Third Quarter 2014

Large-caps end higher after volatile quarter; small-caps stumble
The large-cap benchmarks managed modest gains for the quarter after overcoming a sharp sell-off in July and despite renewed selling pressure as the period came to a close. The smaller-cap indexes fared much worse, however, with a particularly sharp decline for the small-cap Russell 2000 benchmark pushing it into negative territory for the year-to-date period. Performance also varied widely among sectors. Health care stocks saw good gains and fared best within the Standard & Poor's 500 Index, followed closely by information technology shares. Conversely, energy stocks suffered steep declines as oil prices fell, and utilities and industrials and business services shares also performed poorly.

U.S. Stocks
  Total Return
Index Third Quarter 2014 Year-to-Date
DJIA    1.87%    4.60%
S&P 500 1.13 8.34
Nasdaq Composite 1.93 7.59
S&P MidCap 400 -3.98 3.22
Russell 2000 -7.36 -4.41
Note: Returns are for the periods ended September 30, 2014. The returns include dividends based on data compiled by T. Rowe Price, except for the Nasdaq Composite, whose return is principal only.

U.S. economy strengthens
Investors received a variety of signals during the quarter that the U.S. economy was picking up speed in the second half of the year, as many had predicted. Labor market data were especially strong, with payroll statistics reaching their most favorable levels since the late 1990s, by some measures. The manufacturing sector remained robust, while a better job market and rising consumer spending appeared to drive healthy growth in the much larger service sector. Investors were also relieved to see evidence that the housing sector had regained traction as homebuyers reconciled themselves to somewhat higher home prices and mortgage rates.

Corporations leverage economic growth into faster profit growth
Investors were also encouraged that corporations had been able to leverage moderate economic growth earlier in the year into faster profit growth. A generally positive tone to earnings reports helped provide momentum to the market at the start of the third quarter. Analytical firm FactSet reported that overall earnings for companies in the S&P 500 had increased by 7.7% in the previous quarter, well above the 4.9% growth expected before the reporting season began. Moreover, nearly three––quarters of companies' earnings surpassed analysts' estimates.

A change in Fed policy, which occasionally raised concerns, failed to materialize...
Investors kept a wary eye on how the Federal Reserve would react to the improved economic data, however. Some worried that strength in the labor market, in particular, might cause the central bank to signal an increase in short-term rates sooner than anticipated, and markets pulled back on occasion in apparent anticipation of a change in Fed policy. Policymakers put these fears to rest at their September policy meeting by signaling no substantial change in their interest rate forecast, which may have been a catalyst in pushing stocks to record highs soon after.

...while a rising dollar weighed on stocks
While rate increases remained a future threat, healthy U.S. economic growth had a more immediate impact on the U.S. dollar, which also concerned investors. Weaker economic signals from Europe helped the dollar reach a two-year high against the euro, while aggressive monetary easing in Japan took the yen to a six–year low against the greenback. The escalating crises in Ukraine and the Middle East also weighed on non-U.S. stocks and fed demand for the perceived safe haven of the U.S. dollar. Energy and materials stocks declined as the stronger greenback weighed on dollar-denominated commodity prices, and oil prices were pushed lower still by diminishing concerns about supply disruptions in the Middle East and Russia.

Domestic energy boom feeding U.S. manufacturing competitiveness
More broadly, investors worried that the rising dollar would make goods produced in the U.S. less competitive overseas, while also reducing the value of profits earned overseas by U.S. firms. Signs of declining American competitiveness are elusive as yet, however-particularly in the manufacturing sector. Indeed, recent data compiled by T. Rowe Price Chief Economist Alan Levenson show manufacturing activity expanding at a faster clip in the U.S. than in any other major economy. T. Rowe Price managers are carefully watching the rebound in the fortunes of U.S. manufacturers, which have been boosted not only by a cheap dollar in recent years, but also by the boom in low-cost and reliable domestic energy sources.

