Markets chase away ghosts of October and finish on positive note
The major benchmarks managed gains in October but not before experiencing substantial volatility-particularly in comparison to the relative stability of recent months. The Standard & Poor's 500 Index fell sharply in the first half of the month, but then rallied more than 8% in two weeks. The rebound brought the S&P 500 to a record close at the end of the month, although it remained slightly below the intraday high it established in mid-September. The more narrowly focused Dow Jones Industrial Average and the technology-heavy Nasdaq Composite Index established all-time and multiyear highs, respectively. The smaller-cap indexes recorded the best gains for the month but remained short of the records they set earlier in the year. The defensive utilities and health care sectors fared best in the S&P 500, while energy and materials were the only two segments to record a loss for the period amid falling commodity prices and slowing global growth.
|MSCI Indexes||October 2014||Year-to-Date|
|S&P Midcap 400||3.56||6.89|
Month starts on down note due to global growth concerns
Several factors weighed on sentiment early in the month, but worries about slowing growth overseas appeared to loom particularly large. The first few days of the month brought news that the German manufacturing sector was slowing as exports stalled, raising the likelihood that the Continent's biggest economy could fall back into recession. Investors were also concerned that the European Central Bank (ECB) would not take sufficient action to head off deflation in the region. Meanwhile, Asian markets responded to a new round of political turmoil in the region. U.S. stocks followed Asian markets lower as investors worried about growing protests in Hong Kong, where residents are demanding greater political autonomy from mainland China.
Ebola fears seem to intensify declines
Although its impact was difficult to quantify, the alarming news that the Ebola virus has appeared in the U.S. was another factor weighing on sentiment. These fears deepened at mid-month, after reports that two nurses had contracted the disease at a Texas hospital. The Ebola concerns had their most direct impact on the industrials sector, where airline stocks sold off sharply in anticipation of reduced air travel. The recovery of the nurses later in the month appeared to help calm fears, however, which may have helped in the market's rebound.
Global signals grow more hopeful later in the month
Better global economic news also helped investors regain confidence. Markets advanced after an array of data showed manufacturing activity increasing in China, Japan, and even Europe. Investors were also encouraged by reports that the ECB was considering additional steps to boost growth in the region, and the surprise announcement of new stimulus from the Bank of Japan helped spark a global rally on the last day of the month. Tokyo-based T. Rowe Price managers and analysts are keeping a close eye on Japanese stimulus measures, which they note have surpassed expectations. However, they believe that the government must now tackle structural challenges, such as the need to wean Japan from its reliance on imported energy, as well the necessity of boosting wages to promote domestic demand.
U.S. recovery remains on track
October's U.S. economic data did not uniformly surprise to the upside but did suggest continued healthy domestic growth. Job market indicators remained positive, and investors were encouraged by some favorable housing signals. Although gross domestic product (GDP) data are often considered too backward looking to drive markets, the Commerce Department's preliminary estimate that had expanded at a robust annualized rate of 3.5% in the third quarter also appeared to provide a boost to stock prices.
Earnings continue to boost sentiment
A generally positive tone to third-quarter corporate earnings reports was perhaps the most important factor in stocks regaining momentum. Thomson Reuters reported that nearly three-quarters of companies in the S&P 500 that had reported third-quarter results managed to surpass analysts' expectations-an improvement even from the generally positive tone of the previous four quarters, when roughly two-thirds of companies surpassed estimates. At the end of the month, data analytics company FactSet released its own tally, showing that S&P 500 earnings had ended the quarter 7.3% higher than they were a year ago, well in excess of the 4.5% growth expected before the reporting season began.
Company-specific analysis may become more important
Many T. Rowe Price managers expect that an individual company's earnings will be an important driver of stock performance in the coming months. With the financial crisis and dramatic policy responses fading into the background, many of the factors that have taken stocks up and down in unison are likely to become less common—even if the markets are periodically volatile. Careful fundamental research will be necessary to find opportunities, they believe, especially with overall valuations (such as price-to-earnings ratios) unlikely to expand significantly.
Prospect of Fed tightening doesn't derail U.S. Treasuries rally
U.S. Treasury yields moved lower as investors bought U.S. government debt even as they looked toward an eventual tightening of Federal Reserve monetary policy, with many still expecting the first Fed rate hike in mid-2015. Treasury debt prices actually lost ground later in the month after a furious rally on October 15, when the yield on the benchmark 10-year U.S. Treasury note briefly traded as low as 1.87% before rising back to 2.09% by the end of the day. A disappointing September retail sales report seemed to trigger the mid-month Treasury buying binge, and hedge funds racing to unwind positions that would benefit from the widely expected rate increase probably contributed to the rally.
