Second Quarter 2015

Stocks flat as earnings and growth optimism give way to Greek worries
The blue chip benchmarks were roughly flat for the second quarter, as relief over resilient corporate earnings growth and enthusiasm about a reaccelerating U.S. economy gave way to worries over the ongoing Greek debt crisis. The Nasdaq Composite performed better, helped in part by merger and acquisition (M&A) activity, and managed to breach the record high it established in 2000 before pulling back a bit. The smaller-cap indexes recorded mixed performance, with small-caps outperforming, while mid-caps were the poorest performers among the major benchmarks. Utilities and industrials shares underperformed within the S&P 500 Index, while health care and consumer discretionary shares outperformed.

U.S. Stocks
  Total Returns
Index Second Quarter 2015 Year-to-Date
DJIA   -0.29%    0.03%
S&P 500 0.28 1.23
Nasdaq Composite 1.75 5.30
S&P MidCap 400 -1.06 4.20
Russell 2000 0.42 4.75
Note: Returns are for the periods ended June 30, 2015. The returns include dividends based on data compiled by T. Rowe Price, except for the Nasdaq Composite, whose return is principal only.

Earnings sluggish but surprise on upside
Investors braced themselves at the start of April for the arrival of the previous quarter's earnings reports, which appeared likely to reflect the negative effects of both falling energy prices and the strong U.S. dollar. While these headwinds had an impact, markets rose as many companies reported that profits had not declined as much as analysts expected. At the start of the quarter, data and analysis firm FactSet reported that analysts expected overall profits for S&P 500 companies to decline 4.7% over the previous year; when final results were tallied, earnings had in fact risen by 0.8%. While this was the slowest rate of growth in over two years, earnings would have grown 8.5% if not for the plunge in energy sector profits. Even within the troubled energy segment, investors bid up stocks as oil prices rose and as evidence finally appeared that producers were reducing supply and setting the stage for improved profitability.

Winter slowdown proves temporary
The quarter also began with several signs that the economy had experienced another winter slowdown, with a reduced pace of March hiring proving particularly worrisome. T. Rowe Price Chief U.S. Economist Alan Levenson noted that another bout of especially severe weather in much of the country was partly to blame, with much of the hiring weakness concentrated in construction and other weather-related industries. A West Coast ports strike also weighed on economic activity. In fact, job growth picked up in April and May, and weekly jobless claims reached their lowest levels in 15 years. Encouragingly, the tighter labor market finally appeared to be reflected in healthy wage gains and consumer spending. The housing sector also seemed to be picking up speed, with single-family housing sales reaching their best level in eight years.

Fed stays on sidelines
Even if temporary, the winter chill did play a positive role for markets in pushing back expectations for the first increase in short-term interest rates in nearly a decade. Minutes from the Federal Reserve's April policy meeting, which were released on May 20, revealed that the winter slowdown had made it "unlikely" that the Fed would begin raising rates in June—as indeed proved the case. T. Rowe Price traders note that the Fed also sent a clearly dovish signal at its June meeting-the number of members on the rate-setting committee who anticipate one or no rate increase this year went from three at the last meeting to seven. The shift raised the likelihood of a scenario in which the Fed will raise interest rates slightly and then pause to see what the effect will be on financial markets and the economy.

Greece reaches tipping point
A worsening of the Greek debt situation caused the quarter to end on a down note, however. U.S. markets followed their European counterparts lower at the start of the month, after Greece announced that it would bundle several debt payments to the International Monetary Fund (IMF) into a single payment at the end of the month. Bouts of optimism followed news of concessions on both sides, but it became increasingly clear as the month progressed that the European Central Bank and other creditors would not extend further aid to Greece—and that the country, in turn, would fail to make its scheduled June 30 payment to the IMF. U.S. stocks endured their largest daily decline since last October on June 29, following news that Greece had shut down its stock market and banks and instituted capital controls in preparation for the default.

U.S., Europe likely to withstand Greek financial pressures
Generally, T. Rowe Price equity managers are optimistic that the U.S. economy is on solid enough footing to withstand the fallout from the Greek debt crisis, which is unlikely to bring about a broader European financial contagion. Indeed, the firm's London-based European equity analysts believe that European corporate earnings may even accelerate later in the year. European firms are generally in sound financial shape, which should support growth in capital expenditures, healthy M&A activity, and revenues and earnings gains.

