Stocks rise on stronger economic signals
Stocks recorded solid gains in August as enthusiasm over stronger U.S. economic data compensated for worries over turmoil overseas. The gains helped the Dow Jones Industrial Average reach a record intraday high late in the month, while the Standard & Poor's 500 Index crossed the 2,000 mark for the first time. The S&P MidCap 400 Index remained below its late-July peak, and the small-cap Russell 2000 Index, while back in positive territory for the year, stayed well below its spring highs. The small telecommunication services sector was the only S&P 500 sector to record a loss, while energy shares lagged somewhat. The defensive utilities sector recorded the largest gain, followed closely by health care and consumer stocks.
|S&P MidCap 400||5.08||8.13|
Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. It is not possible to invest directly in an index.
1Returns are for the periods ended August 31, 2014. The returns include dividends based on data compiled by T. Rowe Price, except for the Nasdaq Composite, whose return is principal only.
2The Dow Jones Industrial Average and the Standard & Poor's 500 Stock Index of blue chip stocks, the Standard & Poor's MidCap 400 Index, and the Russell 2000 Index are unmanaged indices representing various segments by market capitalization of the U.S. equity markets. The Nasdaq Composite Index is an unmanaged index representing the companies traded on the Nasdaq stock market and the National Market System. It is not possible to invest directly in an index.
Housing sector regains momentum
Investors welcomed a series of data in August that appeared to confirm that the U.S. economy had shifted into higher gear at midyear. Several signals indicated that the housing sector had regained traction as homebuyers became accustomed to somewhat higher mortgage rates. Housing starts jumped nearly 16% in July, while pending home sales reached their highest level in nearly a year. New home sales fell a bit in July, however, which some attributed to both low inventory levels and strict lending requirements that are keeping potential buyers out of the market.
Manufacturing strengthens further
The manufacturing sector, which has remained more robust throughout the recovery, also appeared to pick up speed. The Commerce Department reported a nearly 23% surge in durable goods orders in July, the biggest jump in the history of the data. While the rise was driven almost entirely by a boost in aircraft orders, an upward revision to May and June figures showed a broad increase in consumer and business demand for items such as electronics and machinery. T. Rowe Price Chief Economist Alan Levenson observes that rising order backlogs suggest that momentum on capital expenditures will continue into the second half of the year.
Inflation remains well contained
Investors were also pleased to see that better economic conditions had not yet triggered a rise in inflation. The Labor Department reported that consumer prices rose only 0.1% in July, the smallest increase in several months. The data raised hopes of a "Goldilocks" economy—not hot enough to lead to rising interest rates and falling multiples (Price/Earnings ratios), but not so cold as to choke off continued earnings growth. Slow growth and continued monetary stimulus in Europe also suggested that U.S. rates were unlikely to head significantly higher anytime soon.
Ukraine causes concern, but impact is mixed
The deepening crisis in Ukraine appeared to have a mixed impact on U.S. stock prices. Stocks fell on several occasions as news of heightening tensions appeared to increase the likelihood of further sanctions against Russia, which would also weigh on struggling European economies. On the other hand, tensions with Russia were another factor sending investors to the safe haven of the U.S. Treasury market and lowering bond yields—heightening in turn the relative appeal of U.S. stocks.
M&A activity provides further boost
Continued merger and acquisition (M&A) activity was a final factor in helping stocks move back into record territory. August saw the announcement of important mergers within the retailing and energy sectors, and the total value of mergers and acquisitions around the globe moved closer to levels last seen at the height of the previous economic expansion. T. Rowe Price managers note that heightened M&A activity has been due in part to exceptionally strong corporate balance sheets, which have also led to increasing stock buybacks and rising dividends—all factors that may support stock prices in late 2014, even as recent gains have made valuations less compelling.
Safe-haven European sovereign bond yields at record lows
Yields on safe-haven European government bonds fell to record lows as investors snapped up the debt amid heightened geopolitical risks stemming from conflicts in Ukraine and the Middle East. The yield on 10-year German government bonds, called "bunds," reached a record-low 0.88%, and two-year German sovereigns had a negative yield near the end of the month—meaning investors were paying to lend the country money.
