Stocks gain as fiscal battles come to temporary end
Stocks produced a second consecutive month of solid gains in October as investors were relieved by a temporary end to fiscal battles in Washington and appeared to be moderately encouraged by third-quarter corporate earnings reports. The major indexes moved almost steadily higher through the second half of the month, setting a series of new all-time highs for both the Dow Jones Industrial Average and the Standard & Poor's 500 Index. The technology-heavy Nasdaq Composite reached a 13-year high but lagged the large-cap indexes somewhat, and small-cap stocks trailed by a larger margin. Growth and value stocks performed roughly in line among large-caps, but value stocks handily outperformed growth stocks among smaller-cap equities. Telecommunication services and consumer stocks performed best, although the dispersion of returns among sectors was relatively moderate, continuing a trend toward higher correlation of returns in recent months.
Government shutdown and debt limit fears drives early volatility
The ongoing partisan gridlock in Washington reached another crisis point in October, resulting in a partial shutdown of the federal government that began on October 1, the first day of the government's new fiscal year. With congressional leaders unable to agree on a budget or a continuing resolution to fund government operations, stocks were volatile as investors responded to either setbacks or signs of progress in negotiations. For many, a bigger worry than the shutdown was Congress's failure to raise the debt limit, which risked a default on government obligations if the Treasury Department's borrowing authority was exhausted at mid-month. The market consensus appeared to be that negotiators would eventually reach a compromise, however, which helped avert a sharp sell-off in stocks.
Agreement sent stocks higher in the second half of the month
These hopes were vindicated on October 16, when lawmakers suspended the debt limit for a few months, funded the government until January 15, and established a new set of negotiations over long-term fiscal reforms. While most investors expected very little to come from such talks, they also determined that the odds of another shutdown and debt limit crisis in coming months were minimal given the political cost of another round of brinkmanship. The S&P 500 advanced in nine of the 10 trading days following the announcement of the agreement.
Corporate earnings generally meet or exceed modest expectations
With fiscal concerns at least temporarily at bay, investors were free to concentrate on third-quarter earnings and what they suggested about future profits. Thomson Reuters reported that, as of the end of the month, over two-thirds of the companies that had reported results managed to surpass analysts' earnings estimates, although only a little over half managed to top revenue expectations. The hurdles were not set high, however, as analysts expected earnings for the S&P 500 to grow only slightly faster than the overall economy.
The labor market is sluggish while manufacturing powers ahead
October's data offered mixed messages about whether investors could count on an improved economic environment. Labor market data were delayed by the shutdown but proved discouraging when they were eventually released, with a smaller-than-expected gain in September payrolls. The unemployment rate ticked down to 7.2% from 7.3%, however, and reflected employment growth rather than a decrease in the labor force participation rate, as was the case in August. Consumer confidence fell sharply in October, undoubtedly exacerbated by the spectacle in Washington, but retail spending outside of autos showed a solid gain. The manufacturing sector remained healthy, although factory employment grew only slightly, and the service sector continued to expand at a healthy clip.
|S&P MidCap 400||3.72||27.81|
1Returns are for the periods ended October 31, 2013. The returns include dividends based on data compiled by T. Rowe Price, except for the Nasdaq Composite, whose return is principal only.
2The Dow Jones Industrial Average and the Standard & Poor's 500 Stock Index of blue chip stocks, the Standard & Poor's MidCap 400 Index, and the Russell 2000 Index are unmanaged indices representing various segments by market capitalization of the U.S. equity markets. The Nasdaq Composite is an unmanaged index representing the companies traded on the Nasdaq stock market and the National Market System. It is not possible to invest directly in an index.
Future is looking brighter for U.S. manufacturing
T. Rowe Price economists note that recent manufacturing data indicate that the sector is recovering from the double blow of increased federal taxes and sequester-forced spending cuts earlier in the year. T. Rowe Price portfolio managers are carefully monitoring longer-term drivers in the manufacturing sector, which some believe are leading to an "industrial renaissance" in the United States. These drivers include falling domestic energy costs, rising labor costs overseas, and decisions by more American firms to "onshore" production because of stretched supply chains.
