U.S. stocks decline as overseas concerns take spotlight
A sharp decline on the final trading day of the month pushed large-cap indexes to a modest loss for July, while small- and mid-cap shares fared worse and suffered substantial declines. Investors largely welcomed second-quarter earnings reports, but worries about international conflict and economic turmoil weighed on sentiment, and good data on the U.S. labor market appeared to foster concerns that the Federal Reserve might raise short-term interest rates sooner than expected. Both the Dow Jones Industrial Average and the Standard & Poor's 500 Index managed to establish new highs during the month before retreating.
|S&P MidCap 400||-4.27||2.90|
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1Returns are for the periods ended July 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 Index 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.
Earnings appear to have grown faster than expected in second quarter
A generally positive tone to second-quarter earnings reports helped provide momentum to the market for much of July. At the end of the month, analytical firm FactSet reported that overall earnings for companies in the S&P 500 that had reported to date had increased by 7.5%, well above the 4.9% growth expected before the reporting season began. Moreover, nearly three-quarters of the companies that had reported second-quarter earnings up to that point had surpassed analysts' estimates.
Labor market data raise Fed concerns
Economic figures released in July were also generally positive, although their impact on stocks was mixed. Labor market data were especially strong, with payroll and unemployment claim statistics reaching their most favorable levels since the late 1990s, by some measures. One factor behind the late-month sell-off, however, may have been a Labor Department report revealing that labor costs in the second quarter were rising at their fastest pace since 2008, with wage increases driving much of the gain. The data sparked worries that the Federal Reserve may decide that the labor market had improved enough to move up plans to raise short-term interest rates. T. Rowe Price Chief Economist Alan Levenson notes that hourly wage inflation trends remain benign, however, and he still expects the Fed will wait until the middle of 2015 to raise short-term rates.
Fed believes small-cap valuations are "stretched"
The Fed also appeared to drive markets in an unusual way following the release at mid-month of a monetary policy report. The document, which accompanied congressional testimony by Fed Chair Janet Yellen, stated that "valuation metrics in some sectors do appear substantially stretched-particularly those for smaller firms in the social media and biotechnology industries." The report appeared to spark some selling among small-caps, which substantially trailed large-caps for the month.
Economic and political worries overseas weigh on sentiment
Geopolitical concerns weighed broadly on stocks in July. The mid-month shoot-down of a Malaysian passenger jet over eastern Ukraine caused an immediate swoon in stock prices, and the deepening tensions between Russia and the U.S. kept a pall over markets throughout the rest of month, as did the Israeli-Palestinian conflict in Gaza. Economic troubles in Europe also unsettled investors, as severe financial problems emerged at a major Portuguese bank, and weakening economic signals appeared even in core nations such as Germany. Another factor in the July 31 sell-off may have been a further decline in eurozone inflation, which reignited fears that the Continent might slip into a deflationary trap of generally falling prices and wages.
Rising tide unlikely to lift all boats
A final factor weighing on stocks at month-end may have been growing concerns about valuations, as stock price gains have outpaced increases in corporate profits. Stocks have rallied on the back of Fed policy, historically high profit margins, and price/earnings multiple expansion. With all of these drivers showing some vulnerability, T. Rowe Price managers generally agree that more modest returns are likely going forward-and a pullback at some point would not be surprising. On the other hand, earnings growth is likely to continue at a moderate rate, and the restrained pace of stock gains early this year suggests an absence of the investor euphoria that has characterized previous market tops. Such an environment should encourage investors to focus more closely on company fundamentals, which we believe favors our emphasis on stock-specific analysis and research.
Bond markets mixed in July
Bond performance was mixed in July, with Treasury yields moving higher except for the 30-year yield, which declined slightly. As a result, the Treasury yield curve-which measures the relationship among yields and various maturities-flattened a bit. The yield on the benchmark 10-year U.S. Treasury note edged up to 2.56% from 2.53% at the end of June, while the 30-year yield fell to 3.32% from 3.36% during the month. Most fixed income segments ended lower, except for municipals and dollar-denominated emerging markets bonds, which delivered mildly positive results. Local currency emerging markets bonds did not do as well because of the stronger dollar.