Stalled eurozone growth
The stagnant eurozone economy—reflected in flat second-quarter economic growth—also helped boost demand for government debt. In reaction to the eurozone's stalled growth, European Central Bank (ECB) President Mario Draghi made comments that increased market expectations for the central bank to launch a significant quantitative easing (QE) program. Investor anticipation of the ECB buying government bonds further spurred the rally. However, T. Rowe Price fixed income analysts believe that expectations for an imminent ECB launch of large-scale QE similar to the efforts of other major central banks may be overdone.
Treasuries rally to lowest yields in over 12 months
The ultra-low yields on European government debt made U.S. Treasuries look attractive in comparison, generating demand for intermediate- and long-term Treasuries and driving their yields lower. The yields on 10- and 30-year Treasury debt reached their lowest levels in more than 12 months. The Treasury yield curve flattened significantly as short-term rates stayed anchored.
Strong economic data from the U.S.
Treasuries rallied despite generally strong U.S. economic data, including steadily improving employment figures, an upward revision of second-quarter gross domestic product growth, and a 22.6% jump in durable goods orders in July as a result of a surge in aircraft orders. In addition, the minutes from the July Federal Reserve policy meeting and Fed Chair Janet Yellen's speech at a major economics conference in Wyoming were somewhat hawkish, indicating that the central bank could raise rates sooner than previously expected.
|Barclays U.S. Aggregate Bond Index||1.10%||4.81%|
|Credit Suisse High Yield Index||1.45||5.74|
|Barclays Municipal Bond Index||1.21||7.47|
|Barclays Global Aggregate Ex-U.S. Dollar Bond Index||0.17||4.35|
|J.P. Morgan Emerging Markets Index Plus||0.84||10.02|
|Barclays U.S. Mortgage Backed Securities Index||0.94||4.39|
Rebound in noninvestment-grade bond market
High yield bonds experienced significant selling pressure at the beginning of the month amid record outflows from the asset class. However, the sell-off was not the result of deterioration in the fundamentals of the high yield market, as the financial condition of many high yield issuers remained strong. Much of the early-month decline in the high yield market stemmed from technical factors such as retail investors selling their fund holdings, in turn forcing fund managers to sell into low summer trading volumes. T. Rowe Price's fixed income portfolio managers took advantage of the attractive valuations created by the sell-off and added to high yield bond positions. The market rebounded later in the month as high yield bonds attracted inflows. Investment-grade corporate bonds did not experience the same selling pressure as inflows remained strong. The recent boom in mergers and acquisitions continued to drive investment-grade corporates, but investors judged that many of the announced deals do not seem likely to hurt the credit quality of the companies involved.
Solid demand and low supply support municipal debt
Municipal bonds enjoyed ongoing solid demand and minimal new supply. PREPA, Puerto Rico's electric utility, reached a deal with its major creditors to delay repayment of almost $700 million in bank loans until March 2015, giving the utility extra time to address its low cash levels. Detroit, another major municipal debt issuer with significant financial problems, took a step toward exiting bankruptcy when a judge approved $1.8 billion of new debt issuance from the city's water and sewer department.
|U.S. Treasury Yields|
|Maturity||July 31, 2014||August 31, 2014|
Positive returns from emerging markets bonds
Emerging markets bonds posted positive returns, with investment-grade bonds from developing countries outperforming those with noninvestment-grade ratings. Brazil, a major emerging markets bond issuer, was in the spotlight following the tragic death of presidential candidate Eduardo Campos in an airplane crash. Marina Silva took over as the main challenger to incumbent Dilma Rousseff, who many investors doubt can revive Brazil's lagging economy. Brazilian government bonds gained when polls began to show Silva leading Rousseff.
MBS, CMBS lag other sectors
In securitized debt markets, wider yield spreads, which measure the additional yield that investors demand as compensation for holding a bond with a variable payment schedule versus a similar-maturity Treasury security, created more attractive valuations in residential mortgage-backed securities (MBS). Commercial mortgage-backed securities (CMBS) also lagged the returns of other fixed income sectors, creating potentially attractive opportunities despite the relatively low quality of recent CMBS deals. Continued strong demand absorbed significant new issuance of asset-backed securities.
Relative value opportunities in securitized and emerging markets debt
In addition to selective opportunities to take advantage of relative value in specific types of securitized debt, our outlook for some emerging markets bonds remains favorable. The performance of individual emerging markets has become much more differentiated, so we will continue to look for idiosyncratic opportunities in dollar-denominated emerging markets sovereign or corporate bonds. We also favor certain local currency emerging markets debt; however, we think that the dollar will continue to appreciate as the Fed eventually moves to raise rates, so we are wary of currency risk.
