Stocks generate mixed returns as investors weigh strong U.S. economic data against global concerns
Stocks posted mixed results in December. The Dow Jones Industrial Average and Standard & Poor's 500 Index managed to reach new highs before retreating on the last day of the month to end roughly flat. The Nasdaq Composite Index lagged a bit, reflecting the weaker performance of technology shares. Breaking with the pattern for the year as a whole, the smaller-cap benchmarks outperformed for the month, and the small-cap Russell 2000 Index joined the other major indexes back in record territory for the first time since the summer. Along with technology stocks, telecommunication services, health care, and consumer staples shares underperformed the broad S&P 500. Utilities stocks performed best, helping cement their position as the top-performing segment for 2014. Financial shares were also strong for the month.
|MSCI Indexes||December 2014||Year-to-Date|
|S&P 500 Index||-0.25||13.69|
|S&P MidCap 400 Index||0.82||9.77|
|Russell 2000 Index||2.85||4.89|
Past performance cannot guarantee future results. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.
Best job gains since late 1990s raise consumer spending prospects
Stocks started the month on a strong note as investors welcomed data suggesting that a pickup in economic activity and consumer spending might provide a further boost to corporate profits. The Labor Department announced on December 5 that employers had created 321,000 jobs in November. The increase was the biggest since the start of 2012 and put the economy on pace for its best yearly job gains since 1999. T. Rowe Price Chief Economist Alan Levenson observes that the employment report also showed a solid increase in average hourly earnings after two months of soft growth. As a result, he expects data eventually to show a marked increase in consumer spending, which should combine with rising business capital investment. Indeed, the Thomson Reuters/University of Michigan gauge of consumer sentiment reached its highest level in eight years, as consumer attitudes were boosted by lower gas prices as well as hopes for higher wages.
Oil's slide leads to new emerging markets worries
The flip side of falling gas prices was a continued slide in the prospects for energy firms. The sector actually outperformed the overall S&P 500 for the month, however, suggesting that investors had largely discounted the decline in the sharp sell-off in previous months—energy was the only segment to post a loss for the year. The bigger drag on the market from oil price volatility may have been concerns that it would undermine the energy-dependent Russian economy and spark a broader emerging markets crisis. At mid-month, not only the ruble, but the Turkish lira, Brazilian real, Indonesian rupiah, and other currencies sank to multiyear or record lows against the U.S. dollar. T. Rowe Price credit analysts and portfolio managers generally agree that a replay of the 1998 emerging markets crisis is unlikely. Most developing countries now have flexible exchange rates and monetary policies, ample foreign exchange reserves, and relatively low debt burdens, all of which should help prevent systemic contagion as seen in the late 1990s. In any case, after enduring their largest weekly decline in over two years, U.S. and other global markets stabilized as Russia intervened dramatically to protect its currency.
Turn in oil cycle likely to remain durable
Russia's overall struggle with low oil prices is likely to prove more durable, according to the firm's energy analysts and managers. They observe that a sharp increase in North American shale oil production-excess production capacity that was planned in the last decade is coming into play at precisely the wrong time—and OPEC's refusal to cut its own output are two key reasons for the decline in oil prices. In addition, Russia and Venezuela have been forced to sell every drop they extract to support their fragile economies, while Iraq and Libya, which largely halted production in the midst of political conflict, have largely come back online. Meanwhile, the sluggish global economy has resulted in relatively tepid growth in oil demand. They expect oil prices to remain subdued over the long term, but they believe markets could see some short-term price volatility due to an unexpected demand spike or a geopolitical crisis.
Fed patience sends benchmarks to new highs
Markets reached new highs at the end of the month, as investors appeared to return their focus to Federal Reserve policy. Stocks surged on December 17 following a statement from policymakers that they would be "patient" before increasing official short-term interest rates. The day also brought news that consumer prices declined 0.3% in November, due in large part to the drop in oil prices. The benign inflation data indicated that the Fed has considerable leeway in timing its rate increases, and it may have also reminded investors of the upside to consumer spending from falling prices at the pump.
Rising wages are likely to reduce profit margins but only moderately
While overall inflation has remained tame, T. Rowe Price managers expect that rising wage costs in the U.S. will squeeze record profit margins. Nevertheless, they think the pace of labor cost increases would be manageable, as companies also enjoy modest sales gains. They note that fourth-quarter earnings reports should provide greater clarity on the overall impact on profits of the decline in oil prices, as some firms benefit from increased discretionary spending, particularly on the part of lower-income consumers.