U.S. GDP growth picks up in second quarter
U.S. gross domestic product growth expanded at a 4.0% annual rate in the second quarter of 2014, after contracting in the first quarter. The latest data indicate that U.S. GDP declined at an annual rate of 2.1% during the first three months of the year, less than its previous reading of 2.9%. Consumer demand, housing, business fixed investment, and inventory building fueled the second-quarter recovery. Consensus estimates for growth in the third quarter range from 3.0% to 3.5%, annualized. At the same time, core inflation has been moderating following some upside surprises in March through May, and commodity-based inflation is expected to ease.
Federal Reserve will cast a wary eye on labor costs
The Fed is likely to focus on wage inflation in setting monetary policy as it looks ahead to 2015. The central bank is on track to end its asset purchase program this coming October, setting the stage for the long-anticipated beginning of short-term rate increases sometime next year. "Inflation has moved somewhat closer to the Committee's longer-run objectives," according the Federal Open Market Committee (FOMC) statement at the end of July. The statement also mentioned that the Fed "sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat." In other words, the cost of labor-a major factor in overall inflation-is trending higher, and the Fed will closely monitor developments as it plans its monetary strategy during the coming months.
|Barclays U.S. Aggregate Bond Index||-0.25%||3.66%|
|Credit Suisse High Yield Index||-1.26||4.22|
|Barclays Municipal Bond Index||0.18||6.18|
|Barclays Global Aggregate Ex-U.S. Dollar Bond Index||-1.35||4.17|
|J.P. Morgan Emerging Markets Index Plus||0.40||9.10|
|Barclays U.S. Mortgage Backed Securities Index||-0.59||3.42|
Labor market continues to strengthen
Employers added 209,000 jobs in July, extending the string of monthly job gains in excess of 200,000 to six months. The result has been solid and steady job growth throughout most of the year to date. The unemployment rate rose a notch from 6.1% to 6.2%, as reported on August 1, but that was largely a reflection of an expansion in the labor force, with more job-seekers entering the market. The data underscore the FOMC's concerns about rising labor costs in the months ahead. T. Rowe Price expects wage inflation to trend higher, although the underpinnings for sustained acceleration are not yet in place.
High yield bonds slip due to stretched valuations
High yield bonds sold off slightly in July as a result of higher valuations in the asset class. The strong fundamentals of high yield issuers-stable earnings and cash flows, and limited near-term debt maturities-continue to support high yield bonds and kept the selling pressure contained. The signs of weakness in high yield demand caused the underwriters of new issues to offer higher coupons than in recent weeks. Our high yield investment team had been expecting a minor correction for the past few months due to the oversupply of low-coupon debt in the new issues market. However, we believe this sell-off is likely to be short term given the underlying health of high yield companies, and it could lead to an appealing buying opportunity.
Emerging markets bonds gain despite Argentine default
Emerging markets bonds generated positive returns during the month as stronger data out of China and low rates in developed markets lifted investors' appetite for riskier debt. The bonds gained in the face of ongoing strife throughout the Middle East and other areas of the globe. Argentina defaulted on its debt for the second time in 13 years after failing to make a coupon payment. While this situation is highly fluid, T. Rowe Price's emerging markets bond team expects payments to resume on the defaulted Argentine bonds within the next 12 months, partly because Argentine government officials have displayed good faith within international capital markets. Importantly, Argentina's default had little impact on other emerging markets because investors had been prepared for this possibility and fundamentals are generally solid within this asset class.
Municipal bonds edge higher
Municipal bonds also posted positive results in July. Retired employees of the city of Detroit voted to accept a restructuring plan that involves cuts to their pensions, which helps the city move closer to exiting bankruptcy. Standard & Poor's upgraded its credit rating on New York State's debt to AA+ with a stable outlook, the state's highest rating since 1972, citing New York's "strong state budget management framework."
|U.S. Treasury Yields|
|Maturity||June 30, 2014||July 31, 2014|
Emerging markets equities push higher
Non-U.S. stock markets generated mixed returns for the month, with emerging markets posting solid gains and developed markets, in aggregate, declining due to weakness in Europe. Developed markets in the Asia-Pacific region continued to advance. Australia, Singapore, and Hong Kong posted excellent results in July and for the year to date. However, the Japanese market has been a notable laggard. The largest European markets, including Germany, France, and Spain, posted steep losses in July, but overall the region has generated a modest positive return for the year to date. Within emerging markets, Asia's markets were strongest for the month and year to date, followed by Latin America. The emerging Europe, Middle East, and Africa region declined and is now barely above water this year.
