporting Countries (OPEC) to resist production cuts despite falling oil prices increased economic pressure on major producers such as Brazil, Russia, and Mexico. Crude oil futures ended the month at their lowest levels in more than four years following OPEC's November 27 decision, and many analysts believe that oil prices could continue to decline. T. Rowe Price analysts point out that while some emerging markets will suffer from low oil prices, most stand to gain in the long run, particularly energy-importing countries with large current account deficits.
Seven of the 10 sectors in the MSCI Emerging Markets Index declined, two sectors rose, and the consumer discretionary sector ended virtually flat. Energy stocks fell the most, down more than 9%, while information technology shares performed the best, gaining slightly over 1%.
|MSCI Emerging Markets (EM) Index||-1.05%||2.88%|
|MSCI EM Asia Index||0.18||7.25|
|MSCI EM Europe, Middle East, and Africa (EMEA) Index||-1.80||-5.42|
|MSCI EM Latin America Index||-4.59||-3.20|
Chinese A shares surge after surprise rate cut; Indian stocks gain
- Chinese stocks edged higher, but the A share market restricted to domestic investors surged nearly 10%. China's central bank unexpectedly cut interest rates for the first time since 2012 in an attempt to lift the slowing economy and spur lending to smaller businesses. But a pair of manufacturing reports released after the November 21 rate cut showed continued weakness in China's economy, raising the likelihood of further easing in the coming months.
- Stocks in India, a heavy oil importer, advanced as the drop in oil prices improved the outlook for the country's finances. India's gross domestic product (GDP) growth slowed to 5.3% in this year's third quarter from 5.7% in the previous period. The GDP number slightly exceeded forecasts but underscored the need for major structural economic reforms, which the government has so far not delivered.
- Stocks advanced in Thailand and the Philippines, though both countries separately reported sharply lower-than-expected GDP growth in the third quarter. In the Philippines, quarterly growth slowed to its slowest pace since 2011 amid weak state spending. Thailand cut its 2014 growth outlook for the fourth time this year to a 1.00% target, the slowest pace since 2011. At that rate, Thailand would rank last in projected GDP growth among Southeast Asian countries.
Brazilian, Colombian stocks slump as oil plunges; Mexico's market retreats on weak data
- Brazilian stocks fell nearly 5% as the drop in oil prices and a corruption probe weighed on market heavyweight Petrobras, the state energy company. Brazil's president named a former Treasury secretary, Joaquim Levy, as the country's new finance minister. Markets viewed the appointment of Levy, who is seen as a deficit hawk, as a welcome shift toward more conservative fiscal policy after years of stimulus spending under his predecessor.
- Mexican stocks fell as recent economic data continued to disappoint. Mexico's finance ministry reported third-quarter GDP grew at a rate below analysts' expectations amid weak domestic demand. It also cut its 2014 growth outlook to a range of 2.1% to 2.6% from a previous 2.7% estimate, the second time the ministry lowered its forecast this year.
- Colombian stocks gave up more than 13%, the most in Latin America, as the drop in oil prices weighed on the country's economic outlook. Oil accounts for more than half of Colombia's exports, and the fall in oil prices has worsened a budget deficit projected for 2015.
Russian stocks slump as recession looms; stocks in Turkey, South Africa advance
- Russian stocks slid almost 11% as oil prices plummeted, raising pressure on the country's energy-driven economy that was already reeling from Ukraine-related sanctions. Russia's currency slid to record lows in November, and its central bank moved to a free-floating exchange rate after past months' efforts to defend the ruble drained billions from currency reserves. T. Rowe Price analysts believe that Russia will enter a recession in 2015.
- Turkish stocks added more than 7% as the drop in oil prices lifted the country's economic outlook. The drop in crude oil helps Turkey, a net energy importer, by shrinking its import bill and reducing its sizable current account deficit.
- South African stocks edged higher as lower oil prices eased inflation pressures. South Africa's new central bank governor, Lesetja Kganyago, who took charge November 9, said that lower oil prices had a "significant impact" on the country's inflation outlook and opted to keep borrowing costs unchanged at his debut policy meeting.
Solid long-term fundamentals offset near-term risks
In recent years, we have noted significant dispersion in the returns of emerging markets stocks. Emerging markets appear cheap in aggregate, but valuations vary widely by country and sector. With the end of the global commodities boom and double-digit annual growth in China, we believe that careful stock selection will be increasingly key to long-term outperformance. Near-term risks include a worse-than-expected slowdown in China or a breakdown in its financial system, a sharp rise in U.S. interest rates, and an unexpected bout of risk aversion due to geopolitical events.
Stocks across the developing world are trading at a significant discount relative to their history and developed market peers, making current valuations compelling for long-term investors. Most emerging markets have stronger financial positions, larger currency reserves, and more flexible foreign exchange policies than they did a decade ago. We believe that emerging markets stocks remain an attractive asset class for long-term investors, but they should gradually build their exposure to this asset class.