Stock prices more likely to move in line with earnings growth
Generally, T. Rowe Price equity managers believe that U.S. stock prices are likely to move more in line with earnings growth rather than through an expansion in valuations-or how much investors are willing to pay for a dollar of those earnings. They note that valuations are no longer cheap, but neither are they widely out of line with the pattern of the last two decades. Faster-growing, higher-valued growth stocks are generally less expensive relative to historical patterns than value shares, and large–caps appear cheaper than small–caps. Overall, stocks also appear cheap relative to bonds, which may provide support to equities if interest rates increase and investors rotate away from fixed income.

Third Quarter 2014

Yield curve flattens as investors anticipate first rate hike
The Treasury yield curve flattened as rates on two– and five–year U.S. government notes rose while 10– and 30–year yields fell. Two– to five–year Treasuries, which would experience the largest negative price effects from an increase in the federal funds rate, sold off as the market priced in an expected initial interest rate hike from the Federal Reserve in mid–2015. In the statement following its mid–September policy meeting, the Fed kept the phrase "for a considerable time" in the description of how long it will maintain the target fed funds rate at its current level after ending its asset purchases, helping to ease some anxiety about the initial tightening move coming sooner than expected. Longer-term Treasuries are more responsive to inflation expectations, which remain low.

European sovereign debt yields hit record lows
Yields on safe-haven European government bonds fell to record lows in August as investors snapped them up amid stalled eurozone growth and heightened geopolitical risks. The yield on 10–year German government bonds reached a record-low 0.88%, and two–year German sovereigns briefly had a negative yield. In early September, the European Central Bank (ECB) cut its benchmark lending rates by 0.10 percentage points in an unexpectedly aggressive move to stimulate economic growth in the eurozone. The ECB also said that it will buy certain types of asset-backed and mortgage-related securities, but it stopped short of announcing a large-scale quantitative easing program that would involve direct government debt purchases.

U.S. dollar reaches strongest point in more than four years
With investors anticipating an increase in U.S. interest rates when the Fed begins to tighten policy next year, the U.S. dollar rapidly strengthened. An index of the value of the dollar against a basket of six major developed markets currencies reached its highest point since mid-2010. For U.S. investors, the strength of the dollar hurt the returns of bonds denominated in other currencies. Bonds denominated in euros, for example, generated steep losses in dollar terms despite posting solid gains for eurozone investors.

Total Returns
Index Third Quarter 2014 Year-to-Date
Barclays U.S. Aggregate Bond Index    0.17%   4.10%
Credit Suisse High Yield Index -1.94 3.50
Barclays Municipal Bond Index 1.49 7.58
Barclays Global Aggregate Ex-U.S. Dollar Government Bond Index -5.38 -0.09
J.P. Morgan Emerging Markets Bond Index Global Diversified -0.59 8.02
Barclays U.S. Mortgage Backed Securities Index 0.18 4.22
Figures of September 30, 2014. Past performance cannot guarantee future results. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.

Volatility in high yield corporate bonds increases
High yield bonds sold off in July and early August as a result of the elevated valuations in the asset class but soon recovered as investors came back in search of bargains. However, high yield corporates experienced renewed selling pressure in September amid outflows. T. Rowe Price's high yield portfolio managers and analysts continue to think that the general fundamental credit quality of high yield issuers is solid and that default rates should remain low, although the quality of new deals has declined significantly.

Flat returns for high-grade corporate debt
Investment-grade corporate bonds did not sell off along with high yield securities in July, but investment-grade credit spreads widened near the end of the quarter. Credit spreads measure the additional yield that investors demand as compensation for holding a bond with credit risk versus a similar–maturity Treasury security. New issuance of investment-grade corporate debt boomed, with the dollar volume of new deals running on a year-to-date annual pace to top last year's record. Much of the new issuance came from the financials sector.