Taper delay drives market activity
In a month dominated by news about what Federal Reserve policymakers did not do—start to taper the pace of the Fed's purchases of Treasuries and agency mortgage-backed securities (MBS)—yields on short-term Treasury bills ticked higher while longer-term Treasury yields moved lower, making the yield curve flatter. Treasuries largely shrugged off the partisan battle over government funding as yields on only Treasury bills maturing in late October and early November jumped higher before lawmakers reached a deal in mid-October to end the government shutdown and suspend the debt ceiling until early February 2014.
Fixed income markets remained fixated on when the Fed will start to slow the pace of its asset purchases. A weak September employment report convinced analysts that the Fed would postpone the taper and provided a boost to risk sentiment, giving investors the confidence to favor asset classes with substantial credit risk, including high yield corporate bonds and emerging markets debt. As expected, the Fed did not announce a reduction in the pace of its buying after the October Federal Open Market Committee meeting. T. Rowe Price economists think that the Fed hasn't entirely discounted a December taper start, but economic data would need to show definite improvement for the central bank to start slowing its asset purchases before year-end. They also believe that the Fed is likely to strengthen its interest rate guidance—possibly including an inflation "floor" that must be established before raising short-term rates—when it announces the first tapering step, and perhaps before then.
U.S. corporates post healthy returns
U.S. investment-grade corporate bonds generally posted healthy returns. New issuance was down from September's record because of restrictions on bringing new bonds to market immediately before announcing earnings. Issuance increased later in the month, but demand was still strong enough for the market to easily digest the new supply.
High yield corporate bonds continued their impressive year-to-date performance. The sector offers yields that, although significantly lower than in the past, look quite attractive compared with those on Treasuries and other lower-risk securities. Many high yield issuers are also in relatively good financial health, so investors anticipate that default rates will stay low. The combination of relatively attractive yields and low default rates continues to attract inflows into high yield corporates, leading to strong returns.
Fed buying supports mortgage market
The Fed's decision to maintain the pace of its asset purchases—which help keep mortgage rates low—helped lift the MBS market to a modest return for the month. Commercial mortgage-backed securities (CMBS), which are not involved in the Fed's bond buying, benefited from narrower credit spreads as investors demanded less additional yield over Treasuries to own CMBS. Asset-backed securities were the laggard of the securitized sector but still posted a small positive return.
Munis continue to slowly recover
The municipal bond market continued to slowly recover from its summer sell-off despite ongoing outflows. Debt-laden Puerto Rico was back in the headlines as Massachusetts regulators announced that they are investigating several money managers for possibly misleading investors about the size of their holdings of municipal debt issued by the U.S. territory. New municipal issuance was light, helping to keep prices from dropping amid the outflows.
|Barclays Capital U.S. Aggregate Bond Index||0.81%||-1.10%|
|Credit Suisse High Yield Index||2.42||6.46|
|Barclays Capital Municipal Bond Index||0.79||-2.10|
|Barclays Capital Global Aggregate Ex-U.S. Dollar Bond Index||1.07||-1.34|
|J.P. Morgan Emerging Markets Index Plus||2.70||-6.43|
Non-U.S. government bonds rally
Sovereign bonds issued by developed non-U.S. markets posted positive returns, even in troubled peripheral eurozone countries. For example, Spain reported that its economy grew in the third quarter, causing the spread between the yields on its bonds and equivalent-maturity German government debt to decrease as investors grew more confident in the outlook for Spain. Emerging markets debt performed even better than developed market sovereigns as the ongoing delay in Fed tapering helped boost investor appetite for riskier bonds. The central banks of both Brazil and India raised interest rates during the month to help fight inflation.
|U.S. Treasury Yields|
|Maturity||September 30, 2013||October 31, 2013|
Emerging market corporate sector looks attractive
In particular, emerging market corporate bonds currently seem attractive relative to U.S. investment-grade and high yield corporates. The size of this sector is now comparable with that of the U.S. high yield market, increasing its appeal to investors. Additionally, T. Rowe Price's emerging market corporate analysts expect the debt coverage and liquidity ratios of most issuers to remain largely stable, although moderating global growth could mean that the fundamental condition of corporate issuers worldwide has peaked. Although a large sample of emerging market corporate issuers have increased leverage since 2010, this deterioration was concentrated in a few industries that have come under pressure from falling commodity prices, such as mining.