Mature economic cycle should heighten the importance of individual stock selection
The outlook for U.S. equities remains generally positive, but after a six-year bull run that has seen the S&P 500 rise more than 200%, T. Rowe Price managers note that investors may have grown too complacent about the risk of short-term market volatility. Equities still appear quite attractive when measured against very low Treasury yields, but their somewhat high absolute valuations make them vulnerable to the Fed's timetable for returning interest rates to more historically normal levels. A mature economic cycle also implies that companies will have a harder time expanding margins by cutting costs, and that only companies that are executing well will be able to see solid profit growth. We believe that finding the standout performers in each industry will be increasingly important in coming months and that the careful selection of individual stocks is likely to add value relative to a broad-based, index approach.

Second Quarter 2015

Fed liftoff fears drive loss for Treasuries
U.S. Treasuries posted their first quarterly loss since 2013 as fears of an imminent Federal Reserve rate increase outweighed demand for safe-haven assets as Greece moved toward default. (Bond prices and yields move in opposite directions.) The yield on the 10-year Treasury note increased from under 1.85% in early April to nearly 2.50%—the highest level in 2015—in June before falling somewhat by the end of the quarter. The Treasury yield curve steepened as longer-term yields climbed more than shorter-term rates, with the 30-year Treasury's yield increasing more than 50 basis points (a basis point is 0.01 percentage points).

Despite weak first quarter, U.S. economy poised to rebound
U.S. gross domestic product contracted at an annualized rate of 0.2% in the first quarter, as lower oil prices, the strong dollar, and a shutdown of West Coast ports weighed on growth. However, a stronger-than-expected May nonfarm payrolls report and other healthy data indicated that the economy was rebounding from the weak first quarter, which added to the uncertainty about the timing of the Fed's first rate hike. The Fed did not raise interest rates at its June policy meeting, but the generally strong U.S. economic data indicated that the central bank will begin to tighten monetary policy before the end of the year. T. Rowe Price Chief U.S. Economist Alan Levenson expects the Fed's first rate increase by the end of 2015 and anticipates that the pace of subsequent rate hikes will be much more moderate than in past tightening cycles.

Greece uncertainty creates volatility in German sovereign bonds
Early in the quarter, the European Central Bank's quantitative easing program helped support the prices of high-quality eurozone sovereign debt, as did worries about Greece's ability to meet its debt obligations. The 10-year German government note's yield reached an all-time low of 0.05% in April before a rapid sell-off later in the quarter drove it above 1.00%. However, prices of Germany's sovereign debt gained toward the end of the quarter as the impasse between Greece and its creditors continued. On June 30, Greece missed a large payment due to the International Monetary Fund. Despite the uncertainty of the Greek situation, the euro gained against the U.S. dollar for the quarter.

Total Returns
Index Second Quarter 2015 Year-to-Date
Barclays U.S. Aggregate Bond Index    -1.68%   -0.10%
Credit Suisse High Yield Index  0.30 2.90
Barclays Municipal Bond Index -0.89 0.11
Barclays Global Aggregate Ex-U.S. Dollar Government Bond Index -0.83 -5.43
J.P. Morgan Emerging Markets Bond Index Global Diversified -0.34 1.67
Barclays U.S. Mortgage Backed Securities Index -0.74 0.31
Figures of June 30, 2015. Past performance cannot guarantee future results. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.

Credit spreads on investment-grade corporates widen
Investment-grade corporate bonds underperformed Treasuries to post considerable losses as credit spreads widened. Credit spreads measure the additional yield above that of a comparable-maturity Treasury security that investors demand for holding a bond with credit risk. Heavy issuance continued to weigh on the investment-grade corporate bond market, with the supply of new bonds largely driven by merger and acquisition funding needs. In April, AT&T sold $17.5 billion of bonds—the third-largest corporate bond issue on record—to help fund its acquisition of DirecTV. Late in the quarter, food giant H.J. Heinz issued $10 billion of bonds to finance its previously announced merger with Kraft Foods.

High yield bonds generate positive returns
As one of the few fixed income sectors that avoided posting losses for the quarter, high yield corporate bonds benefited from their relatively low sensitivity to interest rate changes. Oil prices steadied at higher levels than at the beginning of the year, providing support for the asset class. Bonds from oil-related issuers account for a large proportion of most high yield indexes.

