Third Quarter 2013
Stocks see strong gains on Fed hopes
Stocks enjoyed strong gains in the third quarter. Buoyed by hopes for continued monetary stimulus and a rebound in the global economy, investors bid up stocks despite slowing profit growth. Most of the major stock indexes moved further into record territory before pulling back late in the period. Gains were strongest in the Nasdaq Composite Index, which reached its best level in 13 years. Small-cap stocks, which typically see bigger price swings than large-caps, also fared particularly well.
Fears of rising rates diminish
After alarming investors in May and June by signaling that it might soon dial back on its asset purchases, the Federal Reserve played a strong role in bolstering sentiment in the third quarter. Early in the period, Fed officials managed to quell worries that they would soon increase short-term interest rates, while also assuring investors that they would tread carefully in allowing long-term interest rates to drift higher. Indeed, equity markets jumped late in the quarter after the Fed surprised most observers by deciding to delay tapering its purchases of long-term securities, which have suppressed long-term rates to help the economy improve.
Global economy shows signs of resurgence
Investor sentiment was also boosted by encouraging signs on the global economy. The recession in the eurozone appeared to be coming to an end, raising hopes for U.S. firms with substantial operations in the region. Emerging markets economies, which have struggled in recent months, seemed to be gaining traction as well. Renewed conflict in Egypt and the prospect of U.S. intervention in the Syrian civil war weighed on stock prices temporarily, but stocks recovered as it became evident that the Syrian conflict was not spreading to major oil-producing nations in the Middle East.
Slow recovery continues in U.S.
Investors were encouraged by strong readings on U.S. manufacturing and service activity, although the housing sector appeared to be feeling the pinch of rising mortgage rates. Retail sales growth was generally subdued, but healthy auto sales indicated consumers' growing willingness to spend on big-ticket items. The pace of U.S. job growth slackened during the quarter, yet investors generally seemed to interpret the data in a positive light, assuming that the slowdown might stay the Fed's hand in tightening monetary policy. Conversely, good news was sometimes treated as bad news: Reports showing a typically welcome decline in weekly jobless claims prompted market declines on a few occasions.
Quarter ends on a down note
After peaking following the Fed's decision not to taper its asset purchases on September 18, stocks ended the quarter on a down note. Part of the decline may have reflected a growing concern about the Fed's more guarded assessment of the economy. Chairman Ben Bernanke explained that policymakers had observed several signs of weakness in the economy in recent months, which discouraged them from tapering the Fed's asset purchases until they saw more evidence that the recovery was on more stable footing. Investors also worried about impending budget battles in Washington, which threatened to worsen the fiscal headwinds on the economy.
Positive global economic signals helped the materials sector lead gains in the S&P 500 for the quarter, and industrials shares were also particularly strong. Utilities stocks lagged notably as rising bond yields diminished their dividend appeal, but telecommunication services was the only segment to record a loss in the period. Growth stocks handily outpaced value shares across all capitalization ranges.
|Index1||Third Quarter 2013||Year-to-Date|
|S&P MidCap 400||7.54||23.23|
Fundamental factors are likely to become more important
While monetary policy has always played an important role in driving markets, recent months have seen investors paying exceptional attention to signals coming from the central bank. T. Rowe Price managers note that, as the Fed eventually gets closer to winding down its stimulus, fundamental factors, such as corporate earnings and cash flow, should become more important. This may heighten the importance of research into individual stocks when seeking superior long-term returns—particularly as companies wrestle with only a moderately growing economy. Without either Fed policy or a robust economic expansion lifting all boats, investors will have to become increasingly selective as they search for the companies that are able to execute well.
1The 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 of small companies are unmanaged indices representing various segments by market capitalization of the U.S. equity markets. The Nasdaq Composite is an unmanaged index representing the companies traded on the Nasdaq stock market and the National Market System.
Third Quarter 2013
Surprise Fed delay on tapering
For the majority of the third quarter, the fixed income market featured rising yields and an aversion to securities with significant interest rate risk as investors widely anticipated that the Federal Reserve would begin to "taper" its asset purchases in September. However, on September 18 the Fed announced that it would maintain its current monthly pace of buying $45 billion in Treasuries and $40 billion in agency mortgage-backed securities (MBS). The delay in Fed tapering boosted fixed income market sentiment in general and benefited fixed income asset classes with more risk, such as emerging market debt in particular.
Treasury yield curve steepens
The Fed's September statement triggered a rally in Treasuries, pushing yields lower than in early September. The yield on the benchmark 10-year Treasury note, for example, briefly pushed through the 3% barrier at the beginning of September as traders continued to sell Treasuries in anticipation of lower demand from the Fed and stronger economic growth. After the Fed statement, prices rallied and yields declined. However, at the end of the third quarter, longer-term Treasury yields were still higher than they were on June 30. Short-term Treasury yields inched lower over the course of the quarter as the yield curve steepened. Agency MBS, another beneficiary of the Fed's continued rapid pace of asset purchases, turned in respectable returns for the quarter.