U.S. economic data generally positive
Despite the weaker-than-expected retail sales figures, U.S. economic data generally showed a strengthening labor market and healthy growth. The unemployment rate dropped to 5.9% as of September, the lowest level since 2008. The Commerce Department's initial estimate of third-quarter gross domestic product (GDP) showed a stronger-than-expected 3.5% annualized growth rate. As expected, the Fed ended its quantitative easing program at its October policy meeting and stated that the timing of its initial rate increase will be data-dependent.
ECB and Bank of Japan under pressure to revive growth
In contrast, the eurozone and Japan continued to struggle to revive flagging growth and generate inflation in their economies. At the end of the month, the Bank of Japan unexpectedly announced that it will expand the pace of its asset purchases primarily by acquiring more Japanese government bonds. The European Central Bank (ECB) kicked off its program to buy certain types of secured debt and asset-backed securities, but many analysts remained convinced that the ECB will need to expand its buying beyond those limited asset classes and into sovereign bonds. Reports circulated that the ECB was considering purchases of corporate bonds to help ease concerns about deflation.
|Barclays U.S. Aggregate Bond Index||0.98%||5.12%|
|Credit Suisse High Yield Index||0.95||4.49|
|Barclays Municipal Bond Index||0.69||8.32|
|Barclays Global Aggregate Ex-U.S. Dollar Bond Index||-0.68||-0.77|
|J.P. Morgan Emerging Markets Bond Index Global Diversified||1.71||9.87|
|Barclays U.S. Mortgage Backed Securities Index||0.97||5.23|
Emerging markets bonds denominated in dollars lead performance
U.S. dollar-denominated emerging markets debt generated strong returns, while bonds denominated in local currencies lagged amid the dollar's ongoing strength against most currencies of developing countries. Volatility persisted in the asset class as country-specific news drove prices. In Brazil's first-round presidential elections early in the month, the most market-friendly candidate, Aecio Neves, posted a surprising second-place finish to incumbent Dilma Rousseff, triggering a rally in the country's bonds. Rousseff won the runoff election at the end of the month, resulting in some fairly subdued selling in Brazilian government bonds. Developed non-U.S. market government bonds declined in U.S. dollar terms as the dollar strengthened against most other major currencies.
Positive returns for investment-grade corporates
Investment-grade corporate debt posted positive returns even as issuers continued to bring new deals to market to take advantage of the low financing costs generated by the drop in Treasury yields. However, debt with the lowest ratings in the investment-grade category (BBB) underperformed the broader asset class, and bonds issued by commodities-related businesses experienced significant selling pressure as oil prices fell sharply. Demand for newly issued investment-grade corporates outpaced buying in the secondary market.
Rebound in high yield bonds
High yield corporate bonds rebounded from a steep sell-off early in the month amid considerable volatility. Energy-sector bonds declined the most as a result of the pronounced drop in oil prices; because energy is by far the largest sector in the high yield market, this weighed on the performance of benchmark indexes. However, investor sentiment toward high yield bonds improved dramatically later in the month as bargain hunters eagerly moved back into the asset class to take advantage of the more attractive yields.
|Maturity||September 30, 2014||October 31, 2014|
MBS track rally in Treasuries
Mortgage-backed securities (MBS) benefited from the decline in Treasury yields to generate positive returns, overcoming the decline in demand stemming from the end of the Fed's MBS purchases. The Fed has stated that going forward 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 an effort to remove some uncertainty in mortgage lending, the Federal Housing Finance Agency announced an agreement with Fannie Mae and Freddie Mac to clarify the circumstances under which banks would need to buy problematic mortgages back from Fannie and Freddie.
Demand for municipal debt outweighs new supply
Municipal bonds also gained as they tracked the rally in Treasuries. Demand for municipal debt has been robust all year, and the average municipal yield reached its 2014 low in mid-October. However, new municipal supply picked up in October as troubled issuers Detroit and Puerto Rico sold new bonds. In addition, the largest-ever unrated municipal debt deal came to market as developers of 3 World Trade Center in New York sold $1.6 billion in bonds to finance the building's construction.
We see relative value in TIPS, dollar-denominated emerging markets debt
While the environment of very low interest rates has made relative value difficult to find within fixed income, we think that the recent selling pressure on Treasury inflation-protected securities (TIPS) has created some buying opportunities. TIPS now offer considerably more upside potential relative to non-inflation indexed Treasuries and our inflation expectations. Also, emerging markets bonds still present more value than developed market debt with similar credit quality, although we generally prefer dollar-denominated bonds to avoid currency risk.
