Stocks fall on emerging markets concerns
Stocks fell sharply in January, with the bulk of the declines coming late in the month. The Dow Jones Industrial Average fell much more than the Standard & Poor's 500 Index, which saw its largest monthly loss in nearly two years. The smaller-cap indexes, which are typically more volatile, fell less than the large-caps, while the technology-laden Nasdaq Composite declined the least.
|S&P MidCap 400||-2.12||-2.12|
1Returns are for the periods ended January 31, 2014. The returns include dividends based on data compiled by T. Rowe Price, except for the Nasdaq Composite, whose return is principal only.
2The Dow Jones Industrial Average and the Standard & Poor's 500 Stock Index of blue chip stocks, the Standard & Poor's MidCap 400 Index, and the Russell 2000 Index are unmanaged indices representing various segments by market capitalization of the U.S. equity markets. The Nasdaq Composite is an unmanaged index representing the companies traded on the Nasdaq stock market and the National Market System. It is not possible to invest directly in an index.
Markets turn decisively lower on Chinese manufacturing data
Several factors were to blame for the downturn in equities, but fears of a slowdown in emerging markets appeared to weigh heaviest on investor sentiment. Stocks turned decisively lower on January 23 following bad news about the crucial Chinese manufacturing sector. A gauge of Chinese factory activity moved slightly into contraction territory, reviving concerns about China's growth outlook. Investors also reacted to rumors of a possible default in a Chinese investment trust, which threatened to have ripple effects in the country’s so-called shadow banking system.
Capital flight threatens the weakest emerging markets as risk aversion increases
Market losses accelerated at the end of the month due to worries over capital flight from emerging markets and heightened investor risk aversion in general. The prospect of higher long-term interest rates in the U.S. and declining global liquidity as the Federal Reserve continues to reduce its asset purchases have lured capital away from emerging markets, sparking a cycle of growing risk aversion and capital outflows from the weakest economies. Countries that depend on foreign capital to finance their current-account deficits were especially poor performers in January.
T. Rowe Price analysts do not see broader contagion
T. Rowe Price global sovereign credit analysts are keeping a close eye on the situation in troubled emerging markets, but they do not believe that we are in the midst of an emerging markets meltdown similar to the Asian financial crisis of the late 1990s. Many emerging markets have adopted prudent economic policies and accumulated ample foreign exchange reserves, which should help insulate them from rising risk aversion and capital outflows to developed markets.
The U.S. economic outlook is still bright
Investors seemed generally encouraged by the U.S. economic outlook. Markets declined after the government announced a surprisingly weak rise in nonfarm payrolls in December, but generally favorable weekly unemployment claims data suggested that weather-related hiring delays might have been to blame. The manufacturing sector continued to expand at a healthy clip, and consumer spending and business investment appeared to be on the upswing. Stocks enjoyed a brief bounce late in the month on news that the U.S. economy had grown at an annual rate of 3.2% in the final quarter of 2013. T. Rowe Price economists note that the growth data benefited from a solid increase in expenditures by consumers and businesses.
Earnings growth appears to remain on track
While economic concerns dominated headlines, investors also paid close attention to fourth-quarter earnings reports, which proved largely favorable. Analytical firm FactSet reported that, as of the end of January, roughly three-quarters of the S&P 500 firms that had reported earnings exceeded consensus estimates. T. Rowe Price managers note that earnings continue to be supportive of stock prices, but the market’s advance in 2013 outpaced improvement in corporate fundamentals.
Developed markets bonds post strong gains, but emerging markets fall
Most global fixed income asset classes posted solid returns, although emerging markets debt lost considerable ground as investor sentiment toward developing markets soured near the end of the month. U.S. Treasuries benefited from the troubles in emerging markets and volatility in global equity markets. Many investors sold higher-risk assets and moved into the relative safety of developed markets government debt. The demand for high-quality debt triggered a rally in Treasuries that pushed the yields on the 10-year note and the 30-year bond down by more than 30 basis points (a basis point is 0.01 percentage points). The Treasury yield curve flattened as short-term rates did not fall as much as longer-maturity yields.
