Quarterly Market Wrap-Ups

First Quarter 2013

U.S. stocks score solid gains in first quarter

U.S. equities rose in the first quarter of 2013, lifting several major indexes to multiyear, if not all-time, highs. Share prices advanced as the economy continued to expand, the labor market improved somewhat, and the Federal Reserve persisted with its asset purchase plans to suppress interest rates and stimulate growth. Merger activity also raised investor sentiment, although that sentiment was tempered by concerns that the European debt crisis would flare up again. Cyprus temporarily closed its banks to prevent a run on deposits but finally agreed to a controversial bailout plan from the European Union and the International Monetary Fund involving losses to some depositors.

Most sectors turn in robust results

Most S&P 500 sectors posted double-digit returns. The noncyclical health care, consumer staples, and utilities sectors fared best, as investors favored stocks offering relatively high dividend yields, strong brands, and business models that had lagged earlier. Consumer discretionary, financials, industrials and business services, energy, and telecommunication services shares also performed extremely well. Materials and information technology shares lagged. Mid- and small-cap shares outpaced large-caps, although there was strength across the board. The performance of value and growth stocks was mixed, with growth exhibiting the most strength in the small-cap arena.

U.S. economy continues to expand slowly

The U.S. economy expanded at a sluggish annualized pace of 0.4% in the fourth quarter of 2012, according to the last reading from the Commerce Department. It was the slowest growth rate since the first quarter of 2011 and far below what is needed to lower the unemployment rate. However, several factors that restrained results—including a slowdown in inventory accumulation and a steep decline in military spending—are expected to abate this year. In addition, consumer spending, which accounts for roughly 70% of U.S. economic growth, has picked up, and the housing market has grown progressively stronger. Home prices rose 8.1% in January from a year earlier, according to the S&P/ Case-Shiller Home Price Index, which measures prices across 20 of the largest markets in the country. It was the biggest year-over-year gain in housing prices since June 2006, with all 20 markets advancing.

The Federal Open Market Committee (FOMC) ended a two-day meeting in March with no change in monetary policy, although it did alter its assessment of the economy. The FOMC stated that "labor market conditions have shown signs of improvement in recent months," which was slightly more upbeat than its statement a month earlier. The Fed said it would maintain its low interest rate policy until the unemployment rate falls below 6.5% and annual inflation remains below 2.5%. The central bank will also continue to buy $85 billion worth of Treasury and mortgage securities every month but will trim the pace of its purchases incrementally in response to progress on the labor front. "In determining the size, pace, and composition of its asset purchases," the FOMC statement said, "the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases, as well as the extent of progress toward its economic objectives." T. Rowe Price economists believe that the Fed could begin to reduce the pace of its purchases in the second half of this year.

Positives outweigh negatives going forward

Considering the strong run in stocks during the past few months, we would not be surprised to see a short-term correction going forward. That said, the positives outweigh the negatives in our view. The U.S. economy should continue to expand at a moderate pace with contained inflation, propelled by housing and growing strength in the labor market. The U.S. is in a good position relative to other developed markets. The industrials sector is performing better, and Congress and the Obama administration appear less contentious than at the end of last year. The Federal Reserve is likely to keep its stimulus programs in place a while longer. Eurozone risks remain with us, but they could decline in the months ahead. We rarely make dramatic changes to our investment strategies based on macroeconomic concerns. Rather, we prefer to focus on individual companies whose price/earnings multiples look attractive and growth prospects seem promising. An expansion in multiples would add a boost to overall stock market performance.

First Quarter 2013

Bonds flat overall as long-term yields rise

Relatively upbeat news about the global economy and a growing appetite for riskier assets led to a modest overall loss for investment-grade bonds in the first quarter. Longer-term Treasury bond prices fell and yields rose as favorable economic data lessened their appeal as a perceived safe haven. Investmentgrade bonds, with very low nominal yields, performed in line with the overall market and significantly lagged high yield bonds, which benefited from robust capital market activity, including record new issue volume and strong demand for the asset class despite low yields from a historical perspective. Mortgage-backed securities (MBS) recorded a modest loss but performed a bit better than the overall investment-grade market. Higher MBS yields appear to be starting to lure some private buyers back into the market alongside the Federal Reserve. Municipals enjoyed modest gains, as investors sought taxsheltered income amid higher tax rates and supply was constrained early in the period due to seasonal factors. Bonds from overseas markets saw steeper losses. Falling currencies relative to the U.S. dollar weighed on bonds from developed markets, while a rise in risk aversion hampered emerging markets.