Emerging markets continue to outperform developed markets
Non-U.S. stock markets generated mixed results for the month, with many emerging markets posting strong returns and developed markets, in aggregate, little changed. Most developed markets in the Asia-Pacific region edged lower, but Australia rose 1% while Japan declined. European markets were narrowly mixed, with Germany, Spain, and Italy declining while Belgium, the Netherlands, and France advanced. Within emerging markets, Latin America was the strongest performer, followed by Asia. The emerging Europe, Middle East, and Africa (EMEA) region lagged amid continued tensions between Russia and Ukraine.
Within the MSCI EAFE index, a yardstick for the performance of developed stock markets in Europe, Australasia, and the Far East, growth stocks outperformed value and large-cap stocks outperformed small-caps. For the month, four sectors in the index advanced, with only health care showing notable strength. The consumer discretionary and materials sectors lost the most ground. The U.S. dollar continued to strengthen versus most currencies in August. While supportive of economic growth, the potential for continued central bank easing policies in Europe and Japan could pressure the euro and the yen relative to the dollar.
|MSCI Indexes1||August 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||-0.15%||2.93%|
|All Country World ex-U.S.||0.57||5.46|
|All Country Asia ex-Japan||0.72||14.45|
|EM (Emerging Markets)||2.29||10.95|
Asian markets post modest returns
The MSCI All Country Asia ex-Japan Index produced a modest gain in August. Except for Australia, developed markets in the Asia-Pacific region declined. Japan's economic recovery seems to be stalling amid a steep 6.8% annualized economic contraction in the second quarter (its worst performance since the 2011 earthquake and tsunami) and continually falling wages. The country's core inflation rate, which stood at 1.3% when adjusted for last April's tax hike, is well below the Bank of Japan's 2% inflation target. China had a small gain as growth in its manufacturing sector slowed. The government's official manufacturing Purchasing Managers' Index fell to 51.1 from 51.7 in July, while HSBC's similar index fell to 50.2 from 51.7. Observers suggest the drop reflects a correction due to overinvestment, particularly in the property sector. Some analysts also believe additional stimulus will be needed for China to achieve its 7.5% full-year Gross Domestic Product growth goal.
European markets stabilized after weak July
Developed European markets were mixed in August following steep July losses. Belgium, Switzerland, and France produced relatively strong gains while Germany declined. Eurozone deflationary pressures continued to hamper the region's recovery, and the European Central Bank indicated that it would take stronger measures to promote growth.
Non-U.S. stock valuations remain attractive
Overall, we are optimistic about the environment for global equities in the intermediate term. In the near term, we are a bit more cautious. In Europe and Japan, markets moved a decent amount last year in anticipation of improved economic growth and government reforms, respectively, and both have left investors a little wanting this year. We expect further policy actions in Europe and Japan, but progress could be uneven. Corporate earnings should improve as their economies return to growth, and valuations remain attractive. Many European companies could benefit from reducing costs and improving their market positions over time. In Japan, increased domestic consumption, fed by wage inflation, needs to be the next growth engine. Evidence of a shift in corporate culture is encouraging, as companies transform business practices and governance standards to focus more on growing profits and generating value for shareholders.
Emerging markets have moved higher as growth seems to be bottoming, with the exception of Russia and Brazil, and elections and fiscal and monetary policies have been generally favorable. Here too, progress will be slow. However, T. Rowe Price managers believe that growth in emerging markets and returns, while uneven, should outpace those of most developed markets. We remain disciplined buyers of companies that create value over time.
Emerging markets stocks gain as U.S. economy strengthens
Emerging markets stocks advanced in August as investors bet that the strengthening U.S. economy would boost demand for exports from developing countries, easing fears about rising political instability overseas. The MSCI Emerging Markets Index rose to its highest level in three years on August 27 but pared some of its gain by month-end. August marked the seventh straight month of gains for the index, its longest stretch of monthly gains since 2005, according to Bloomberg. Nine sectors in the index advanced, led by health care, which added more than 6%. The materials sector was the only decliner, down roughly 1.5%.
|MSCI Indexes1||August 2014||Year-to-Date|
|Emerging Markets (EM)||2.29%||10.95%|
|EM Latin America||7.96||17.18|
Chinese stocks advance despite weak data; Indian stocks extend record highs
- Stocks in China edged higher despite several indicators showing that its economy is losing steam. The preliminary HSBC China Manufacturing PMI fell to a three-month low in August, while a broad measure of credit unexpectedly sank in July to its lowest level since Lehman Brothers collapsed in 2008. While targeted stimulus measures could help prop up China's near-term economic growth, T. Rowe Price analysts think that longstanding problems with excessive credit and unresolved bad debt will curb any sustained growth pickup in the future.