Treasuries benefit from the flight to safety
The strong demand for Treasuries more than offset the $5 billion decrease in the Federal Reserve’s monthly purchases of Treasuries as part of the central bank’s tapering of its asset purchases. The Fed did not mention the turmoil in emerging markets in its statement following the January 28‒29 monetary policy meeting, when it announced that it would further reduce its asset buying in February. U.S. economic data released in January were mixed and the Fed did not see enough in the data to justify a change in the gradual tapering process. The Commerce Department reported that gross domestic product increased at a 3.2% annual rate in the fourth quarter despite the drag from the government shutdown in October. The unemployment rate dropped to a five-year low of 6.7% in December, but T. Rowe Price economists attribute much of the decline to people leaving the labor force.
|Barclays Capital U.S. Aggregate Bond Index||1.48%||1.48%|
|Credit Suisse High Yield Index||0.76||0.76|
|Barclays Capital Municipal Bond Index||1.95||1.95|
|Barclays Capital Global Aggregate Ex-U.S. Dollar Bond Index||0.80||0.80|
|J.P. Morgan Emerging Markets Index Plus||-1.63||-1.63|
|Barclays U.S. Mortgage Backed Securities Index||1.56||1.56|
Emerging markets debt and currencies drop
Emerging markets bonds posted losses, although emerging markets debt denominated in U.S. dollars fared significantly better than locally denominated bonds. Sovereign bonds rated below investment grade bore the brunt of the selling pressure. Currencies of developing nations dropped steeply against the dollar, forcing the central banks of countries such as Turkey, India, and South Africa to raise their benchmark lending rates in an effort to slow the declines. A mid-month report showing that manufacturing activity contracted in China seemed to trigger the sell-off in emerging markets, although various country-specific factors, including a political corruption scandal in Turkey and violent protests against a Ukrainian government financing agreement with Russia, contributed.
Non-U.S. developed market sovereigns extend rally
The sovereign debt of non-U.S. developed markets extended its strong 2013 performance. The extra yield demanded by investors to hold Spanish and Italian 10-year government debt versus comparable-maturity German government bonds declined to the lowest levels since 2011. Moody’s raised its sovereign credit rating for Ireland back to investment grade, helping Irish debt continue its recent rally. Later in the month, high-quality German government debt benefited from the sell-off in emerging markets bonds.
Investment-grade corporates outperform high yield bonds
While investment-grade corporate credit spreads, which measure the additional yield that investors demand as compensation for holding a bond with credit risk versus a similar-maturity Treasury security, widened slightly, the sector posted positive total returns as a result of the fall in Treasury yields. Issuance of new investment-grade corporate debt accelerated sharply in the second half of the month after the holiday lull. In a reversal of 2013’s trend, investment-grade corporates outperformed high yield bonds. However, investor sentiment about the financial stability of U.S. high yield issuers remained generally positive.
Municipal bonds rebound from rough 2013
In another reversal of last year’s trends, municipal bonds posted an impressive monthly return of nearly 2%. Months of outflows from municipal debt came to an end, and light issuance of new bonds supported the asset class. Improved valuations in municipal debt helped offset investor fears about Puerto Rico’s credit problems and Detroit’s bankruptcy.
|U.S. Treasury Yields|
|Maturity||December 31, 2013||January 31, 2014|
Positive returns from MBS and ABS
Mortgage-backed securities (MBS) turned in solid results despite a decline in demand from the Fed taper—the Fed bought $5 billion less in agency MBS than it did in December. Asset-backed securities (ABS) lagged other U.S. fixed income sectors but still posted positive returns.
Some emerging markets bonds appear attractive
T. Rowe Price fixed income analysts think that some emerging markets bonds have been indiscriminately sold off to levels where they represent strong relative value, although they prefer debt denominated in U.S. dollars as a way to avoid volatility and risk in emerging markets currencies. Dollar-denominated sovereigns appear to offer particularly attractive opportunities. Emerging markets corporate bonds do not seem quite as cheap as dollar-denominated sovereign debt, but they boast considerably wider spreads than similar-quality U.S. corporate bonds. While we expect ongoing near-term volatility in emerging markets, we do not think that there will be a broad emerging markets meltdown like the Asian crisis of the late 1990s.