Treasury yields rise as data suggest continuing recovery…

Treasury yields rose over the first quarter as most forward-looking signals suggested that the U.S. economic recovery remained on track. Both weekly jobless claims and the unemployment rate dropped to multiyear lows, while gauges of manufacturing and service sector activity were generally favorable. Further evidence arrived that the U.S. housing market had turned a long-awaited corner, as prices, sales, and construction activity all increased. A modest rebound in the crucial Chinese manufacturing sector suggested that the slowdown in the global economy had also come to an end, boosting the prospects for U.S. exports.

…While fiscal uncertainty temporarily eases

Uncertainty over fiscal policy also diminished, lessening a serious threat to the economy that had hampered economic prospects in 2012 and encouraged investors to seek out Treasuries and other lowrisk assets. In particular, a vote to delay a confrontation over the federal government's statutory debt limit removed an important layer of uncertainty hanging over the economy and markets. Congress and the Obama administration were unable to come up with an agreement to avoid sequestration, a series of automatic spending cuts to defense and domestic discretionary and nondiscretionary programs that were designed to force deficit reduction. Markets took the cuts largely in stride, however, as their short-term impact appeared to be muted, and hopes grew that the two sides would be able to replace them with a longerterm budget deal. Nevertheless, T. Rowe Price managers note that the debt ceiling fight is due to resurface soon, next year's budget still needs to be worked out, and the U.S. will face another "fiscal cliff" at the end of 2013.

Worries resurface over Europe and limit rise in yields

After having faded somewhat from the headlines in recent months, concerns about the eurozone moved back to the forefront in the middle of the quarter. Allegations of political corruption in Spain and election gains by anti-austerity parties in Italy led to worries that a turn from austerity in these two significant economies would threaten to reignite the eurozone's sovereign debt crisis, which has cooled since a new round of measures was introduced last fall. Late in the quarter, a bungled plan to save the banking system in the small eurozone economy of Cyprus raised additional concerns. These episodes caused the euro to fall sharply against the U.S. dollar throughout the second half of the quarter, while also limiting the rise in U.S. Treasury bond yields, as investors favored them as a perceived safe haven.

Federal Reserve may stop purchasing long-term bonds sooner than expected

Finally, the Federal Reserve played an important role in driving credit markets, even as it kept monetary policy unchanged in the short term. At the start of the quarter, the Fed released minutes from its December meeting, which revealed that some members were growing more reluctant about increasing the size of the Fed's balance sheet. The Fed's portfolio of holdings has grown dramatically as the Fed has been purchasing debt—in the form of Treasury bonds and MBS—in order to suppress interest rates. Although Fed Chairman Ben Bernanke defended the Fed's program, by the end of the quarter, the Fed's policy committee was acknowledging that it would take account of further economic gains "in determining the size, pace, and composition of its asset purchases." T. Rowe Price's economics team notes that further asset purchases could make it more difficult to remove monetary accommodation and could hamper market functioning and financial stability. A sooner-than-expected end to Fed purchases could cause yields to rise, however, as the Treasury market loses a key buyer.

"Great Rotation" or not, stick to your plan

The underperformance of fixed income markets relative to stocks in the first quarter led to increasing speculation that a "Great Rotation" from bond to equity markets had begun. Over the past several years, individual investors have redirected billions in assets from stocks to bonds, suggesting that a turnaround will eventually be at hand. T. Rowe Price fixed income analysts note that while investors' interest in equities has clearly grown in 2013 and flows into equity mutual funds have increased, bond funds also continue to receive inflows, and interest in global bond funds remains strong.

Whether or not a broader shift from fixed income to equities has begun, T. Rowe Price's financial planners stress that it is important for individual investors to choose an appropriate allocation between stocks and bonds and stick to it. Indeed, investors should take care to periodically rebalance their portfolios in response to rising valuations in one segment or the other. Rebalancing too frequently might be counterproductive because of trading fees and capital gains taxes; in many cases, an annual adjustment may be sufficient.