Within the MSCI EAFE Index, a yardstick for the performance of developed stock markets in Europe, Australasia, and the Far East, value and large-cap stocks outperformed growth and small-cap shares, respectively. For the month, information technology and materials were the only sectors to advance in the EAFE index, while the energy, consumer discretionary, and consumer staples sectors posted significant declines. The U.S. dollar strengthened versus most currencies in July. While supportive of economic growth, the potential for continued central bank easing policies in Europe and Japan could pressure their currencies relative to the dollar.
|MSCI Indexes1||July 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||-1.96%||3.08%|
|All Country World ex-U.S.||-0.97||4.86|
|All Country Asia ex-Japan||3.83||10.65|
|EM (Emerging Markets)||2.02||8.46|
The Asian markets post solid returns
The MSCI All Country Asia ex-Japan Index posted strong gains in July. Except for Japan (+0.6%) and New Zealand (-1.7%), developed markets in the Asia-Pacific region logged solid returns. The Bank of Japan said that the economy is growing in line with its forecasts as the consumer price index rose 3.6% in June from a year ago and retail sales rose 0.4%. However, exports and industrial production declined. The Chinese market gained 8.2% as industrial production rose 9.2%; retail sales gained 12.0%; and the HSBC purchasing managers' index, at 52.0, edged up to its highest level in 18 months. T. Rowe Price sovereign analysts caution that China's long-running problems with excessive credit and unresolved bad debt issues could curb a sustained growth pickup. However, China reported second-quarter gross domestic product (GDP) growth of 7.5%, which exceeded analysts' expectations. The Chinese economy appears to be stabilizing after a slowdown earlier this year.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.
Europe's stock markets stumble
Developed European markets continued to weaken and several of the region's largest markets declined. Germany, which accounts for approximately one-third of the eurozone's GDP, appears to be faltering, leading to a 6.4% stock market decline for the month. Eurozone inflation fell to 0.4% in July from 0.5% in June, and deflationary pressures are intensifying. Slower growth in the eurozone's largest economy has led investors to question whether the weaker economies will be able to maintain their economic turnaround, given their elevated debt loads and high unemployment.
Non-U.S. stock valuations remain attractive
Overall, we remain reasonably optimistic about the environment for global equities, although the macroeconomic picture in Europe has become somewhat murkier. Inflation remains below target, but we believe the European Central Bank will take actions necessary to stimulate growth and fight deflation. Stagnant corporate earnings should improve as the economy returns to growth, and valuations remain attractive. Many European companies could benefit from reducing costs and improving their market positions over time. In Japan, increased domestic consumption, fed by wage inflation, needs to be the next growth engine. Evidence of a shift in corporate culture is encouraging as companies transform business practices and governance standards to focus more on growing profits and generating value for shareholders. However, the three-month slide in export orders has called attention to the likelihood of a sharp second-quarter GDP pullback following the April 1 consumption tax hike.
The divergence in emerging markets economies and fiscal positions continues to widen. Growth has slowed in China and Brazil, but other developing countries are showing signs of improvement in current accounts and currencies due to positive monetary policy actions and a pullback in long-term U.S. interest rates. Overall, we believe the outlook for emerging markets is still attractive for long-term investors. Based on current valuations, T. Rowe Price managers believe that emerging markets stocks are trading at a discount to developed markets on an absolute and relative basis, and, in aggregate, emerging markets' economic growth, while uneven, is forecast to outpace that of most developed markets over time.