Slow economic recovery continues
Data released during the quarter generally pointed to a slow but steady return to a more vigorous U.S. economy. This helped boost market expectations that the Fed would start to scale back its asset purchases. The unemployment rate fell to 7.3% in August from 7.6% in June, although some of that decline stemmed from potential workers dropping out of the labor force. The unemployment rate is still far above the 6.5% threshold that the Fed has said would cause it to consider raising the federal funds rate. In late August, the government reported that gross domestic product (GDP) grew at a 2.5% annual rate in the second quarter, which was up from an original estimate of 1.7% and significantly higher than the 1.1% annual rate in the first quarter. Inflation remained tame, with the consumer price index (CPI) for August increasing at an annual pace of only 1.5% (the core inflation rate, which the Fed closely monitors, was 1.8%).
|Index1||Third Quarter 2013||Year-to-Date|
|Barclays Capital U.S. Aggregate Bond Index||0.57%||-1.89%|
|Credit Suisse High Yield Index||2.39||3.94|
|Barclays Capital Municipal Bond Index||-0.19||-2.87|
|Barclays Capital Global Aggregate Ex-U.S. Dollar Government Bond Index||4.38||-2.38|
|J.P. Morgan Emerging Markets Index Plus||0.51||-8.89|
Credit concerns weigh on municipals
Municipal bonds endured a sell-off for most of the quarter before recovering to some degree in September. Rising yields triggered some municipal market outflows in June, and concerns about the credit quality of municipalities started to build in mid-July, when Detroit filed for bankruptcy protection, and accelerated amid negative media headlines over the summer about Puerto Rico's deteriorating fiscal condition. Puerto Rico's municipal bonds are widely held as a result of their exemption from federal and state taxes. Eventually the yields on longer-term municipal debt moved significantly higher than Treasury yields, which, because of the tax advantages of munis, is unusual. These yields attracted more buyers to the municipal market, and demand started to return after the Fed's September announcement that it would not yet start to taper its asset buying.
Strong new corporate issuance
Corporations continued to take advantage of interest rates that are still quite low by historical standards by issuing new bonds. Both investment-grade and high yield issuers rushed to bring new debt to market in the quarter rather than waiting and taking the risk that another increase in interest rates would boost their cost of funding. Verizon brought $49 billion of new bonds across a range of maturities to market in September, shattering the previous $17 billion record set by Apple in April. The underwriters of the blockbuster Verizon issue priced the bonds attractively, and the new debt traded actively in the secondary market.
Market demand for corporates was strong enough to offset the additional supply coming to market, and this demand increased after the Fed's decision not to taper in September. High yield bonds, which are less sensitive to changes in interest rates than investment-grade debt, performed particularly well. However, T. Rowe Price analysts believed that some of the new high yield bond issues reaching the market were poorly priced and aggressively structured, highlighting the need for thorough credit analysis to find value in the high yield market.
Emerging market bonds rebound
Money steadily flowed out of emerging market debt portfolios over the summer due to concerns about Fed tapering and falling emerging market currencies. However, market sentiment turned abruptly in September as emerging market bonds were among the biggest beneficiaries of the Fed's announcement that it would delay scaling back its asset purchases. Also, the sovereign debt of non-U.S. developed markets produced strong returns in U.S. dollar terms in a significant rebound from a difficult second quarter.
|U.S. Treasury Yields|
|Maturity||June 30, 2013||September 30, 2013|
Uncertain political environment
The Fed's decision not to taper its asset purchases in September may help the economy overcome the potential drag caused by the partial government shutdown on October 1. T. Rowe Price economists still expect the Fed to start to taper before the end of 2013. However, a prolonged political battle over raising the federal debt ceiling later in October could damage investor sentiment toward riskier asset classes and trigger a flight to quality similar to the most recent partisan standoff over the debt ceiling in the summer of 2011. At this point, T. Rowe Price analysts think that this sort of extreme outcome is unlikely, but it is certainly not impossible given the lack of compromise between the political parties in Washington.
High yield and dollar-denominated emerging markets attractive
In this environment, T. Rowe Price fixed income analysts think that investment-grade corporate debt is fairly valued in general. There is a risk that more merger and acquisition (M&A) activity could increase the supply of investment-grade corporates issued to fund acquisitions, potentially causing the supply of corporate debt on the market to outstrip demand. On the positive side, M&A deals could also create opportunities for managers willing to thoroughly analyze credit to find compelling relative value in corporate bonds. Our analysts are positive on high yield debt, which seems positioned to continue to perform well as a result of low default rates and inflows from investors seeking yield. Dollar-denominated emerging market debt also appears poised to post solid returns as a result of attractive valuations; however, the asset class could experience more outflows if rates rise further.