International stocks rally strongly
Global stock markets rallied in October, adding to September's outsized gains, following the U.S. Federal Reserve's surprise September decision to postpone tapering its bond purchase program. International markets also benefited from encouraging revenue and earnings results, as well as improving economic news from the eurozone and Asia. While growth in Europe remained lackluster, the situation is no longer getting worse, and more robust growth could be in the offing. In Japan, the broad stock market was flat. However, there is hope that government reforms and the Bank of Japan's easy monetary policy will fuel gains. Although emerging markets stocks generated good gains in back-to-back months, they have significantly lagged developed markets for the year to date.
Within the MSCI Europe, Australasia, and Far East (EAFE) Index, value shares outperformed growth stocks, while small-caps underperformed their large-cap counterparts. Although all sectors in the EAFE index posted gains, the telecommunication services, financials, and energy sectors outperformed, while information technology, materials, and industrials and business services advanced the least. The U.S. dollar strengthened versus the British pound, was basically unchanged versus the Japanese yen, and was marginally lower against the euro.
|MSCI Indexes1||October 2013||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||3.36%||20.51%|
|All Country World ex-U.S.||3.68||14.53|
|All Country Asia ex-Japan||4.38||4.30|
|EM (Emerging Markets)||4.87||0.62|
Past performance cannot guarantee future results. It is not possible to invest directly in an index.
European markets advance as the economic recovery gains traction
Stocks in Europe posted solid gains. Greece, Italy, and Spain outperformed. The region benefited from improving sentiment, better economic data, and signs that the protracted recession had ended. Europe still faces structural issues and, without further reforms, will likely struggle to maintain an above-average trend growth of 1.5% to 2.0%. Investor sentiment is improving, and stocks in the region have climbed on signs that the economic expansion will gather momentum.
China's economic growth was in line with expectations
China reported third-quarter gross domestic product growth of 7.8%, modestly better than its second-quarter growth of 7.5%. The improvement was due in part to credit expansion, reduced red tape on international trade, and increased infrastructure investment. T. Rowe Price's analysts forecast that China's growth will slow to 7.3% in 2014 and to below 7.0% in 2016, which could remove an important tailwind for some emerging markets that depend on China for growth. "Slowing economic growth in China, a global commodity sell-off, and other factors have complicated emerging market investing," says Scott Berg, portfolio manager of the Global Growth Stock Fund. "Many investors are choosing to get exposure to emerging markets through developed market companies that do business in emerging markets."
The Bank of Japan continues to move aggressively to bolster the country's economy, and Japanese gross domestic product growth is expected to remain positive into 2014. Although a weaker global environment could weigh on exports, strong policy implementation could spur business spending, which has declined significantly over the past two years. Overall, developed markets in the Pacific region generated positive, albeit generally lackluster, returns, while emerging markets across Asia posted robust gains.
Non-U.S. stock valuations remain attractive
We remain optimistic about the intermediate- and long-term prospects for non-U.S. equities. However, short-term gains may be somewhat muted as stocks have advanced in anticipation of improved fundamentals. While we believe that many economies are stable or improving, the results may take some time and could be uneven. Although it will likely remain challenging for companies in Japan and Europe to generate stable revenue growth, investor sentiment in both regions has improved. We're focused on buying and holding high-quality companies with sustainable competitive advantages and sound fundamentals as evidenced by above-average revenue, income, and cash flow generation. Many of these corporations have used the low interest rate environment to strengthen their balance sheets, and valuations of many companies remain reasonable from a historical perspective.
We expect the Federal Reserve will slowly unwind its low interest rates and easy money policies in the coming years. Anticipation of higher rates has contributed to market volatility and weakness in most emerging markets, but it also signals improving demand, which should be a long-term plus for stocks. While emerging markets have lagged mature markets, we are still able to identify attractively valued companies with solid long-term prospects. We would not be surprised to see volatility pick up around an unexpected geopolitical event, and when we sense temporary market weakness, we will attempt to be opportunistic buyers.