Tumbling commodities prices hit high yield, emerging markets bonds
Falling oil prices continued to take a toll on fixed income sectors with significant exposure to oil- and gas-related industries, including U.S. high yield bonds and emerging markets debt. The U.S. crude oil price declined about 18% in December, extending a slide that began in the summer. Debt issued by companies in energy-related industries accounts for a large portion of most high yield bond indexes, so the steep drop in oil prices hit the high yield asset class particularly hard.
The Fed will be "patient"
On the positive side, T. Rowe Price Chief Economist Alan Levenson expects the decline in oil prices—which has translated to lower gasoline prices—to act like a tax cut for U.S. consumers, boosting their discretionary spending and helping support the U.S. economic recovery. In fact, the U.S. economy has displayed more consistent signs of health as gross domestic product grew 5.0% in the third quarter, the fastest pace since the summer of 2003. Following its December policy meeting, the Federal Reserve said that it would be "patient" on raising interest rates, which helped allay some fears that the signs of economic strength would prompt the Fed to hike rates sooner than expected.
Treasury yield curve flattens
The Fed's initial interest rate increase would negatively affect the prices of shorter-term debt more than longer-maturity bonds, and shorter-term Treasury yields rose in anticipation of the start of the Fed's policy tightening. The yield on the10-year Treasury note finished December unchanged after a dip at mid-month. The 30-year Treasury "long bond" yield decreased to the lowest levels in over 12 months, contributing to a flattening in the overall Treasury yield curve.
|Barclays U.S. Aggregate Bond Index||0.09%||5.97%|
|Credit Suisse High Yield Index||-1.72||1.86|
|Barclays Municipal Bond Index||0.50||9.05|
|Barclays Global Aggregate Ex-U.S. Dollar Bond Index||-1.21||-3.08|
|J.P. Morgan Emerging Markets Bond Index Global Diversified||-2.31||7.43|
|Barclays U.S. Mortgage Backed Securities Index||0.15||6.08|
Yields on eurozone, Japanese government bonds decline to historic lows
The eurozone economy continued to struggle to grow and avoid deflation. Comments from European Central Bank President Mario Draghi made it appear increasingly likely that the central bank will expand its asset purchase program to include eurozone sovereign bonds, which helped to drive long-term eurozone government bond yields to record lows. However, the strength of the U.S. dollar against the euro (and most other currencies) resulted in negative returns in dollar terms. The Bank of Japan expanded its monetary easing measures, causing the yield on the Japanese 10-year government bond to fall to only 0.31%. The greenback also appreciated against the yen, offsetting the price appreciation on Japanese bonds in terms of U.S. dollars.
Sharp drop in emerging markets debt and currencies
Emerging markets bonds and currencies dropped sharply early in the month before making up some lost ground after the Fed's statement about being "patient" on raising rates. The general malaise in the global economy contributed to the selling pressure in emerging markets, and the rapid decline in oil prices triggered deep concerns about the health of major commodities exporters such as Russia and Venezuela. Russia's central bank hiked its benchmark lending rate by one percentage point and then an additional, staggering 6.5 percentage points in an effort to stabilize the plunging ruble.
Defaults could spike in 2016 if oil price stays low
High yield bonds continued to lose ground as a result of the selling pressure on debt from energy-related issuers, although the sector recovered some of its losses following the dovish Fed policy statement. Mark Vaselkiv, portfolio manager of the T. Rowe Price High Yield Fund, anticipates that the high yield default rate will remain below 2% in 2015. However, he anticipates a spike in the default rate in 2016 if the price of oil falls further or stays at current levels for an extended period. On the positive side, the sell-off in high yield bonds has significantly improved valuations and created the potential for attractive relative value.
|Maturity||November 30, 2014||December 31, 2014|
New issuance dominates investment-grade corporate bond market
The broad investment-grade corporate bond market, which has less exposure to the energy industry than the high yield market, finished the month little changed. The rapid pace of new investment-grade corporate debt issuance continued up to the holidays, as companies took advantage of low borrowing costs to sell an annual record of more than $1.5 trillion in new investment-grade bonds in 2014. Medical device manufacturer Medtronic brought $16.5 billion of new bonds to market at the beginning of the month in the largest new issue of the year. Investors focused on the new deals while demand in the secondary market was lackluster.
Municipal bonds, MBS generate healthy returns
On the other hand, the solid positive results of municipal bonds extended the streak of monthly gains for the asset class to cover the entire year, marking the first time that has happened in more than two decades. The ongoing strong demand for munis offset an uptick in new supply during the month. Mortgage-backed securities (MBS) also posted positive returns for the month as they benefited from the lack of any significant exposure to the energy sector.