Emerging markets bonds fall
Although they are also generally less sensitive to changes in Treasury yields than debt with lower credit risk, emerging markets bonds declined nevertheless, with locally denominated debt prices falling more than dollar-denominated bonds. Early in the quarter, Petrobras, Brazil's state-owned oil company, filed audited financial statements that showed almost $17 billion of charges and write-offs related to a corruption investigation, allowing it to avoid a potential technical default. Petrobras subsequently issued new bonds for the first time since the scandal by selling $2.5 billion of debt maturing in 100 years. China's central bank lowered interest rates by 25 basis points in May and again in June due to concerns about a slowing economy and sharply lower stock prices.

Municipal debt holds up better than taxable bonds
Tax-free municipal bonds moved lower in the second quarter but broadly held up better than taxable bonds. Lower-quality and longer-maturity municipal bonds lagged higher-quality and shorter-term issues, respectively. Late in the quarter, bonds issued by the commonwealth of Puerto Rico, a major muni issuer, fell sharply after the highly indebted U.S. territory's governor announced that it will not be able to repay its debt obligations.

U.S. Treasury Yields
Maturity March 31, 2015 June 30, 2015
3-Month    0.03%   0.01%
6-Month 0.14 0.11
2-Year 0.56 0.64
5-Year 1.37 1.63
10-Year 1.94 2.35
30-Year 2.54 3.11

Strengthening housing market provides some support for MBS
Prices of mortgage-backed securities (MBS) declined less than Treasuries as light volumes of new mortgage origination and securitization provided support. The increase in intermediate- and longer-term Treasury yields also benefited MBS by making refinancing less attractive for homeowners. Refinancing causes prepayments of existing mortgages, which hurts the value of MBS backed by those mortgages. Housing market indicators pointed to continued strengthening, as data on May new and existing home sales were much better than expected. Asset-backed securities produced slightly positive returns as the market easily absorbed an uptick in new supply.

Potential for higher volatility to create relative value opportunities
The monetary policies of the world's major central banks will likely continue to dominate the global interest rate environment. While the central banks of the eurozone and Japan aggressively purchase assets in an effort to stimulate economic growth, the Fed's move toward tightening monetary policy should eventually create an upward bias for U.S. interest rates. This divergence in central bank policies, along with the uncertainty inherent in the Greece situation, could lead to increased volatility in global fixed income markets as well as more relative value opportunities.

Second Quarter 2015


Stock markets post modest gains
A strong stock market rally early in the second quarter reversed in June amid renewed concerns over the fate of Greece and uneven economic data. Developed markets ended the second quarter with small gains as measured by the MSCI Europe, Australasia, and Far East (EAFE) Index. The local-currency return for the EAFE index was -1.61%. The euro and British pound strengthened versus the U.S. dollar, but the yen declined. U.S. dollar strength, which had been a significant factor in returns over the last several quarters, moderated in the past three months. An appreciating U.S. dollar detracts from the returns for dollar-based investors that own nondollar-denominated securities.

In the EAFE index, small-cap stocks handily outperformed large-caps, while growth stocks outperformed value shares. From a sector perspective, energy, telecommunication services, and utilities performed best. The worst-performing sectors in the index were materials, health care, and information technology.

Within emerging markets, stocks in Latin America and the Europe, Middle East, and Africa region recorded solid gains, but Asian emerging markets posted a modest loss. Brazil, Russia, and China advanced more than 6%, but India declined nearly 4%.

International Indexes
  Total Return
MSCI Index Second Quarter 2015 Year-to-Date
EAFE (Europe, Australasia, Far East)    0.84%    5.88%
All Country World ex-U.S.A 0.72 4.35
Europe 0.68 4.28
Japan 3.12 13.79
All Country Asia ex-Japan 0.65 5.59
EM (Emerging Markets) 0.82 3.12
All data are in U.S. dollars as of June 30, 2015. Past performance cannot guarantee future results. This chart is shown for illustrative purposes only and does not represent the performance of any specific security
Regional Recap

