U.S. stocks gain ground in volatile month
U.S. stocks posted a gain in June during a volatile month of trading. Market cap segments staged a bit of a reversal during the month, with smaller-cap stocks-which had underperformed earlier in the year-outpacing both the large- and mid-cap segments. U.S. equities advanced in the face of ongoing tensions in Ukraine, a flare-up of sectarian violence in Iraq, slowing economic growth and credit concerns in China, and mixed readings on the U.S. economy.
|S&P MidCap 400||4.14||7.50|
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1Returns are for the periods ended June 30, 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.
All market caps higher, but some sector returns were negative
Small-cap stocks led the way in June, staging a reversal from their weak performance earlier in the year. Mid-cap stocks outperformed large-caps during the month. Value shares led growth stocks in the latter two categories, but growth surpassed value in the small-cap area. Performance was varied among the S&P 500 sectors. The strongest areas were energy and utilities, with returns of around 5% for the month, while both telecommunication services and consumer staples lost ground. In between the outlying groups, financials, information technology, health care, and consumer discretionary delivered fairly uniform results, followed by materials and industrials and business services, which eked out a barely positive return.
U.S. gross domestic product growth revised downward
At the end of June, the Commerce Department sharply lowered its assessment of first-quarter economic growth from an earlier reading of -1.0% on an annualized basis to -2.9%, surprising most analysts who expected a less severe revision. The sluggish reading was attributed to shrinking business inventories, awful winter weather throughout much of the nation, and a decline in health care spending. The first quarter of 2014 was the worst for U.S. gross domestic product performance since the first quarter of 2009. The economy's poor performance was all the more startling since it occurred against the backdrop of an improving labor market and healthy overall business activity.
Many analysts, including T. Rowe Price economists, regard the contraction as an aberration-something of a payback for the unsustainable 3.4% advance in the second half of 2013. T. Rowe Price expects stronger U.S. economic growth in the neighborhood of 3% in the second quarter of this year. Total annual growth of 3% for the year, however, is probably unlikely. If growth falls short of 3% during the next 12 to 18 months, it would be due largely to a shortfall in residential and business fixed investment.
Federal Reserve captures the spotlight so far in 2014
All eyes were on the Federal Reserve and its evolving policy stances during most of the year to date. The central bank, under the leadership of Janet Yellen who replaced Ben Bernanke when she was sworn in on February 3, 2014, has been scaling back its quantitative easing program since the beginning of the year. The next step for the Fed will be a widely anticipated ratcheting up of short-term interest rates, but exactly when that will take place is unclear. T. Rowe Price does not expect monetary tightening to occur until around the middle of 2015.
A lot depends on the health of the labor market and the rate of inflation, which has begun to inch up recently. Fed policymakers predicted after their last meeting that the unemployment rate could fall a notch, from 6.1% currently to 6.0% by the end of the year-already below the 6.2% they forecast in March. However, the Fed acknowledged that the figure reflects discouraged job seekers who have stopped looking for work; should they return in force, the decline in unemployment could be more gradual. Regarding inflation, the Fed estimates that consumer prices could rise by 1.5% to 1.6% this year, slightly higher than a previous forecast of 1.4% to 1.6%. Others disagree, however, and think inflation is trending higher than the Fed is stating.
The bull market appears to have further room to run
We don't expect to see a repeat of the expansion in price/earnings multiples that drove stocks last year. Stocks are more likely to be influenced by corporate earnings growth, which we think will continue at a moderate pace through the rest of the year. Valuations are reasonable from a historical perspective, and stock market performance should be more or less in line with the rate of earnings growth. We believe that the bull market that has been taking place over the past five years has further room to run. In many instances, a sharp decline such as the one we witnessed in 2008 has led to a sharp V-shaped, shorter-lived recovery. Stocks have advanced at a more moderate pace since spring 2009, however, which leads us to the view that the upturn in stocks has not yet run its course.
Non-U.S. debt, high yield bonds lead performance
Most fixed income sectors posted muted but positive returns in June, with the strongest performance coming from non-U.S. debt as well as U.S. high yield corporate bonds. Intermediate- and long-term Treasury yields rose and the Treasury yield curve continued to flatten as long-term rates climbed less than yields on intermediate maturities. The yield on the benchmark 10-year U.S. Treasury note edged up from 2.48% at the beginning of the month to 2.53% at the end of June.