Late-month rally eases losses
Developed non-U.S. stock markets recorded modest losses in October as measured by the MSCI Europe, Australasia, and Far East (EAFE) Index. However, the small decline for the period belies a surge in volatility as heavy selling in the first part of the month was followed by sharply rising stock prices in the second half. Results for emerging markets were positive for the month, and, overall, they remain in the black for the year to date, thanks largely to the strong performance of stocks in the Asia-Pacific region. The largest emerging markets, excluding Russia, have continued to prop up the performance of the emerging markets universe.
As has been the case in recent months, U.S. dollar strength continued to hurt the performance of assets denominated in most other currencies. The euro, British pound, and yen all weakened versus the dollar in October. For the year-to-date period, the euro has declined more than 9%, the pound has fallen 3%, and the yen has declined 6%. Within the EAFE index, growth stocks held up better than value shares, and large-caps outperformed small-caps. The telecommunication services and financials sectors performed best, posting small positive returns. All other sectors in the EAFE Index posted a loss, with energy and materials stocks falling the most, 8% and 3%, respectively.
|MSCI Indexes||October 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||-1.45%||-2.42%|
|All Country World ex-U.S.||-0.98||-0.59|
|All Country Asia ex-Japan||1.95||6.99|
|EM (Emerging Markets)||1.19||3.97|
Asian markets were a bright spot in a weak month
The U.S. dollar is near a seven-year high versus the yen, and the dollar could continue to appreciate following the Bank of Japan's (BoJ) new stimulus measures. The Japanese economy has struggled since the sales tax increase in April. As a result of lower-than-expected inflation and a slowdown in household spending in the third quarter, the BoJ announced an expansion of its monetary base. The government also announced that it will reallocate its public pension fund, doubling the allocation to domestic and international equities, slashing the allocation to domestic bonds, and eliminating the 5% cash target. The moves sparked a rally in Japanese stocks, and the Nikkei 225 Stock Average climbed to its highest level since 2007. Australia and Hong Kong were the best-performing developed markets in the region in October; both posted gains exceeding 5%. Emerging markets in Asia were higher, led by strong results in China, India, and Taiwan.
European markets continue to trend lower
Subpar economic growth, weak inflation data, and the potential for rising interest rates in the U.S. caused the euro to fall to a two-year low versus the U.S. dollar. However, the latest data show that eurozone consumer prices rose by 0.4% year-over-year in October. Although that level is still well below the European Central Bank's (ECB) 2% target, the news likely staves off any additional near-term monetary policy action by the central bank. 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. Additional central bank easing would likely put more downward pressure on the euro.
ECB gives failing grade to 25 banks
Near the end of October, the ECB announced the results of its bank stress testing. Of the 130 banks under review, 25 of them failed the stress testing, but about half had already taken steps to address their shortcomings. The ECB simultaneously carried out a comprehensive audit of 123 big eurozone banks, the Asset Quality Review (AQR), on institutions it will regulate in the near future. The ECB says total capital shortfall was €25 billion and it found €136 billion in "troubled loans" that the banks had not already reported, bringing the total to €879 billion ($1.1 trillion). The audited were as of the end of 2013, and a lot has changed since then. Nevertheless, the stress-tests and the AQR go a long way toward enhancing the ECB's credibility as a regulator and its ability to judge the health of the eurozone's banking system
Non-U.S. stock valuations appear reasonable, 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. Overall, 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. In Europe, earnings growth has been disappointing, and the dispute between Western powers and Russia over Ukraine has called into question the viability of near-term economic improvement. Dollar strength is likely to remain a key focus for eurozone investors, and growth forecasts have been ratcheted lower. In Japan, we believe domestic consumption and wage inflation need to be the next growth engine for a sustained recovery. Prime Minister Shinzo Abe has been applying intense pressure on corporations to raise wages in order 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, should also favor an increase in salaries.
We remain encouraged by the continued dispersion of returns within emerging markets. In 2013, we saw emerging markets treated as a homogeneous asset class, labeled almost uniformly as bad assets due to Fed tapering and currency concerns. In 2014, both at the stock and country level, returns have been considerably more reflective of underlying fundamentals-a positive and overdue development, in our view.
