Stocks end lower after large-caps reach new highs
Stocks reached new highs in mid-September, but losses in the latter half of the month erased prior gains. Generally, riskier asset classes underperformed, with smaller-cap stocks incurring steep losses and substantially trailing large-caps. Likewise, the noncyclical health care, consumer staples, and telecommunication services sectors posted gains and outperformed sectors in the Standard & Poor's 500 Index that are more dependent on economic growth, such as consumer discretionary and industrials and business services stocks. Typically defensive utilities stocks lagged as their dividends became less attractive in the face of rising bond yields, however. Falling commodity prices took a particularly large toll on energy stocks, while materials shares underperformed modestly.
|MSCI Indexes||September 2014||Year-to-Date|
|S&P Midcap 400||-4.55||3.22|
Economic signals remain favorable
Markets fluctuated through much of the first half of the month as investors weighed whether the pace of economic growth fully justified increased stock valuations. Early data suggested the economy was advancing on several fronts. The Institute for Supply Management's gauge of manufacturing activity reached its highest level in three years in August, while other data suggested that the service sector was expanding at the fastest pace since 2005. Although a pullback in August payroll growth gave investors pause, more current weekly unemployment data indicated that the labor market recovery also continued at a healthy clip. The housing sector continued to offer mixed signals, but a sharp jump in new home sales raised hopes that it was gathering momentum.
Investors relieved that Fed stance remains unchanged
Investors continued to view good economic data as a mixed blessing, however, as the data increased the possibility that the Federal Reserve would act sooner rather than later in beginning to raise short-term interest rates. It came as a relief to some, therefore, when Fed officials left their interest rate forecast largely unchanged at their mid-month policy meeting–a patience that appeared to be justified by an absence of inflationary pressures in the latest readings. The S&P 500 Index and the Dow Jones Industrial Average reached new highs soon after the Fed's meeting.
Turmoil overseas weighs on sentiment at month's end
Stocks reversed course and declined late in the month as worrisome economic signals and political turmoil overseas appeared to take the spotlight. Growth in Chinese industrial production in August decelerated to its slowest pace since the onset of the global financial crisis in 2008, and investors appeared to be concerned by signals from Chinese officials that they were unlikely to respond with further stimulus measures. Late–month student-led protests in Hong Kong also raised concerns about the region. Deepening Western intervention in the conflict in Syria and Iraq may have also weighed on sentiment, and worries that Russia would retaliate against Western sanctions grabbed headlines as September came to a close. Finally, an indicator of German business sentiment reached its lowest level in two years, raising the possibility that the former powerhouse of the European recovery might slip back into recession.
Rising U.S. dollar leads to competitiveness fears...
The diverging paths of the U.S. and other major economies helped drive an increase in the value of the U.S. dollar, which reached its highest level against the euro since 2012 and its peak relative to the yen since 2008. Energy and materials stocks declined as the stronger greenback weighed on dollar–denominated commodity prices, and oil prices were pushed lower still by diminishing concerns about supply disruptions in the Middle East and Russia. More broadly, investors worried that the rising dollar would make goods produced in the U.S. less competitive overseas, while also reducing the value of profits earned overseas by U.S. firms.
...But U.S. manufacturing sector remains robust
Signs of declining American competitiveness are elusive as yet, however–particularly in the manufacturing sector. Indeed, recent data compiled by T. Rowe Price Chief Economist Alan Levenson show manufacturing activity expanding at a faster clip in the U.S. than in any other major economy. T. Rowe Price managers are carefully watching the rebound in the fortunes of U.S. manufacturers, which have been boosted not only by a cheap dollar in recent years but also by the boom in low–cost and reliable domestic energy sources.
Stock prices more likely to move in line with earnings growth
Generally, T. Rowe Price equity managers believe that U.S. stock prices are likely to move more in line with earnings growth rather than through an expansion in valuations–or how much investors are willing to pay for a dollar of those earnings. They note that valuations are no longer cheap, but neither are they widely out of line with the pattern of the last two decades. Faster–growing, higher–valued growth stocks are generally less expensive relative to historical patterns than value shares, and large–caps appear cheaper than small–caps. Overall, stocks also appear cheap relative to bonds, which may provide support to equities if interest rates increase and investors rotate away from fixed income.
Fed's "considerable time" language reassures on rate hike timing
Prices of U.S. Treasury debt fell as generally healthy U.S. economic data offset geopolitical worries, pushing yields higher. Yields rose in most fixed income asset classes as prices dropped roughly in parallel with Treasuries. During the month, the Commerce Department revised its estimate of second-quarter gross domestic product growth to 4.6% from 4.2%, and Bureau of Labor Statistics data showed that the unemployment rate declined to 6.1% in August. The strong economic statistics seemed to indicate that the Federal Reserve could start to raise interest rates sooner than expected. However, in the statement following its September policy meeting, the Fed kept the phrase "for a considerable time" in the description of how long it will maintain the target federal funds rate at its current level after ending its asset purchases.