Fed continues to taper amid mixed economic signals
U.S. economic data released during the month were decidedly mixed. On the positive side, the May employment report showed well over 200,000 workers added to payrolls as the unemployment rate stayed at 6.3%, which was the lowest in more than five years. On the negative side, the Commerce Department's third estimate of first-quarter U.S. gross domestic product (GDP) growth showed an annualized contraction of 2.9%, the weakest quarterly GDP figure in five years. The Federal Reserve maintained the gradual tapering of its quantitative easing program by announcing that it will reduce the amount of its monthly purchases of Treasuries and agency mortgage-backed securities (MBS) by another $10 billion. T. Rowe Price Chief Economist Alan Levenson thinks that the central bank will hike rates in mid-2015, basing its decision on labor market improvement and wage pressures, not necessarily GDP growth.
ECB stimulus measures spark rally in eurozone sovereign bonds
In contrast to the Fed's preparations to tighten monetary policy, the European Central Bank (ECB) announced further stimulus measures to try to revive growth and spark inflation in the eurozone. Although it did not implement a quantitative easing program, the ECB lowered all three of its benchmark lending rates and started an expanded long-term loan program to encourage eurozone banks to increase their lending. The ECB cut its deposit rate to -0.10%, meaning that it will charge banks to keep cash at the central bank. The central bank's actions triggered a significant rally in eurozone sovereign debt. Later in the month, the yield on the 10-year Spanish government bond (not adjusted for exchange rate effects) dropped below the 10-year U.S. Treasury yield for the first time since before the eurozone debt crisis.
|Barclays U.S. Aggregate Bond Index||0.05%||3.93%|
|Credit Suisse High Yield Index||0.84||5.55|
|Barclays Municipal Bond Index||0.09||6.00|
|Barclays Global Aggregate Ex-U.S. Dollar Bond Index||1.18||5.59|
|J.P. Morgan Emerging Markets Index Plus||0.36||8.66|
|Barclays U.S. Mortgage Backed Securities Index||0.26||4.03|
Corporate bonds enjoy strong demand
High yield corporate bonds benefited from the ongoing search for yield. The strong fundamental condition of high yield issuers and the relatively low default rate continued to draw investors into the market. Buyers still outweighed sellers in high yield, and the level of new supply did not keep up with the vigorous demand. Investment-grade corporate bonds enjoyed similarly healthy conditions. Credit spreads on investment-grade corporate bonds, which measure the additional yield that investors demand as compensation for holding a bond with credit risk versus a similar-maturity Treasury security, narrowed to 97 basis points (a basis point is 0.01 percentage point) near the end of the month, according to data provided by Barclays. The last time that investment-grade credit spreads were below 100 basis points was in July 2007.
Appetite for risk lifts emerging markets bonds
Emerging markets bonds also generated positive returns as the ECB's accommodative actions boosted investors' appetite for riskier debt. Although the flare-up of instability and violence in Iraq raised geopolitical concerns and boosted global oil prices, the tensions between Russia and Ukraine ratcheted down somewhat as both sides took steps to de-escalate the situation. Argentina's sovereign debt was volatile after the U.S. Supreme Court refused to hear an appeal of a lower court's ruling that the country must pay holders of its defaulted bonds who refused to participate in an earlier restructuring of those bonds.
Limited new supply supports MBS
The agency MBS market was able to overcome the lower demand from the Fed, the major buyer in the sector, as a result of a limited amount of new supply reaching the market. There was also very little new issuance of non-agency MBS, which helped support that market. Asset-backed securities produced minimal returns amid slowing flows into the sector.
|U.S. Treasury Yields|
|Maturity||May 31, 2014||June 30, 2014|
Puerto Rico municipal bonds back in the news
Municipal bonds were essentially flat after their rally earlier in the year resulted in valuations relative to Treasuries that are now much less attractive. Puerto Rico, once again, made headlines by enacting legislation to restructure its public corporations, essentially declaring them bankrupt and causing a sell-off in their bonds. The legislation will not affect Puerto Rico's beleaguered general obligation debt, which gained in price immediately after the news.