Emerging markets stocks rise as strong U.S. GDP data and Japan stimulus boost risk appetite
Emerging markets stocks rose in October as strong U.S. economic data and aggressive stimulus measures in Japan propelled a late-month buying spree of riskier assets. Better-than-expected U.S. gross domestic product (GDP) growth in the third quarter, combined with the unexpected news that Japan's central bank would ramp up its asset purchase program, shored up confidence in the global economy. A plunge in oil prices also brightened the outlook for oil-importing markets such as India, Turkey, and most of Southeast Asia. Prices for Brent crude, the global oil benchmark, sank 9.3% in October, a drop seen as boosting domestic consumption and taming inflation for emerging markets dependent on imported oil. Seven of the 10 sectors in the MSCI Emerging Markets Index gained, led by health care and financial stocks, which each rose more than 3%. Energy, materials, and industrials and business services stocks declined.
|Emerging Markets (EM) Index||1.19%||3.97%|
|Europe, Middle East, and Africa (EMEA) Index||1.56||-3.69|
|Latin America Index||-0.11||1.45|
Chinese stocks strengthen on reform hopes; Indian stocks advance
- Chinese stocks advanced amid expectations that the government would relax monetary policies, reform state-owned enterprises, and take other steps to shore up a slowing economy. China's third-quarter GDP expanded 7.3% year-over-year in the slowest growth since the first quarter of 2009. Though the quarterly growth rate topped forecasts, it revealed further slowing in the property sector and increased the odds that China will miss its official 7.5% growth target this year.
- Indian stocks advanced nearly 4% on reform optimism. The domestic Sensex equity benchmark hit a record high at month-end, propelled by the drop in oil prices and a pair of landmark energy reforms that deregulated diesel fuel prices and raised natural gas tariffs. In addition, Prime Minister Narendra Modi's Bharatiya Janata Party won two state elections, which will increase the ruling party's chances of passing tough economic and fiscal reforms.
- Philippine stocks declined but are up nearly 25% since January, making the country one of Asia's best performers year-to-date. The country's central bank kept the benchmark interest rate unchanged in October as inflation pressures eased. T. Rowe Price analysts believe that the Philippines currently is one of the best growth stories in Asia, with high economic growth, a current account surplus, easing inflation, and a politically stable environment.
Brazilian stocks advance as election volatility subsides; Mexico declines
- Brazilian stocks rose, erasing earlier losses following President Dilma Rousseff's October 26 reelection. Brazil's domestic stock market and currency each slid more than 2% the day after Rousseff's victory amid investors' skepticism about her ability to revive a flagging economy. After the sell-off, Brazil's central bank raised interest rates to fight inflation-a surprise move that bolstered the bank's credibility to many investors. T. Rowe Price analysts think that the rate hike was positive but caution that real and long-lasting improvements in Brazil will take time.
- Mexican stocks declined. The country's central bank kept its benchmark interest rate at a record low 3.0% at its October 31 meeting, noting that third-quarter economic activity appears to have shown a "moderate recovery" and that a recent surge in inflation would subside by mid-2015.
- Colombian stocks retreated more than 3%. Colombia's central bank kept its benchmark interest rate unchanged at 4.5% for the second straight month. It also maintained its 2014 economic growth estimate of 5% but forecast that next year's growth would decline from this year's pace. Falling oil prices and the end of the global commodities boom have diminished two of the biggest growth drivers in Colombia, but it remains Latin America's fastest-growing economy.
Russian stocks fall as Ukraine crisis weighs; Turkish stocks rally on oil price drop
- Russian stocks declined as investors continued to shun Russian assets in response to the Ukraine crisis and ensuing international sanctions. Moody's cut Russia's sovereign debt rating due to the Ukraine situation and escalating sanctions, which it said "are likely to have an increasingly negative macroeconomic impact" on the country. Separately, Russia's central bank hiked its main interest rate much more than expected to defend the ruble, which repeatedly fell to record lows against the dollar in October.
- Turkish stocks rallied more than 10%, erasing some of September's 12% drop, as investors bet that plunging oil prices would benefit the country's economy. The drop in oil prices reduces the import bill for Turkey, which has one of the developing world's biggest current account deficits and imports oil to meet most of its energy needs. Turkey's outlook remains fragile, however, and the government slashed its growth targets and raised inflation forecasts for this year and next.
- South African stocks surged more than 6%, paring some of September's drop, as global risk appetite rebounded. However, the country's near-term economic outlook remains poor. South Africa's government will cut spending and raise taxes over the next two years, moves that the finance minister called "a necessary dampening effect" on the economy as it tries to stop debt from reaching unsustainable levels.
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.