Some opportunities exist in emerging markets bonds, but security selection is critical
The selling pressure on almost all emerging markets debt and currencies has created some pockets of attractive relative value in bonds denominated in emerging markets currencies as well as some corporate bonds issued in developing countries. However, country- and issuer-specific risks are elevated in emerging markets, making security and currency analysis and selection essential. We also carefully assess market liquidity when evaluating emerging markets bonds.
Developed markets post gains while emerging markets struggle
Most non-U.S. stocks recorded large losses in December in U.S. dollar terms due to ongoing currency weakness, especially in the euro and the yen. The MSCI Europe, Australasia, and Far East (EAFE) Index, which measures the performance of developed non-U.S. markets, declined 3.44%. Over the past 12 months, the dollar has rallied more than 12% versus the euro and the Japanese yen, and it has appreciated about 6% versus the British pound sterling. The appreciating U.S. dollar detracts from returns for dollar-based investors in foreign markets.
Within the EAFE index, growth and value stocks generated similar returns, and for the month, small-caps outperformed large-caps. Although every sector in the EAFE index posted a loss in December, the information technology, consumer discretionary, and industrials and business services sectors held up best in the malaise. Energy, health care, and telecommunication services logged the poorest performance.
|MSCI Indexes||December 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||-3.44%||-4.48%|
|All Country World ex-U.S.||-3.57||-3.44|
|All Country Asia ex-Japan||-2.05||5.11|
|EM (Emerging Markets)||-4.56||-1.82|
Asia's markets hold up best
Among Asia's developed markets, the Japanese economy contracted 1.9% in the third quarter and slipped into recession (commonly defined as two successive quarters of economic contraction). Data showed that inflation slowed for a fourth consecutive month-core consumer prices rose 0.7% in November from 0.9% in October, which is well short of the Bank of Japan's (BoJ) 2.0% annual inflation goal. Prime Minister Shinzo Abe and his Liberal Democratic Party won December's snap elections and secured a two-thirds majority in the Parliament's Lower House. Abe is pushing the BoJ to inject more funds into the financial system through purchases of government bonds and other debt instruments. Though the yen is already at a seven-year low versus the U.S. dollar, the central bank intends to introduce more currency-depreciation measures to revive growth. Abe also approved a $29 billion spending package designed to encourage consumer spending and spur economic activity. The Australian market declined more than 2% due in large part to steep currency exchange losses (more than 4% versus the U.S. dollar) and weakness in materials/commodities prices. Stocks in New Zealand gained about 3%, and stocks in Singapore recorded a slight decline.
European markets decline—further monetary easing may be on the horizon
Weak inflation data caused the euro to fall to a multiyear low versus the U.S. dollar due in part to slow economic growth and low inflation. Economic growth in the eurozone is expected to be in the 1% area for 2014 and only marginally better in 2015. Deflation remains a serious threat, which is due, in part, to the plunge in oil prices—eurozone inflation fell to 0.3% in November, well below the European Central Bank's (ECB) 2% annual inflation target. These data will likely prompt the central bank to take further aggressive monetary policy actions in the first quarter of 2015. Mario Draghi, the ECB president, 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.
Non-U.S. stock valuations remain attractive, but dollar strength is worrisome
T. Rowe Price portfolio managers are optimistic about the environment for global equities in the intermediate and longer term, but potential near-term headwinds include the strengthening U.S. dollar and continued global economic weakness. 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. Overall, European earnings growth has been disappointing, and Europe's ability to make structural reforms that would improve long-term growth prospects remains uncertain. In Japan, we believe domestic consumption and wage inflation need to be the next growth engines for a sustained recovery. Prime Minister Abe has been pressing corporations to raise wages 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, would also improve wage growth. In emerging markets, 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 retreat as Russia's currency crisis curbs risk appetite
Emerging markets stocks fell in December as Russia entered a full-blown currency crisis and oil prices continued to drop, curbing investors' risk appetite. Russia's currency rout began after an emergency interest rate hike on December 15 failed to stem a fall in the value of the ruble, which sank to a record low the next day. The ruble's plunge coincided with the release of disappointing purchasing managers' reports out of Europe and China that underscored the weak global growth environment. Though the ruble eventually recovered most of its recent losses after Russia's government intervened to defend the currency, it lost roughly 45% against the dollar for the year, making it the second-worst-performing currency in 2014, according to MSCI. Other emerging markets currencies fell, with those in Turkey, Indonesia, Brazil, and South Africa hitting record or multiyear lows throughout the month. The MSCI Emerging Markets Index slid to its lowest level since July 2013 on December 16, though it clawed higher by month-end as investors took comfort from the Federal Reserve's announcement the next day that it would be "patient" in deciding when to raise short-term interest rates.