ECB moves aggressively to stimulate growth
The European Central Bank (ECB) continued to shift its monetary policy in the opposite direction from the Fed. In an unexpectedly aggressive move to stimulate eurozone economic growth, the ECB cut its benchmark lending rates by 0.10 percentage points. The ECB also said that it will buy certain types of asset–backed and mortgage–related securities, but it stopped short of announcing a large–scale quantitative easing program that would involve direct government debt purchases.
U.S. dollar reaches strongest point in more than four years
With investors anticipating an increase in U.S. interest rates when the Fed begins to tighten policy next year, the U.S. dollar rapidly strengthened. An index of the value of the dollar against a basket of six major developed markets currencies reached its highest point since mid-2010. For U.S. investors, the strength of the dollar hurt the returns of bonds denominated in other currencies. Debt denominated in euros, for example, generated steep losses in dollar terms despite posting solid gains for eurozone investors.
|Barclays U.S. Aggregate Bond Index||-0.68%||4.10%|
|Credit Suisse High Yield Index||-2.11||3.50|
|Barclays Municipal Bond Index||0.10||7.58|
|Barclays Global Aggregate Ex-U.S. Dollar Bond Index||-4.25||-0.09|
|J.P. Morgan Emerging Markets Index Plus||-1.81||8.02|
|Barclays U.S. Mortgage Backed Securities Index||-0.16||4.22|
Sell-off in high yield bonds spans sectors, credit ratings
High yield corporate bonds experienced selling pressure across all sectors and credit rating categories amid outflows. T. Rowe Price's high yield portfolio managers and analysts continue to think that the general fundamental credit quality of high yield issuers is solid and that default rates should remain low, although the quality of new deals has declined significantly. Leveraged loans, which generally have noninvestment-grade credit ratings, also experienced outflows. However, steady issuance of collateralized loan obligations (derivatives formed by packaging multiple loans together and dividing them into pieces with different levels of risk) has supported that market.
Credit spreads on investment-grade corporates widen
Investment-grade corporate bonds also lost ground as credit spreads widened. Credit spreads measure the additional yield that investors demand as compensation for holding a bond with credit risk versus a similar–maturity Treasury security. New issuance of investment-grade corporate debt boomed, with over $40 billion coming to market in the first week of the month after the summer lull. Much of the new issuance came from the financials sector. Investors favored newly issued bonds over the secondary market, which contributed to the increase in credit spreads.
Decline in emerging markets bond prices
Emerging markets debt prices fell, with bonds denominated in local currencies experiencing the steepest losses in dollar terms. Many emerging markets currencies dropped sharply against the U.S. dollar. The European Union and the U.S. tightened their sanctions against Russia for its role in the Ukraine conflict, with the U.S. barring American companies from providing technology or services for Russian oil exploration ventures. In Latin America, Standard & Poor's downgraded its credit rating for Venezuela to CCC+ from B-, triggering a sell-off in Venezuelan sovereign bonds.
|Maturity||August 31, 2014||September 30, 2014|
Positive return for municipal bonds
Municipal bonds eked out a slightly positive return, helped by continued investor inflows. Investor interest in the asset class helped absorb an uptick in new issuance from a slow pace earlier in the year. At the end of the month, California sold more than $2 billion of new general obligation debt, and New York City issued over $2 billion of bonds backed by sales tax revenue.
Fed pledges continued support for MBS
Prices of mortgage–backed securities (MBS) generally tracked Treasuries lower. On the positive side, the Fed said that it will keep reinvesting the interest and principal payments from its large holdings of MBS into the asset class until sometime after it starts to raise interest rates. In another supportive measure for the MBS market, the central bank also stated that it doesn't expect to use MBS sales as a tool to tighten monetary policy. New issuance of commercial mortgage-backed securities was high, although the market easily digested the new supply.
Relative value is hard to find
It remains difficult to find compelling areas of relative value in the ongoing low interest rate environment. Still, we believe that dollar–denominated emerging markets sovereign bonds offer some value relative to U.S. corporate debt and that emerging markets corporate bonds are attractive in general. However, we are mindful of the risks of emerging markets debt, particularly with U.S. rates poised to rise. Also, the well-publicized job change of Bill Gross, who formerly managed the world's largest bond mutual fund, appears to have created some idiosyncratic dislocations in a few fixed income asset classes-such as Treasury inflation- protected securities-that may be attractive.