Greece defaults on IMF loan
Global stock markets rallied and swooned on speculation as to whether Greek Prime Minister Alexis Tsipras would be able to craft a last-minute deal with Greece's creditors. As the second quarter came to a close, it became apparent that Greece would become the first advanced economy to miss a payment to the International Monetary Fund (IMF). The Greek government temporarily closed its banks and stock market, and it imposed capital controls limiting withdrawals from ATMs. Tsipras criticized the European finance ministers for refusing to extend Greece's loan program, claiming that they had "no other goal apart from blackmailing the Greek people." Europe's geopolitical dysfunction has led to a spike in global stock market volatility, especially in Europe, where the broad market fell about 5% in the last week of June. Greece's future appeared to rest on a snap referendum set for July 5, in which Greek voters issued a resounding "No" vote on the European Union's proposed bailout terms that were required for continued financial assistance. What comes next is a highly uncertain path, possibly culminating in Greece exiting the eurozone.

Consumer prices in the eurozone stabilize
Consumer prices in the eurozone rose modestly in the second quarter, arresting concerns about deflation. The quantitative easing program that kicked off in March appears to be having a positive impact despite the near 50% slide in oil prices since mid-2014. European Central Bank (ECB) President Mario Draghi indicated he was pleased with the eurozone's consistent policy response and predicted that "the weak and uneven recovery experienced in 2014 will turn into a more robust, sustainable upturn." Draghi confirmed that the ECB intends to continue its quantitative easing program until September 2016 or when the eurozone achieves its inflation target of 2%.

Japanese stocks post solid three- and six-month gains
The Japanese government's efforts to pull the country out of its multidecade pattern of deflation and stagnating economic growth appear to be working, as investors continued to bid up Japan's stock market. Japan's first-quarter economic growth was revised sharply higher to an annualized rate of 3.9% to reflect stronger-than-estimated capital expenditures. Japanese consumers increased spending for the first time in more than a year in May. The weak yen provided a boost to Japan's large export sector, spurring sales for automakers and other industries. However, consumer prices rose a scant 0.1% for the year through May, well shy of the Bank of Japan's 2% target.

The white-hot Chinese market doused with cold water
China's restricted A-shares market gained nearly 13% in the second quarter and is up more than 100% in the past 12 months. Mainland A-shares are generally only available to Chinese citizens and qualified institutional investors. However, the market has been extremely volatile. From its June 12 peak the market fell about 20% in two weeks, prompting the Chinese central bank to cut its benchmark interest rate to a record low and reduce reserve-requirement ratios for some lenders. The central bank's rate and reserve cuts (the fourth reduction since November) are designed to prevent a so-called economic "hard landing."

Non-U.S. stocks should continue to benefit from quantitative easing initiatives Overall, T. Rowe Price portfolio managers are confident that Europe offers long-term growth potential. "The recent earnings season has been broadly positive, with seven out of 10 sectors beating forecasts. This has led earnings expectations to be revised higher, particularly for more cyclical areas of the market," notes Dean Tenerelli, portfolio manager of the European Stock Fund. In general, portfolio managers are also encouraged by the changes taking place at the corporate level in Japan, including the newfound focus on return on equity, improvements in corporate governance, and generally improving returns for shareholders. Central bank monetary policies diverge as the U.S. looks toward interest rate policy normalization, Europe and Japan advance their quantitative easing programs, and many emerging markets lower interest rates to stimulate growth.

In this changing environment, U.S. stocks have slightly higher valuations than the rest of the world, but perhaps deservedly so. Developed European valuations are no longer particularly cheap, though they remain generally appealing on a relative basis. Having enjoyed a sharp rally to date in 2015, Japanese equities now also seem to be optimistically priced. Emerging markets valuations vary widely by country, which is an appropriate reflection of the considerable disparity in fundamentals and currency concerns in developing nations.

Second Quarter 2015

Emerging markets stocks edge higher on hopes for Fed inaction
Emerging markets stocks rose in the second quarter, lifted by an April rally on speculation that the Federal Reserve would delay a widely expected interest rate hike until this year's second half. Rising U.S. rates reduce the relative attractiveness of assets in emerging markets, where yields are currently higher than those in developed markets, and raise the risk of capital outflows from the developing world. The MSCI Emerging Markets Index rose to a seven-month high in late April but pared most of its gains over the rest of the quarter as talks between Greece and its creditors failed to produce an agreement on its debt. The index tumbled on June 29 after negotiations broke down and Greece shut down its banks, raising fears of a disorderly exit from the euro. Greece's imposition of capital controls coincided with a one-day plunge in Chinese stock markets in Shanghai and Shenzhen that, after several days of losses, pushed China's benchmark index into a bear market—a drop of more than 20%. Six of 10 sectors in the MSCI Emerging Markets Index rose, three declined, and the utilities sector ended almost flat. Energy stocks performed the best, while health care stocks fell the most.