Third Quarter 2013
International markets broadly higher despite heightened volatility
Developed non-U.S. stock markets generated strong returns in the third quarter of 2013, while emerging markets posted less robust gains. Developed European markets outperformed most markets in Asia and the Americas, largely due to signs of improving economic growth and investor sentiment. Despite several bouts of heightened volatility, Asia's largest markets—China and Japan—returned solid third-quarter results. However, most emerging markets continued to struggle amid concerns about slowing growth, rising interest rates across developed markets, political unrest, and currency weakness. The emerging Europe, Middle East, and Africa region outperformed other emerging regions.
Within the MSCI Europe, Australasia, and Far East (EAFE) Index, value shares outperformed growth stocks, and small-caps significantly outperformed their large-cap counterparts for the three-month period. Stocks in the telecommunication services, industrials and business services, and materials sectors generated standout performance, and many sectors in the EAFE index posted double-digit gains. Consumer staples, health care, and utilities advanced the least in the quarter but still posted positive returns. The U.S. dollar was significantly weaker versus the euro and British pound and, to a lesser extent, the Japanese yen.
|MSCI Index1||Third Quarter 2013||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||11.61%||16.59%|
|All Country World ex-U.S.||10.17||10.47|
|All Country Asia Ex-Japan||5.86||-0.08|
|EM (Emerging Markets)||5.90||-4.05|
Japan added to its solid year-to-date gains
Japanese stocks rallied more than 6% for the quarter and are ahead 24% for the past nine months. The benchmark Nikkei Average was volatile as investors questioned whether the government would succeed in its effort to end the multi-decade deflationary spiral and attain a 2% inflation target through monetary policy measures and structural reforms. The Bank of Japan continues to move aggressively to bolster the country's economy. Japanese gross domestic product (GDP) grew at a 3.2% pace in the first half of 2013 and is expected to maintain that growth through year-end. Japan's GDP growth is expected to remain above 3% into 2014. Although a weaker global environment could weigh on exports, strong policy implementation could spur business spending, which has declined significantly over the past two years. Consumer spending remained buoyant, supported by positive wealth effects and solid gains in labor compensation, and exports widened at their fastest pace in several years, aided by the significant decline in the value of the yen. Emerging markets across the rest of the Asia-Pacific region posted mixed third-quarter results. China's new leadership is rolling out structural reforms, which could accelerate in 2014, paving the way for more balanced economic growth in the years ahead. The region's largest economy posted modest second-quarter economic growth; however, improvement in the third quarter fueled double-digit gains for stocks. Tighter credit and monetary policies indicate that Chinese policymakers are willing to tolerate slower GDP growth (in the mid-7% range) in the near term as they try to stimulate domestic consumption.
European markets rally over the quarter
Thanks to a solid advance in September, the European region ended the third quarter with excellent gains. The region's largest markets were good performers, and the peripheral countries, including Greece, Spain, and Italy, surged. The largest eurozone countries are benefiting from improving sentiment, better economic data, and signs that the protracted recession ended over the summer. Europe still faces structural issues, and without further reforms and progress completing the banking union, the eurozone will likely struggle to maintain above-average trend growth of 1.5% to 2.0%. The European Central Bank remains concerned that GDP growth could remain under pressure for the rest of the year due to austerity measures and record unemployment, which was still about 12% in August. German Chancellor Angela Merkel, who won a third four-year term in late September, said that youth unemployment was Europe's most pressing challenge. The unemployment rate for those under 25 was above 50% in Spain and Greece. Nevertheless, sentiment is improving, and stocks in the region have climbed on hopes that the green shoots of economic expansion will take hold, gather momentum, and blossom.
Non-U.S. stock valuations remain attractive
We remain optimistic about the intermediate- and long-term prospects for non-U.S. equities. However, short-term gains may be somewhat muted as stocks have moved up in anticipation of improved fundamentals. While we believe that many economies are stable or improving, the results may take some time and could be uneven. Although companies in Japan and Europe will likely remain challenged to generate stable revenue growth, investor sentiment in both regions is improving. We're focused on buying and holding high-quality companies with sustainable competitive advantages and that have sound fundamentals as evidenced by above-average revenue, income, and cash flow generation. Many of these corporations have used the low interest rate environment to strengthen their balance sheets, and valuations of many companies remain reasonable from a historical perspective.