Nowhere to hide in September's broad-based sell-off
Non-U.S. stock markets posted steep losses for the month. Many investors pointed to geopolitical strife, concern about China's economic slowdown, and the potentially deleterious effects of rising U.S. interest rates as catalysts for the sell–off. These issues certainly contributed to investor anxiety and demand for safe–haven investments, but the most significant reason for the steep losses was the strength of the U.S. dollar, which gained more than 4% versus the euro, 5% against the Japanese yen, and over 2% versus the British pound. As shown in the table below, the MSCI Europe Index fell nearly 4% for dollar–based investors, but investors that owned the same stocks in euros actually generated a small gain. Similarly, the MSCI Japan Index shows about a 1% loss for U.S. investors, but Japanese investors who owned the same basket of stocks in yen reaped almost a 5% gain. While slower-than-expected economic growth in Europe and Asia cast a pall on non-U.S. investments, currency translation was the largest factor in the rout.
Within the EAFE index, a yardstick for the performance of developed stock markets in Europe, Australasia, and the Far East, growth stocks held up marginally better than value shares, and large-caps solidly outperformed small-caps. For the month, the health care and information technology sectors performed best, but only health care managed a positive result. The poorest-performing sectors in the index were materials and energy.
|MSCI Indexes||September 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||-3.81%||-0.99%|
|All Country World ex-U.S.||-4.81||0.39|
|All Country Asia ex-Japan||-5.86||4.93|
|EM (Emerging Markets)||-7.39||2.75|
Asia's markets stumble in September
Although Japan returned -0.60% for the month, it was the best performer among developed markets in the Asia/Pacific region. However, Japan's economic recovery appears to be stalling following a brief rebound from the second-quarter economic contraction, and other data suggest that exports and industrial production declined. The Australian market fell more than 11% largely due to steep currency exchange losses (-6% versus the dollar) and weakness in materials/commodities prices.
Among emerging markets in the region, China, South Korea, and Taiwan each declined more than 6%. The modest gains for several smaller countries in the region paled next to the losses for the largest markets. While targeted stimulus measures could help prop up China's near-term economic growth, T. Rowe Price analysts believe that longstanding problems with excessive credit and unresolved bad debt will curb any sustained growth pickup in the future. Recent data point to a third-quarter slowdown after a short-lived, policy-aided pick-up in the second quarter as industrial production downshifted in August and real estate activity and price trends continue to weaken. T. Rowe Price analysts believe that China's 7.5% economic growth target for 2014 looks tenuous and is unlikely to be achievable in 2015. Recent policy actions have been swift but are unlikely to have a game-changing economic impact.
European markets lower on weak inflation and economic data
Weak inflation data caused the euro to fall to a two-year low versus the U.S. dollar. The euro also fell against the yen and the British pound late in the month. Declining energy and food prices led to a 0.4% inflation rate in August, which is well below the European Central Bank's (ECB) 2% target. The latest data will likely prompt the central bank to take more aggressive monetary policy actions. 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. The flip side of further central bank easing is that it will likely put additional downward pressure on the euro.
Eurozone economic growth slowed in the second quarter. The economies of Germany and Italy contracted (Italy entered its third recession in six years), and France's gross domestic product growth was flat. The leading economic indicators are now pointing to slower growth for the next six months, which has hurt business and consumer confidence. In the UK, now that the Scottish independence referendum is out of the way, investor focus is back on British economic fundamentals and the timing of rate hikes. The key issue is labor market data (and wages in particular). Improving employment conditions suggest a UK rate hike in early 2015, but policymakers are waiting for an upturn in wage inflation as well. T. Rowe Price portfolio managers that invest in European stocks are increasingly favoring companies that generate a significant portion of their revenues in the U.S.
Non-U.S. stock valuations remain attractive, but dollar strength is worrisome
While T. Rowe Price portfolio managers remain optimistic about the environment for global equities in the intermediate and longer term, our near-term outlook remains somewhat guarded. Dollar strength will remain a key focus for investors in coming quarters. Markets have been roiled by political upheaval in Russia/Ukraine; strife in the Middle East; and, most recently, civil unrest in Hong Kong. At the same time, global growth forecasts are being almost uniformly ratcheted lower, and non-U.S. stock markets just endured their worst quarter since the height of the eurozone crisis.
We expect that further monetary stimulus in Europe and Japan as growth momentum has moderated. Europe faces headwinds, including high debt loads and unemployment and deflation concerns. European corporate earnings should benefit from a resumption of economic growth, and valuations are currently near historical norms, which is attractive for long-term investors. In Japan, increased domestic consumption, fed by wage inflation, needs to be the next growth engine. T. Rowe Price analysts believe that the Japanese market will benefit if companies transform business practices and governance standards to focus more on growing profits and generating value for shareholders.