Opportunities in emerging markets corporates and local currency sovereigns
In the current environment of low interest rates, tight credit spreads, and low volatility, it is difficult to capitalize on undervalued fixed income sectors. However, we think that some emerging markets corporate bonds represent good value because of their attractive valuations relative to U.S. corporates with similar credit quality. Also, as a result of the growing differentiation in monetary policy and interest rate cycles in emerging markets, we believe that there are some interesting opportunities in emerging markets debt denominated in local currencies. However, selectivity is vital for investing success in the bonds and currencies of developing countries.
Developed and emerging markets equities push higher
Non-U.S. stocks posted solid returns for the month, with emerging markets outperforming developed markets. In aggregate, developed European markets trailed the returns for developed Asia-Pacific markets. Europe's best-performing countries included Spain, Belgium, and Denmark, while France, Germany, and Ireland posted losses. In the Asia-Pacific region, Japan, India, China, Taiwan, Thailand, and Hong Kong posted strong gains, but the majority of other markets in the region were little changed. We believe that the outlook for emerging markets is still attractive for long-term investors. Based on current valuations, emerging markets stocks are trading at a discount to developed markets on an absolute and relative basis, and their economic growth, while uneven, is forecast to generally outpace most developed markets.
Within the EAFE Index, value stocks marginally outperformed growth shares, and small-caps generated better gains than large-caps. The energy sector was strongest in June, with a gain of more than 4%, and utilities and information technology also posted good results. Financials was the only sector to decline in the EAFE index, and consumer staples stocks posted a modest positive return. The yen, British pound, and euro advanced versus the U.S. dollar. While supportive of economic growth, the potential for continued central bank easing policies in Europe and Japan could pressure their currencies lower relative to the U.S. dollar and weigh on returns.
|MSCI Indexes1||June 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||0.99%||5.14%|
|All Country World ex-U.S.||1.72||5.89|
|All Country Asia ex-Japan||2.37||6.57|
|EM (Emerging Markets)||2.70||6.32|
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.
The largest Asian markets post solid returns
Japan and the All Country Asia ex-Japan Index posted strong gains in June. Although developed markets in the Asia/Pacific region generated mixed results, the largest markets in the region logged solid returns. Japan and China returned more than 5% and 3%, respectively. Japanese Prime Minister Shinzo Abe outlined a series of reforms designed to reinvigorate corporate earnings and position the country for solid economic growth. The plan includes a corporate tax cut, allows more flexibility in the workplace, and eases regulations on the agriculture and health care sectors. In China, the government announced further stimulus measures that should ramp up infrastructure spending, and the central bank revealed plans to cut reserve requirements for banks that make loans to small businesses and the agricultural sector. India, Taiwan, and Thailand also continued their year-to-date rallies, advancing 4%, 5%, and 7% for the month, respectively.
Europe's stock markets generate mixed results
Developed European markets underperformed in June. Several of the largest markets in the region, including France, Germany, and Italy, declined. Economic growth appears to be gradually improving, thanks to receding challenges in the eurozone periphery. However, concerns remain over the slow progress toward economic reforms by some member states, elevated debt loads, high unemployment, and declining inflation. The European Central Bank (ECB) announced further stimulus measures in an attempt to revive growth and spark inflation. Although it did not implement a quantitative easing program, the ECB reduced its benchmark lending rates and announced a targeted longer-term refinancing operation (TLTRO), which allows banks to borrow funds for up to four years at 0.25% and is designed to encourage lending to small and medium-sized businesses. The rate cuts and TLTRO program should help anchor short-term eurozone rates as the Federal Reserve and the Bank of England get closer to implementing interest rate increases.
Non-U.S. stocks remain attractive
The leading indicators continue to point to a slowly improving macroeconomic picture, especially in Europe. Overall, investor sentiment is generally optimistic and improving. This is somewhat reflected in European stock prices as valuations have continued to rise. Higher prices, coupled with sluggish but improving earnings, lead us to be somewhat cautious in the near term. However, over the long term, we believe that performance will be determined by how well individual companies execute on their plans. Many European companies should benefit from reducing costs and improving their market positions over time. While we remain optimistic about Japan's intermediate-term prospects, we would become more positive if policymakers would implement structural reforms to labor markets, tax and regulatory regimens, and social spending.