We expect the Federal Reserve's low interest rates and easy money policies to be slowly reversed in the coming years. Anticipation of higher rates has contributed to market volatility and weakness in several emerging markets but also signals improving demand, which should be a long-term plus for stocks. While several emerging markets have endured steep declines, we are still able to identify attractively valued companies with solid long-term prospects. We would not be surprised to see volatility pick up around an unexpected geopolitical event, and when we sense temporary market weakness we will attempt to be optimistic buyers.
Third Quarter 2013
Emerging markets stocks gain after Fed maintains stimulus in September
Emerging markets stocks advanced in the third quarter due to a late rally after the Federal Reserve decided to maintain the pace of its monetary stimulus. Stock markets across the developing world soared after the Fed's surprise decision on September 18, which briefly pushed the MSCI Emerging Markets Index to a four-month high. The Fed-induced rally more than offset weakness in the first two months of the quarter, when most emerging markets struggled with slumping currencies, slowing economic growth, and rising tensions in the Middle East. The Fed's move gave some breathing room to emerging markets that had been hit by heavy capital outflows since May, when the Fed suggested it might start to taper its monthly bond purchases later this year in light of the improving U.S. economy. The change in policy—which the Fed has now delayed—spurred investors to move money into the U.S. and developed markets in search of higher yields.
All sectors in the MSCI Emerging Markets Index advanced for the quarter except for consumer staples, which slightly declined. Energy stocks rose the most, gaining more than 10%, followed by materials, consumer discretionary, and information technology, each of which added more than 9%.
|MSCI Index1||Third Quarter 2013||Year-to-Date|
|Emerging Markets (EM)||5.90%||-4.05%|
|EM—Europe, Middle East, and Africa
China gains as economy stabilizes; Indonesia slumps on currency weakness
Stocks in China rose more than 12% as data showed its economy stabilized following supportive measures by the government, easing worries about a steep slowdown. China's gross domestic product (GDP) grew 7.5% in the second quarter, in line with the government's official growth target for the year. Indian stocks retreated as its currency repeatedly hit record lows over the summer despite the central bank's efforts to defend the rupee and stanch capital outflows. India has been struggling with a wide current account deficit and high inflation, leading its central bank to raise its benchmark rate in September for the first time in two years. Indonesia was the region's biggest decliner, giving up more than 23%, reflecting investors' growing alarm about the country's widening current account deficit, persistent inflation, and weak currency. The rupiah was the worst performer among all emerging and developed currencies tracked by MSCI for the quarter and year-to-date period. In response, the country's central bank unexpectedly raised its benchmark rate in September, its fourth rate hike this year.
Brazil gains on September rally; Mexico declines as GDP slows
Brazilian stocks advanced more than 8% thanks to the September rally. Both the domestic Ibovespa stock index and the local currency sank to multiyear lows over the summer. Brazil's central bank raised its benchmark rate twice over the quarter as it tried to control inflation, although the tightening is expected to weigh on already weak growth. T. Rowe Price analysts believe that Brazil is suffering from mild stagflation resulting from a mix of short-sighted government policies, lower commodities demand, and an unfavorable domestic backdrop. In our view, Brazil will achieve a stronger and more balanced economy very slowly over time. Mexican stocks declined. Mexico has been trying to shore up its economy, which suffered its first contraction in four years in the second quarter. In response, its central bank unexpectedly cut its benchmark rate in September for the second time this year.
Turkey falls on currency worries; Russia rallies despite ailing economy
Turkey ranked among the biggest decliners in the EMEA region for the quarter and year to date as it experienced several setbacks, ranging from antigovernment protests starting in June to a currency that sank to record lows over the summer. Investors have grown increasingly wary about Turkey's ability to finance a sizable current account deficit as the lira has weakened. Its central bank raised one of its three policy rates twice over the quarter in an effort to defend the lira, which slid more than 4% over the period. Russian stocks rallied more than 13%, but the country continued to struggle with weakening domestic demand, stubborn inflation, and a generally poor business climate that has deterred investment. South African stocks rose due to gains in metals and mining stocks following the Fed's September announcement. However, South Africa is grappling with problems such as high unemployment, weak growth, and labor unrest in the mining and manufacturing sectors.
Solid long-term fundamentals outweigh near-term worries
Emerging markets stocks have lately lagged those in developed markets due to disappointing growth and the cyclical nature of their economies. Nevertheless, we are confident that emerging markets stocks are an attractive asset class over the medium to longer term. Most emerging markets have implemented sensible macroeconomic policies over the past 15 years, resulting in greater fiscal discipline, relatively tame inflation, stronger financial systems, and improved political stability. A growing middle class, rising consumerism, and attractive demographics in many emerging markets continue to support good growth opportunities for a wide range of companies. Finally, stocks across the developing world are trading at a significant discount relative to their history and their developed market peers, making current valuations compelling for long-term investors. We believe that the solid fundamentals underpinning the emerging markets companies in which we invest are intact despite their disappointing year-to-date performance.