International markets retreat in January
Developed non-U.S. stock markets gave back some of last year’s gains in January. While several markets were able to post modest positive returns, the broad MSCI Europe, Australasia, and Far East (EAFE) Index of developed markets fell about 4%. Within the developed markets universe, Europe’s markets held up slightly better than those in the Asia-Pacific region. Emerging markets underperformed developed markets—Latin American and emerging European stocks trailed those in Asia. Risk aversion spiked toward the end of the month after China reported weaker-than-expected manufacturing data and on concerns about India, Indonesia, Brazil, Turkey, and South Africa, which have been dubbed the “fragile five.” Each of these countries is dealing with slowing economic growth, political uncertainties, weakening currencies, and large fiscal and current-account deficits.
Within the EAFE index, value shares held up marginally better than growth stocks, while small-caps outperformed large-caps. Every sector in the EAFE benchmark posted losses for the month, with stocks in the health care and utilities sectors holding up the best. The energy and consumer staples sectors declined the most. The U.S. dollar strengthened versus the euro and the British pound but fell against the yen.
|MSCI Indexes1||January 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||-4.02%||-4.02%|
|All Country World ex-U.S.||-4.53||-4.53|
|All Country Asia ex-Japan||-4.98||-4.98|
|EM (Emerging Markets)||-6.47||-6.47|
1Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
Most Asian markets post losses in January
Japanese stocks held up better than most of the other markets in the Asia-Pacific region, but its near 4% decline (the loss would have been greater but currency translation added about 3% for U.S. dollar-based investors) highlights that investors have become increasingly concerned about the long-term effectiveness of Prime Minister Abe’s monetary and fiscal stimulus efforts. However, the Japanese economy edged further toward recovery based on December’s economic data: The consumer price index showed more inflation than expected, and the Bank of Japan forecasts about 1.25% annualized inflation for the next six months; industrial production advanced rapidly; and labor market indicators were generally strong.
Weak Chinese manufacturing data lead to a spike in volatility
Several factors were to blame for the global sell-off, but fears of a slowdown in emerging markets appeared to be the trigger. Stocks turned sharply lower in late January following bad news about the crucial Chinese manufacturing sector. A gauge of Chinese factory activity moved slightly into contraction territory, reviving concerns about China's growth outlook—rising unemployment and higher manufacturing input costs contributed to the decline. Investors also reacted to rumors of a possible default in a Chinese investment trust, which threatened to have ripple effects in the country’s so-called shadow banking system.
Developed European markets fall but hold up better than other regions
An uneven recovery is underway in Europe, with notable pockets of strength and weakness. Most Nordic and eurozone markets fell, but Denmark, Ireland, and Italy bucked the negative trend. T. Rowe Price economists believe that the European Central Bank may inject more liquidity into the financial system, which remains under pressure due to austerity measures and record-high unemployment levels. In a mid-January speech, the International Monetary Fund’s managing director, Christine Lagarde, voiced concerns about deflation risk in advanced economies. Inflation is indeed running below many central banks’ targets across the spectrum of large advanced economies. However, Dean Tenerelli, manager of the European Stock Fund, is optimistic about the eurozone’s future, noting that because of budget cuts, competitiveness, restructuring, and labor and pension reforms, the downside should be relatively limited. Euro-area governments are now running their highest current account surpluses in the last 15 years.
Non-U.S. stock valuations remain attractive
International equity portfolio managers at T. Rowe Price are optimistic about equities based on their valuations and because central bank monetary policy in many advanced economies remains highly accommodative. It seems that Europe is past the worst of its financial crisis, and its recovery is starting to be self-sustaining. Companies also appear poised to take advantage as the economy finally starts to recover from its double-dip recession. Despite the Continent’s modest economic growth prospects, the risk/reward ratio appears more attractive in Europe than in Japan, where aggressive, growth-oriented monetary policies and other economic stimulus have revived the country’s economy. However, we await signs that Japanese policymakers are politically willing and able to address important structural reforms to labor markets, tax and regulatory regimes, and social spending. We believe emerging markets also offer compelling valuation opportunities, given their recent underperformance and strong long-term growth prospects. However, several emerging economies appear vulnerable to the prospects of rising U.S. interest rates with nations highly dependent on external funding the most at risk.