Emerging markets stocks advance as Fed maintains stimulus
Emerging markets stocks rose for the second straight month as optimism that the Federal Reserve would maintain the current pace of its monetary stimulus encouraged investors to buy riskier assets. The MSCI Emerging Markets Index hit a five-month high on October 22 after a weaker-than-expected monthly U.S. jobs report fueled speculation that the Fed would stand pat in its $85 billion-a-month asset purchase program. Those expectations were met when the Fed announced at the end of its October policy meeting that it will press on with its asset purchase program until it sees more evidence that the economic recovery is sustainable. All 10 sectors in the MSCI Emerging Markets Index rose. Information technology and financials gained the most, with each exceeding 6%. Consumer staples and telecommunication services advanced the least, with returns of less than 2%.
|MSCI Indexes1||October 2013||Year-to-Date|
|Emerging Markets (EM)||4.87%||0.62%|
|EM Latin America||4.80||-6.87|
India rally leads Asian markets
Asian stocks rose, led by India, where stocks jumped more than 10% in U.S. dollar terms. India's central bank raised its benchmark interest rate for the second straight month to fight inflation and reduced its gross domestic product (GDP) forecast for the year ending March 2014. Still, Indian stocks have rallied due to optimism about the new central bank governor, who took charge in September and has bolstered investor confidence with measures to curb inflation and support growth. Stocks in China posted slimmer gains. China reported third-quarter GDP growth of 7.8% from a year ago, putting it on track to meet its full-year 7.5% growth target. China's top leaders are due to gather in November for a meeting held every five years to outline the government's economic priorities for the next decade. The outcome of that meeting, known as the Third Plenum, will indicate the leadership's appetite for reform. T. Rowe Price analysts believe that it will be difficult to make investment decisions based on any announcements coming out of the meeting and that major reforms—most of which entail difficult decisions—are unlikely to be announced next month.
Brazil and Mexico post solid gains despite weak growth
Latin American stocks posted positive returns. In Mexico, the central bank cut the benchmark interest rate to a record-low 3.5% and signaled that it wouldn't reduce rates any further. The rate cut, its second in two months, comes as Mexico's growth has slowed sharply this year. T. Rowe Price analysts believe Mexico's growth is picking up, but the recovery will probably be uneven and not fully take hold until 2014. In contrast, Brazil's central bank raised its benchmark rate to 9.5%, its fifth straight rate increase. Brazil is attempting to counter inflation without discouraging growth, which has been sluggish for three years. Moody's cut its outlook on Brazil's credit rating to stable from positive, citing deterioration in the country's finances and signs that the economy is going through an "extended low-growth period."
EMEA stocks gain, but entrenched problems still weigh
EMEA stocks advanced as investors' risk appetites improved, but the region's major economies continued to struggle with slowing growth and other problems. Russian shares advanced, with the domestic Micex Index hitting an eight-month high in mid-October. Despite the rise, Russia continues to grapple with an ailing economy marked by weak external demand, high inflation, and a poor business climate that has sparked big capital outflows. Turkey cut its growth forecasts for 2013 and 2014 as the country tries to tame inflation and a widening current account deficit. However, it forecast that the current account deficit—the biggest worry for investors—would decline next year. Finally, South Africa is wrestling with high inflation, unemployment close to 25%, and labor unrest in various industries that has hurt output and the country's investment reputation. In an October report, the International Monetary Fund (IMF) warned that South Africa faces "continued sluggish growth and elevated current account deficits." The IMF also said that risks for South Africa "are tilted firmly to the downside" due to lower capital inflows.
Solid, long-term fundamentals outweigh near-term worries
Emerging markets stocks have lately lagged those in developed markets due to disappointing growth and the cyclical nature of developing economies. Nevertheless, we are confident that emerging markets stocks are an attractive asset class over the medium to longer term. Most emerging markets have implemented sensible macroeconomic policies over the past 15 years, resulting in greater fiscal discipline, relatively tame inflation, stronger financial systems, and improved political stability. A growing middle class, rising consumerism, and attractive demographics in many emerging markets continue to support good growth opportunities for a wide range of companies. Finally, stocks across the developing world are trading at a significant discount relative to their history and their developed market peers, making current valuations compelling for long-term investors. We believe that the solid fundamentals underpinning the companies in which we invest are intact despite the disappointing year-to-date performance of many emerging markets.