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February 21, 2013

Stocks have generated strong gains in the past couple of years, but slower global economic growth, decelerating earnings growth, and fiscal instability in developed markets could weigh on performance. With bonds continuing to generate historically low yields, uncertain investors are wondering which assets offer the best opportunities. Rich Whitney, director of asset allocation for T. Rowe Price and head of the firm's Asset Allocation Committee, offers his insights and points to the potential for large-cap and growth-oriented stocks to outperform, as well as high yield and emerging markets debt.

We currently favor stocks over bonds due to their attractive valuations and healthy balance sheets, with the potential for merger and acquisition activity to provide a further boost.

  • While stock valuations have risen from those experienced during the depths of the global financial crisis, they remain reasonable relative to historical valuations and appear favorable versus many fixed income investments in a low-yield environment.
  • Corporate earnings and revenue growth have proven surprisingly resilient despite a modest global economic recovery, and profit margins are healthy. Strong balance sheets and low payout ratios offer the potential for attractive dividend growth.
  • Balance sheet health and attractive financing terms could help merger and acquisition activity provide further support to stock valuations.
  • A low-growth economy often benefits growth stocks more than value, as growth companies tend to rely less on a strong economy to increase earnings.
  • Valuations currently favor large-cap stocks over small-caps, as the latter's solid performance in recent years has reinforced the rich pricing in the small-cap universe.

It's hard to be overly optimistic about bond returns in light of record-low interest rates, but we continue to see opportunities in high yield and emerging markets bonds.

  • High yield bonds remain attractive relative to other fixed income sectors due to the gradual global economic recovery and low interest rates that have allowed many issuers to refinance their debt and improve their financial condition.
  • Emerging markets debt benefits from higher economic growth rates and healthier fiscal positions than most developed markets, and the market's improving size, scope, and quality continue to lure investors searching for yield and diversification.
  • Despite huge inflows into bond funds since the 2008 global financial crisis, the trauma of that event remains fresh in the minds of many investors, and we do not expect a large-scale structural rotation back into stock funds in the near future.

There are inherent risks associated with investing in the stock market, including possible loss of principal, and investors must be willing to accept them. International investing is also subject to currency risk and political risk. These risks are heightened in emerging markets. Yield and share price will vary with interest rate changes, and investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term.

The views are as of February 12, 2013 and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

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