Emerging markets stocks sink as China PMI sparks currency rout
Emerging markets stocks fell in January after a weaker-than-expected manufacturing report in China triggered a flight from higher-risk assets. The sell-off started after HSBC reported that its Flash China Manufacturing PMI contracted in January for the first time in six months, which revived longstanding concerns about China’s slowdown. Emerging markets with the weakest fundamentals suffered the most, with currencies hit particularly hard. The Turkish lira sank to a record low by month-end, while the Russian ruble and South African rand each fell to multiyear lows. Political turmoil in many countries also curbed investor risk appetite: Turkey’s prime minister is mired in a corruption probe; Thailand is wrestling with a political crisis that has essentially rendered it ungovernable; and Argentina is at risk of a full-blown economic crisis after its government unexpectedly devalued the peso. In an effort to stem the currency sell-off, central banks in Turkey and South Africa separately raised their key benchmark rates within a day of each other at month-end. The MSCI Emerging Markets Index ended the month at its lowest level since August 2013. All 10 sectors in the index fell, led by energy and consumer staples, each of which retreated more than 8%.
|MSCI Indexes1||January 2014||Year-to-Date|
|Emerging Markets (EM)||-6.47%||-6.47%|
|EM Latin America||-9.45||-9.45|
China pulls Asian markets lower; Thailand falls amid political deadlock
Stocks in China fell the most, down more than 6%, though the restricted A-share market for foreign investors declined 4.5%. China’s economy grew 7.9% year-over-year in the final quarter of 2013, up from 7.4% in the prior quarter. The stronger-than-expected GDP data, however, was offset by the subsequent PMI report, which attributed January’s weakness to cooling domestic demand. T. Rowe Price analysts believe that the risks of a financial crisis in China are low but that growth there will continue slowing in the coming years. Indian stocks declined. In a surprise move, India’s central bank lifted its benchmark rate for the third time in five months, signaling its determination to fight inflation, which has hovered close to 10% in recent months. In Southeast Asia, stocks in Indonesia and the Philippines advanced, while those in Malaysia and Thailand fell. Our analysts are uncertain about how Thailand’s governance crisis will play out but forecast weaker growth in 2014 as the political deadlock takes its toll on the economy. We believe that valuations there—particularly for domestic banks—are starting to look attractive, but the consumer stocks that we favor remain relatively expensive.
Argentina sinks after easing currency controls
Argentine stocks sank almost 24% as worries mounted that the country is heading toward an economic crisis with repercussions across the region. After maintaining price and currency controls for many years, Argentina’s government unexpectedly devalued the peso and eased foreign currency curbs. The move caused the peso to plunge the most in a single day since Argentina’s economy collapsed in 2002, forcing the government to reverse course and spend several hundred million dollars to prop up the currency. Besides undermining the government’s credibility, the devaluation also raises the risk of social unrest resulting from rampant inflation. Brazil’s market shed more than 10% as the country continues to battle stagflation, or weak growth combined with rising prices. Brazil’s central bank raised its benchmark rate for the sixth straight time as inflation picked up. Mexican stocks fell more than 6%, while Peru was the region’s sole advancer, up less than 1%.
Turkey and South Africa fall amid currency turmoil
Turkey and South Africa ranked among the worst performers in the EMEA region, down roughly 13% and 10%, respectively. Both countries hiked their interest rates within a day of each other at the end of January in a bid to stem their respective currency slides. Turkey’s central bank increased a series of short-term policy rates at an emergency meeting, while South Africa boosted its benchmark lending rate for the first time since 2008. Stocks in Russia slid about 10% as it too battled currency selling pressure. In response, Russia’s central bank lifted the ruble’s trading band against a euro/dollar basket that serves as the country’s main currency benchmark.
Solid long-term fundamentals offset near-term worries
Looking ahead, we believe that stock selection will take on more importance for emerging markets investors. In recent years, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. Over time, we expect this trend to continue, particularly with the end of the global commodities boom and runaway growth in China. Now that these longtime growth tailwinds have faded, we believe that investing in the right companies and in the right countries will be crucial for long-term outperformance.
We remain confident that emerging markets stocks are an attractive asset class over the medium to longer term. Stocks across the developing world are trading at a significant discount relative to their valuation history and their developed market peers, making current valuations compelling for patient investors. We believe that the solid fundamentals underpinning the companies in which we invest are intact despite the recent disappointing performance of many emerging markets.