Emerging markets stocks fall as investors expect higher U.S. interest rates
Emerging markets stocks tumbled in September, snapping seven straight months of gains, as anticipation of higher U.S. interest rates dimmed the appeal of developing nations' assets. Though the U.S. Federal Reserve isn't expected to raise interest rates until mid–2015, many investors have begun rotating out of emerging markets assets in favor of less– risky U.S. assets. Currency weakness also reduced the attractiveness of emerging markets assets as expectations of higher U.S. rates caused the dollar to rally. Nearly all currencies fell against the dollar in September, with currencies in Brazil, Turkey, Russia, and South Africa sinking more than 5%. Protests in Hong Kong also curbed risk appetite as investors worried that the unrest could lead to a harsh response from Beijing and instability in an Asian financial center. The MSCI Emerging Markets Index fell to a four–month low in its biggest monthly loss since 2012, according to Bloomberg. Nine of the 10 sectors in the index fell, while health care stocks advanced.
|Emerging Markets (EM) Index||-7.39%||2.75%|
|Europe, Middle East, and Africa (EMEA) Index||-6.43||-5.17|
|Latin America Index||-13.33||1.56|
Chinese stocks fall as economic data disappoint; Indonesian stocks fall on currency weakness
- Chinese stocks sank more than 6%, but the restricted A-share market for domestic investors advanced. Economic data showed China's economy continued to lose steam. This month's reports showed that industrial output in August grew at its slowest pace since 2008, while foreign direct investment unexpectedly fell from a year ago to its lowest level in two years. In response to the bad data, China's central bank boosted liquidity in the domestic financial system, continuing a recent trend of targeted stimulus measures.
- Indian stocks declined. Standard & Poor's raised its outlook on India's credit rating to stable from negative. Though S&P kept its BBB- rating unchanged, the change in outlook removes the risk of a near-term downgrade to junk status for India, which now has a stable outlook from all three major credit agencies.
- Indonesian stocks shed roughly 3%, and the domestic JCI stock index fell to a seven–week low amid currency weakness and political uncertainty after the country passed a law scrapping direct elections for local officials. The law, which was opposed by Indonesia's President-elect Joko Widodo, raised concerns about the new leader's ability to pass economic reforms in the face of a strong opposition coalition. T. Rowe Price portfolio managers believe that uncertainty over the pace of reforms will restrain Indonesia's stock market for a while and create some good buying opportunities.
Brazilian stocks tumble as Rousseff's support grows; Colombian stocks drop
- Brazilian stocks slumped about 19%, the biggest drop in the emerging world, as polls showed a greater chance of President Dilma Rousseff winning reelection in October. Rousseff's lead over her chief opponent widened, dampening speculation that a new government will take power and implement more market-friendly policies. Separately, Moody's cut its credit outlook on Brazil to negative.
- Mexican stocks retreated. Mexico's government projected gross domestic product (GDP) growth of 3.7% next year, down from an earlier 4.7% forecast but significantly better than this year's expected pace. The outlook reinforces many analysts' views that Mexico's economy is improving after a sluggish start this year.
- Colombian stocks sank roughly 10%. Colombia's GDP expanded at a slower–than-expected 4.3% pace in this year's second quarter from a year ago due to contractions in the mining and manufacturing sectors. However, the country maintained its 4.7% growth forecast for the year and remains Latin America's fastest-growing economy.
Russian stocks fall as Ukraine crisis weighs; South Africa drops as current account gap widens
- Russian stocks fell as investors continued to shun Russian assets in response to the ongoing Ukraine crisis and ensuing sanctions. The ruble repeatedly fell to record lows, triggering reports that Russia was considering capital controls if net outflows rise significantly. T. Rowe Price analysts believe that system–wide capital controls are unlikely but that Russia's government may opt to use more subtle forms of controls, like delaying dividend payments, to stanch outflows.
- Turkish stocks slid roughly 12% as the currency weakened and investors worried about the impact of higher U.S. rates on its economy. Turkey depends on foreign investment to finance its current account deficit–one of the biggest in the developing world–making it more vulnerable to capital outflows. Turkey's GDP grew at a worse–than-expected 2.1% annualized pace in the second quarter, which officials said may cause the country to miss its official 4% growth target this year.
- South African stocks sank about 9% amid currency weakness and a poor economic outlook. South Africa's current account gap widened sharply in the second quarter after labor strikes curbed exports. The worse–than–expected current account deficit sparked a sell–off in the rand and revived concerns about the health of South Africa's economy, which is still struggling after a five–month– long platinum mining strike this year.
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. Generally, those areas that are expensive deserve to be expensive, and those that are cheap deserve to be cheap. 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 as the Fed ends tapering; 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.