First Quarter 2013

Developed non-U.S. stock markets posted solid first-quarter gains, the bulk of which were recorded in January as fear about the European debt crisis receded. Although the market retreated a bit in February, most regions and countries recorded decent gains in March. While most agree that the eurozone financial crisis is not over, the European Central Bank's infusion of liquidity into its banking system and a regional agreement to slash deficits have reduced borrowing costs and assured investors about the safety of the euro. Emerging markets stocks were broadly lower, giving back all the gains from January and February in March in part due to concerns about slowing growth and on currency weakness. The largest emerging markets, known as the BRIC countries (Brazil, Russia, India, and China), were weak as a group and declined more than the overall emerging markets benchmark. Valuations in developed and emerging markets remain selectively attractive despite the first-quarter gains.

Growth stocks outperformed value shares within the MSCI Europe, Australasia, and Far East (EAFE) Index. Small-cap companies outperformed large-caps for the three-month period. Stocks in the health care sector were the best performers, advancing more than 12%; consumer staples posted a double-digit gain; and consumer discretionary stocks also performed well. The materials sector was weakest, falling nearly 5% in the quarter. Other poorly performing sectors included energy and utilities. The yen and the British pound declined substantially versus the U.S. dollar, and the euro was also weaker, but not to the same extent.

Japan leads Asia's markets higher

Investors embraced Japan's efforts to kill its deflationary spiral and attain a 2% inflation target through aggressive monetary policy measures. The Japanese stock market rallied as exports increased more than expected. Sales to the U.S. showed the biggest improvement, helped by the strength of the dollar versus the yen. Developed markets across the rest of the Pacific region posted solid three-month results. Emerging markets within the region were mixed. China, India, South Korea, and Taiwan recorded losses for the three-month period, while Indonesia, the Philippines, and Thailand saw returns in excess of 10%. China, the world's second-largest economy, is forecast to have expanded at an 8% annualized clip in the first quarter, following 7.4% and 7.9% gains in the third and fourth quarters of 2012, respectively. The good news for the region is that China's manufacturing index expanded in March. The official purchasing manager's index rose to 52.7; a reading above 50 indicates expansion.

European markets post uneven gains

Despite marginal losses in March, stock markets in Europe posted solid first-quarter returns. After Greece managed the largest debt write-down in history, it received a second round of bailout monies worth €130 billion. Although Greece still faces a slow recovery and needs to enact strenuous economic reforms, its stock market advanced 14% in the first quarter. Italy's stock market went in the other direction, falling nearly 10% in the past three months. The Italian government was recently forced to sell three-year bonds at 2.48%, the highest interest rate it has paid since December. A combination of events, including the recent stalemated election, inaction on reform initiatives, and lack of economic growth, led credit rating agency Fitch to downgrade Italy's debt rating to BBB+, which is only three notches above junk bond status. The eurozone's third-largest economy is staggering under a €2 trillion debt burden. Investors have pushed up the risk premium on Italy's bonds due to the uncertainty. Much like Italy, Spain, the eurozone's fourth-largest economy, is struggling under a giant debt load. However, its bond yields have continued to drift lower since European Central Bank President Mario Draghi said he would do "whatever it takes" to save the euro. Nevertheless, the Spanish stock market was among the largest first-quarter decliners, falling more than 5%.

Longer-term outlook remains favorable

Policymakers continue to provide more monetary and fiscal support than most investors had expected, which is contributing to positive sentiment and higher equity prices in most developed non-U.S. markets. Investor concerns about the European sovereign debt crisis have eased, and equity markets are benefiting from a steady shift from low-yielding money funds into stocks. In Japan, markets have been even more positively influenced by policy aimed at lifting inflation and asset prices. Although most emerging markets generate stronger economic growth than their developed counterparts, several of the larger developing stock markets are challenged to meet growth expectations and are challenged by policy issues. Overall, we remain optimistic on the long-term for non-U.S. equities. While near-term trends may persist for a bit, longer term we think that emerging markets offer a better risk/reward proposition than developed equity markets. As always, we remain focused on bottom-up stock selection, and right now we favor companies that generate stable growth and solid cash flow.