International Averages
  Total Returns
MSCI Index Second Quarter 2015 Year-to-Date
Emerging Markets (EM) Index     0.82%    3.12%
Asia Index -0.04 5.22
Europe, Middle East, Africa (EMEA) Index  2.05 4.10
Latin American Index  3.61 -6.22
All data are in U.S. dollars as of June 30, 2015. This table is for illustrative purposes only and does not represent the performance of any specific security. Past performance cannot guarantee future results
Regional Recap

Chinese stocks reach seven-year high; Indian stocks decline

  • Chinese stocks advanced. The restricted A-shares market surged nearly 13%, but mainland stock markets tumbled from their highs in June after regulators took steps to clamp down on margin financing. China's central bank unexpectedly reduced its benchmark interest rates and the required level of reserves for certain banks on June 27, a move that was seen as a sign that the government wants to support the market without fueling more speculative trading.
  • Indian stocks declined as some investors opted to lock in profits after the Sensex benchmark rose to a record in January. India's central bank cut its key rate in June for the third time this year, days after the government reported that gross domestic product (GDP) grew at a better-than-expected 7.5% annual pace in the first quarter. But weak corporate performance and other gauges have raised doubts about whether the economy is as strong as the GDP data suggest.
  • Southeast Asian markets declined. Most countries in the region reported first-quarter GDP growth that missed economists' forecasts. Indonesian stocks fell the most, losing roughly 14%, as economic growth slowed to a five-year low, raising expectations of a shake-up in the newly elected president's cabinet.

Brazilian stocks rise despite looming recession; Andean markets mixed

  • Brazilian stocks advanced despite data showing the economy is falling into a recession this year and news of a widening bribery scandal involving Petrobras, the state oil producer. In April, Petrobras filed its long-awaited audited financial statements, which lifted some investor uncertainty about Brazil's sovereign credit rating.
  • Mexican stocks rose slightly. Mexico's central bank kept its benchmark interest rate at a record low and the government cut its full-year GDP growth forecast during the quarter. The revised GDP growth target of 2.2% to 3.2% signals another disappointing year of growth for Mexico, which has been hit by lower crude oil prices and weak U.S. activity early this year.
  • Andean markets were mixed. Stocks rose in Colombia and Peru but retreated in Chile. Central banks in all three countries kept their respective interest rates unchanged over the quarter as they grappled with commodity weakness, rising inflation, and sagging currencies against the U.S. dollar.

Russian stocks rebound on increased risk appetite; Turkish stocks advance

  • Russian stocks added almost 8% on increased risk appetite. Russia's central bank cut its key rate twice during the quarter, and officials deemed that the worst of the economic crisis due to Western sanctions and slumping oil prices is over. But in June, the European Union extended sanctions on Russia until January, and most analysts think the country will be in a recession into 2016.
  • Turkish stocks strengthened despite greater political uncertainty after the ruling AK Party lost its majority in parliamentary elections in June. The majority loss means that the AKP must form a coalition government and raises the possibility of another election if a new government cannot be formed. The lira sank to a record low against the dollar and the domestic benchmark plunged the day after the elections.
  • South African stocks declined. Unemployment rose to a 10-year high in South Africa and its GDP growth slowed from last year's fourth quarter. Despite the poor state of the economy, South Africa's central bank is expected to raise interest rates in the near term to stem inflation, which faces upward pressure from currency weakness and rising electricity prices.

Solid fundamentals offset near-term risks
We are optimistic about the long-term outlook for emerging markets. Rising consumption, an expanding middle class, and real wage growth are the drivers of huge economic potential in the developing world. Emerging markets are trading at a significant discount on an absolute and relative basis, 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. Finally, most emerging markets are still expanding faster than developed ones and offer solid growth opportunities for long-term investors. In recent years, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. We anticipate more divergence in the performance of countries and companies than we have seen in the past 15 years, and we believe that careful stock selection will be crucial for producing good returns over time.