Emerging markets stocks advance, but Mideast unrest curbs sentiment
Emerging markets stocks advanced in June as a new round of stimulus measures in Europe and better-than-expected trade data from China lifted confidence in the global economic outlook. Hopes for a diplomatic resolution to the Ukraine crisis also encouraged investors to rotate into riskier assets. The MSCI Emerging Markets Index rose to a 13-month high on June 10 but pared some of its gain by month-end amid concerns about rising oil prices due to sectarian violence in Iraq. Crude oil futures rose to nine-month highs as worries grew that a spreading Islamist offensive in Iraq would disrupt global oil supplies, though the insurgency so far has spared the country's oil-producing region. All 10 sectors in the MSCI index rose. Health care stocks gained the most, adding more than 5%, while consumer staples and telecommunication services rose the least, with gains of roughly 1%.
|MSCI Indexes1||June 2014||Year-to-Date|
|Emerging Markets (EM)||2.70%||6.32%|
|EM Latin America||4.15||7.40|
Indian stocks again hit record highs; Chinese stocks rise as economy stabilizes
- Indian stocks advanced as the domestic (SENSEX) index rose to new records in June amid optimism that the country's newly elected government will implement sweeping economic reforms. In a speech to parliament, India's new president pledged to encourage foreign investment, bolster spending, and speed up approvals for infrastructure projects.
- Stocks in China strengthened as surprisingly strong May export data and other indicators showed stabilization in the economy, which analysts attributed to targeted stimulus measures and looser monetary policy. However, mounting evidence of a property and credit slowdown has raised speculation that China will miss its 7.5% annual growth target. T. Rowe Price analysts believe that the falling property market will pressure China's gross domestic product (GDP) growth over the next few years but that the government will support the economy through infrastructure spending.
- Thai stocks rose more than 6%, the most in Asia. Thailand's stock market has rallied since a May coup as investors bet that the military would restore stability and increase infrastructure spending in the near term. Separately, Thailand's central bank slashed its 2014 growth forecast to 1.5% from its prior 2.7% estimate due to a bigger-than-expected contraction in the first quarter. It predicted growth would rebound to normal levels next year.
Brazilian stocks rise as polls show waning support for Rousseff
- Brazilian stocks rallied as recent polls showed a diminishing lead for President Dilma Rousseff, who is seeking re-election, and growing support for opposition candidates, who are seen as more business-friendly. Critics have blamed Rousseff's interventionist policies for Brazil's sluggish growth and high inflation, leading investors to bid up stocks as they anticipate that a more market-friendly government will take power in October elections.
- Mexican stocks advanced. Mexico's central bank unexpectedly cut its benchmark interest rate in early June to a record 3% low to help revive a sluggish economy, a month after it slashed its 2014 growth forecast. Despite several months of weak growth, T. Rowe Price analysts believe that Mexico's medium-term outlook is positive due to a more competitive manufacturing sector and major structural reforms passed last year.
- Colombian stocks rose. The country's central bank raised its benchmark rate for the third time in three months as strong economic growth fanned inflation. Earlier in the month, Colombia announced that its GDP grew at a better-than-expected 6.4% pace in this year's first quarter.
Russian stocks rise as Ukraine tension eases; UAE stocks tumble on property concerns
- Russian stocks rallied as prospects rose for an end to hostilities between Russia and Ukraine, diminishing the likelihood that the U.S. and Europe would impose a third round of sanctions on Russia's already weak economy.
- Turkish stocks retreated on fears that growing instability in Iraq, a key export market, would disrupt the economy. Turkey's central bank cut its main interest rate by 0.75% to 8.75%, despite annual inflation hovering close to 10%. The rate cut raised questions about the bank's independence from the government, which has frequently called for lower rates.
- Stocks in the United Arab Emirates (UAE) sank more than 24% amid concerns that property values in Dubai, the UAE's financial and cultural center, have become excessive after a real estate boom over the past two years.
- South African stocks strengthened despite growing pressures from a prolonged platinum miners' strike on the economy. Standard & Poor's cut South Africa's foreign currency and locally denominated debt ratings to just above junk status, while Fitch Ratings cut its country outlook to negative. Separately, the World Bank slashed its 2014 growth forecast for South Africa, citing the impact of the strikes on the economy.
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, which would exacerbate capital outflows; and an unexpected rise in 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 they 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.