Emerging markets stocks advance on China PMI data
Emerging markets stocks rose for the sixth straight month in July as data from China showed its economy was stabilizing after a slowdown early this year. Manufacturing activity in China rose to an 18-month high in July, according to HSBC's preliminary manufacturing purchasing managers' index. The surprisingly strong reading marked the second month of expansion in China's manufacturing sector and came a week after China reported that gross domestic (GDP) product grew 7.5% in this year's second quarter, up from 7.4% in the previous three months. Both reports reassured investors that targeted stimulus efforts this year had some impact and that China would meet its 7.5% annual GDP target. The MSCI Emerging Markets Index rose to an 18-month high on July 24 but pared some of the gain by month-end. Seven sectors in the index rose, and three fell. Telecommunication services led advancers with a gain of more than 5%. Energy stocks fell the most, sagging more than 1%.
|MSCI Indexes1||July 2014||Year-to-Date|
|Emerging Markets (EM)||2.02%||8.46%|
|EM Latin America||1.06||8.54|
China stocks rally on stronger data, Indonesian stocks gain after election
- Chinese stocks added more than 8% and the A share market restricted for domestic investors surged more than 10%. Despite an improved outlook for the rest of the year, T. Rowe Price sovereign analysts caution that China's long-running problems with excessive credit and unresolved bad debt will curb any sustained growth pickup in the future.
- Indonesian stocks surged after Joko Widodo, the reformist governor of Jakarta, won a tightly contested presidential election. Indonesia's benchmark stock index rose to a one-year high after the July 9 election but pared some of its gains by month-end after the losing candidate said he would contest the vote in the country's highest court.
- Indian stocks advanced as the benchmark Sensex Index reached record highs in July, lifted by expectations that the recently elected government led by Prime Minister Narendra Modi will engineer an economic turnaround. The government forecast economic growth from 5.4% to 5.9% in the current fiscal year, up from the previous year's 4.7% pace.
Brazilian stocks rise on poll results, Argentina rallies on debt accord hopes
- Brazilian stocks advanced as investors reacted to polls showing that President Dilma Rousseff's lead in October presidential elections continues to shrink, increasing the likelihood that a more market-friendly government will take power. Separately, Moody's said in a report that Brazil's weak macroeconomic conditions would not improve this year even after election-induced uncertainty subsides. It also forecast lower economic growth for Brazil over the next two years, with risks tilted toward the downside.
- Argentine stocks rallied more than 6% as investors bet that its government would reach a last-ditch accord with holdout creditors to avert defaulting on its sovereign bonds. Those hopes were dashed, however, after talks with a court-appointed mediator broke down and Argentina missed a deadline on a scheduled interest payment to its main creditors on July 30, leading Standard & Poor's to declare that the country was in "selective default."
- Chilean stocks fell more than 4%, the most in Latin America. Chile's central bank cut its benchmark interest rate, its fifth rate cut since October, to bolster slowing growth. The rate cut came shortly after Chile's government reduced the country's 2014 growth forecast due to cooling domestic demand.
Russian stocks sink on more sanctions, Turkish stocks gain ahead of elections
- Russian stocks slid more than 8% after the U.S. and European Union ramped up sanctions against the country in response to its intervention in Ukraine. The latest sanctions, which target some of Russia's biggest banks and energy companies, added to the risks weighing on Russia's already fragile economy. T. Rowe Price analysts believe that the sanctions will have little impact in the short term but may lead to barely positive growth this year and, if sanctions are maintained, an economic contraction in 2015.
- Turkish stocks advanced, buoyed by demand for higher-yielding assets and relative political stability ahead of the country's first direct presidential election on August 10. Most polls show outgoing Prime Minister Recep Tayyip Erdogan easily winning the election.
- South African stocks edged higher, though the country's economy continued to suffer from high inflation and slowing growth worsened by labor strikes. More than 200,000 metal and engineering workers went on strike at the start of July to demand higher pay. The latest strike, which follows a five-month-long strike hitting the platinum industry, led Moody's to warn that South Africa's credit rating may be at risk of being downgraded. Additionally, the country's central bank increased its benchmark interest rate and cut its 2014 growth forecast.
Solid long-term fundamentals offset near-term risks
In recent years, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. 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 due to Fed tapering, and an unexpected bout of risk aversion due to geopolitical events. Political risk has increased in many countries holding elections in the coming months, though we believe that new governments in some cases will adopt market-oriented reforms.
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 investors should gradually build their exposure to this asset class. Emerging markets may not outperform developed markets by the same magnitude as they did in the past decade, but we believe they will resume their role as global leaders over time.