The continuing collapse in oil prices also increased uncertainty about the global outlook. Brent crude ended December at its lowest level since May 2009 and fell 49% for the year in its biggest annual decline since 2008, according to Bloomberg. While cheaper oil is good for consumers and the finances of oil-importing countries, it spells trouble for Russia and many commodity-dependent economies in Latin America. All 10 sectors in the MSCI Emerging Markets Index fell, led by energy, which dropped roughly 12.5%.
|MSCI Emerging Markets (EM) Index||-4.56%||-1.82%|
|MSCI EM Asia Index||-1.84||5.27|
|MSCI EM Europe, Middle East, and Africa (EMEA) Index||-9.85||-14.74|
|MSCI EM Latin America Index||-9.12||-12.03|
Chinese stocks advance; most Southeast Asian stocks decline
- Chinese stocks edged higher, while the restricted A-share market for domestic investors surged nearly 20%. The latest economic data from China showed a deepening slowdown, raising speculation that growth will miss the official 7.5% annual target as well as expectations that the government will follow a surprise interest rate cut in November with more economic stimulus. Separately, the government reportedly injected nearly $65 billion of short-term credit into the banking system, its latest effort to bolster growth.
- Indian stocks shed nearly 6% on foreign outflows, as some investors grew more guarded about the reform outlook after a month-long parliament session ended without major economic initiatives.
- Most Southeast Asian stock markets fell, ranging from a slight decline in Indonesia to a roughly 7% drop in Thailand. Investors have grown more cautious about the outlook for Indonesia's commodity-driven economy, and its currency sank in mid-December to its lowest level since the 1998 Asian financial crisis before the government intervened. Thailand's central bank cut its economic forecasts for 2014 and 2015 due to weaker export growth.
- Philippine stocks edged higher. Moody's upgraded the country's sovereign credit rating for the second time in little over a year, citing favorable growth prospects and limited exposure to the common risks currently facing other emerging markets.
Brazil leads Latin American stocks lower
- Brazilian stocks fell 11%. The country's central bank hiked its benchmark rate by half a percent to 11.75% in its ongoing struggle against inflation, a task made more difficult by the weakening real, which hit a nine-year low in December amid more signs of slowing growth.
- Stocks in Mexico and Colombia each gave up nearly 8%. Mexico's central bank kept its key interest rate unchanged at a record low, citing a weaker growth outlook since its last meeting in October. Meanwhile, Colombia reported that its third-quarter gross domestic product (GDP) grew 4.2% from a year ago, the fastest pace in Latin America. However, its government subsequently cut its 2015 economic growth target to reflect lower prices for crude oil, the country's top export.
Stocks in Russia, Turkey, and South Africa drop on currency declines
- Russian stocks sank roughly 23% as oil's collapse and the ruble crisis caused investors to sell Russian assets. Russia's economy could shrink as much as 4.7% next year and another 1.1% in 2016 if oil averages $60 a barrel, the country's central bank said. Separately, Russian GDP shrank in November in its first monthly contraction in five years, signaling that the country was entering a long-expected recession.
- Turkish stocks fell. The country's currency, the lira, repeatedly hit record lows in December, and its central bank kept interest rates unchanged for the fourth straight month. Despite falling oil prices and weak economic growth, inflation remains high in Turkey, which has reduced the central bank's scope to cut rates.
- South African stocks declined about 4%. The South African rand sank to a six-year low after the government reported that the country's current account deficit shrank less than expected in the third quarter, disappointing investors who hoped that lower oil prices would help narrow the gap. Separately, Fitch and S&P left their credit ratings for South Africa unchanged in separate credit reviews, alleviating worries about a ratings downgrade.
Solid long-term fundamentals offset near-term risks
We are optimistic about the long-term outlook for emerging markets. Rising consumption, an expanding middle class, and real wage growth are the drivers of huge economic potential in the developing world. Emerging markets are trading at a significant discount on an absolute and relative basis, 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. Additionally, most emerging markets are still expanding faster than developed ones and offer solid growth opportunities for long-term investors. Since China's slowdown and the end of the global commodities boom, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. Going forward, we anticipate more divergence in the performance of countries and companies than we've seen in the past 15 years, and we believe that careful stock selection will be crucial for producing good returns over time.