First Quarter 2013

Emerging markets decline as developed world outlook improves

Emerging markets stocks fell in the first quarter as slowdowns in a few emerging countries led investors to shift money out of the asset class in favor of developed markets, which have lately benefited from a better growth outlook. Lower commodity prices hurt resource-dependent emerging economies like Russia, while sagging currencies across the developing world further dampened emerging markets stocks. Flagging growth in Brazil, India, and China from the rapid pace of recent years spurred investors to rotate funds into the U.S. and Japan, where growth expectations have picked up due to unprecedented accommodative monetary policies. As a result, emerging markets stocks widely trailed stock markets in the U.S. and Japan, both of which rallied more than 10% over the quarter.

The MSCI Emerging Markets Index sank to a three-month low on March 22, ending a week during which Cyprus struggled to avoid a banking system collapse in the latest flare-up of the European debt crisis. However, the index pared some of its losses by quarter-end after European leaders agreed on a bailout for the troubled country. Five sectors advanced, and five declined. Materials, energy, and telecommunication services paced decliners with losses of more than 4%. Among gainers, health care, consumer staples, and utilities rose the most.

China slumps on housing measures; Southeast Asia shines

Stocks in China fell after the government announced policies in March aimed at cooling the real estate market, including higher down payments and mortgage rates. The measures from China's State Council sparked the biggest drop for the Shanghai stock exchange's property index since 2008 and reflect the government's latest efforts to tamp down prices in response to growing discontent about housing affordability. India's market declined largely due to a drop in February after the prime minister outlined more external borrowing than expected in next fiscal year's budget, raising concerns about the government's ability to control a widening fiscal deficit. Indonesia, the Philippines, and Thailand all posted double-digit gains. Southeast Asian markets have generally benefited from resilient domestic consumption and are driven less by export demand compared with other Asian countries, factors that have helped them outperform their larger neighbors. Additionally, the Philippines won its first investment-grade credit rating from Fitch Ratings, which helped propel its stock market to a record high on March 27.

Mexico rallies on reform optimism; Brazil declines

Mexico added more than 6% and was the region's top performer, lifted by reform hopes of its new president, who pushed through several key reforms soon after he took office in December. Mexico's central bank cut its benchmark interest rate on March 8 for the first time since 2009. The rate cut to a record-low 4% followed several indicators showing slowing growth and a tame inflation outlook in Latin America's second-largest economy. Brazilian stocks declined amid a weak macroeconomic environment as the government continued efforts to boost growth through tax cuts and other measures without fanning inflation. Brazil's central bank has held its benchmark rate at a record-low 7.25% since the start of the year, although inflation is hovering near the top of its target range. Stocks in the smaller Andean markets of Colombia and Peru fell.

Turkey rallies on upgrade; Russia and South Africa stumble

Turkey was among the top gainers in the EMEA region, surging more than 8%, after Standard & Poor's raised its sovereign credit rating to one level below investment grade. S&P's upgrade, which came after Fitch gave Turkey its first investment-grade rating in November, raised speculation that Turkey will win another investment-grade rating this year. Russian stocks fell as prices for oil, its biggest export, declined. Russia's economy has shown signs of weakness, with rising inflation and softening consumer demand. The financial crisis in Cyprus also raised concerns that Russian investors, who deposited billions in Cypriot banks, would suffer huge losses as a result of the bailout package it obtained from European lenders. South African stocks retreated more than 8%. In addition to the hurtful impact from mining unrest that started last summer, South Africa is grappling with rising inflation worsened by a weak currency, which has prevented the central bank from easing monetary policy to boost growth.

Long-term growth outlook remains intact despite near-term volatility

We expect that developments in Europe, slowing growth in China, and unresolved fiscal problems in the U.S. will drive volatility in emerging markets stocks in the coming months. Emerging markets stocks have underperformed U.S. stocks in the year-to-date period, and recent fund flow data show investors have retreated from developing markets stocks as their returns have lagged. As a result, valuations for developing markets stocks have become increasingly attractive relative to developed markets stocks in recent weeks. We believe that current valuations are pricing in many of the near-term risks for the asset class.

Over the medium to longer term, we remain optimistic about the growth outlook for emerging markets. We believe that increasing consumption, a growing middle class, rising real wages, and greater upward mobility will drive strong and sustainable growth across the developing world over time.