- Indian stocks rallied as the domestic Sensex Index hit fresh records in August and investors remained confident about reform prospects under the government of Prime Minister Narendra Modi. India's gross domestic product (GDP) grew at a better-than-expected 5.7% rate in the June quarter from a year ago, its fastest pace since early 2012, while the country's fiscal and current account deficits both improved.
- Thai stocks rose as investors welcomed the political stability and increased spending ushered in by the country's new military government, which seized power in May. The army general who led the coup was named Thailand's new prime minister in August, sealing the military's power over the country.
- Philippine stocks strengthened. The country's GDP grew at a surprisingly strong 6.4% pace in the second quarter from a year ago, reinforcing expectations that its central bank will hike interest rates at its September policy meeting.
Brazilian stocks surge on election bets; Argentine stocks sink as default weighs
- Brazilian stocks soared roughly 11% as data showing that the country fell into a recession this year added to speculation that President Dilma Rousseff will lose her reelection bid in October. Brazil's GDP shrank 0.6% in the second quarter from the first quarter, when it contracted at a revised 0.2% pace. The recession data provide more fuel for opposition candidates who have criticized Rousseff's handling of the economy. Regardless of who wins the election, T. Rowe Price analysts believe that 2015 will be a tough year for the Brazilian economy, marked by very low growth and persistently high inflation.
- Mexican stocks strengthened. Mexico's GDP expanded at a better-than-expected pace in the June quarter, while a separate report showed a rebound in factory exports in July. The data raised hopes that Mexico's economy is picking up after a disappointing start this year. The government kept its full-year 2.7% growth forecast unchanged.
- Argentine stocks slid more than 13%, the most in Latin America, as the country continued to wage a legal battle in U.S. courts following a July ruling that pushed it into default on its sovereign bonds. Argentina's government, which maintains that it has not defaulted, proposed legislation that would circumvent the ruling, but the U.S. judge overseeing the case declared that such an action would be illegal.
Russian stocks decline as Ukraine crisis worsens; Turkish stocks fall after elections
- Russian stocks declined as the country stepped up its military intervention in Ukraine, raising the prospect of more sanctions from the U.S. and Europe that would further jeopardize Russia's already weak economy. The ruble depreciated to a record low against the dollar.
- Turkish stocks slid roughly 3% but are up more than 21% this year, making them among the EMEA region's best performers. Turkey's former Prime Minister Recep Tayyip Erdogan won the country's first direct presidential election, which will extend his leadership for at least five more years. T. Rowe Price analysts believe that Turkey's new cabinet will continue its pro-cyclical economic policies despite being less market friendly than the previous one, and they expect more controversial and authoritarian policymaking under Erdogan's rule.
- South African stocks advanced. South Africa avoided a recession in this year's first half as the country's GDP expanded 0.6% in the June quarter from the previous quarter, when it contracted amid a prolonged mining strike. The quarterly growth pace trailed forecasts, however, and South Africa's finance minister said the government would likely cut its full-year growth forecast to 1.8% from a prior 2.7% estimate.
Solid long-term fundamentals offset near-term risks
In recent years, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. With the end of the global commodities boom and double-digit annual growth in China, we believe that careful stock selection will be increasingly key to long-term outperformance. Near-term risks include a worse-than-expected slowdown in China or a breakdown in its financial system; a sharp rise in U.S. interest rates due to Fed tapering; and an unexpected bout of risk aversion due to geopolitical events. Political risk has increased in many countries holding elections in the coming months, though we believe that new governments in some cases will adopt market-oriented reforms.
Stocks across the developing world are trading at a significant discount relative to their history and developed market peers, making current valuations compelling for long-term investors. Most emerging markets have stronger financial positions, larger currency reserves, and more flexible foreign exchange policies than they did a decade ago. We believe that emerging markets stocks remain an attractive asset class for long-term investors, but they should gradually build their exposure to this asset class. Emerging markets may not outperform developed markets by the same magnitude as they did in the past decade, but we believe they will resume their role as global leaders over time.