Decline in emerging markets bond prices
Emerging markets debt prices fell, with bonds denominated in local currencies experiencing the steepest losses in dollar terms. Many emerging markets currencies dropped sharply against the U.S. dollar. Argentina defaulted on its debt for the second time in 13 years after a U.S. judge blocked it from making coupon payments to some of its bondholders. However, investors had expected the default, and it had little impact on other emerging markets. The European Union and the U.S. tightened their sanctions against Russia for its role in the Ukraine conflict, with the U.S. barring American companies from providing technology or services for Russian oil exploration ventures.

Healthy returns for municipal debt
Municipal bonds generated healthy returns amid continuing inflows and generally strong demand. New issuance of municipal debt remained limited, although California and New York City each sold more than $2 billion of new bonds in September. The market easily absorbed the new deals.

U.S. Treasury Yields
Maturity June 30, 2014 September 30, 2014
3-Month 0.02% 0.02%
6-Month 0.06 0.03
2-Year 0.46 0.57
5-Year 1.63 1.76
10-Year 2.53 2.49
30-Year 3.36 3.20

Fed pledges continued support for MBS
Mortgage-backed securities (MBS) were flat as the Fed continued to scale back its purchases of the debt. On the positive side, the Fed said that it will keep reinvesting the interest and principal payments from its large holdings of MBS into the asset class until sometime after it starts to raise interest rates. In another supportive measure for the MBS market, the central bank also stated that it doesn't expect to use MBS sales as a tool to tighten monetary policy.

Relative value is hard to find
It remains difficult to find compelling areas of relative value in the ongoing low interest rate environment. Still, we believe that dollar-denominated emerging markets sovereign bonds offer some value relative to U.S. corporate debt and that emerging markets corporate bonds are attractive in general. However, we are mindful of the risks of emerging markets debt, particularly with U.S. rates poised to rise. Also, the well–publicized job change of Bill Gross, who formerly managed the world's largest bond mutual fund, appears to have created some idiosyncratic dislocations in a few fixed income asset classes-such as Treasury inflation-protected securities-that may be attractive.

Third Quarter 2014


Third-quarter malaise largely due to dollar strength
Non–U.S. stock markets posted steep declines for the quarter. Many investors pointed to geopolitical strife, concern about China's economic slowdown, and the potentially deleterious effects of rising U.S. interest rates as catalysts for the sell–off. These issues certainly contributed to investor anxiety and demand for safe–haven investments, but the most significant reason for the steep losses was the strength of the U.S. dollar, which gained nearly 8% versus the euro and the Japanese yen and 5% versus the British pound. As shown in the table below, the MSCI Europe Index fell nearly 7% for dollar-based investors, but investors that owned the same stocks in euros actually generated a small gain. Similarly, the MSCI Japan Index shows a 2% loss for U.S. investors, but Japanese investors who owned the same basket of stocks in yen reaped about a 5% gain. While slower-than–expected economic growth in Europe and Asia cast a pall on non–U.S. investments, currency translation was the largest factor in the third-quarter rout.

For investors without currency hedges, developed markets stocks fell further than emerging markets equities. Developed markets in the Asia-Pacific region held up better than most markets in Europe. Singapore and Japan posted small losses, while the major markets in Europe declined sharply. Germany (-11%), France (-8%), and Italy (-9%) saw significant losses, but the worst markets in Europe were Austria and Portugal, which each plunged more than 20%. Within the emerging markets universe, the Europe, Middle East, and Africa (EMEA) region was the poorest performer, falling nearly 8%. Latin America fell more than 5%, dragged lower by Brazil, which declined more than 8% (the Brazilian real lost 10% versus the dollar). Emerging Asian markets generated mixed returns and ended the quarter modestly lower overall.

Within the EAFE index, a benchmark for the performance of developed stock markets in Europe, Australasia, and the Far East, growth stocks held up marginally better than value shares, and large-caps solidly outperformed small–caps. In the third quarter, the health care and information technology sectors performed best, but only health care managed a positive result. The poorest-performing sectors in the index were materials and energy.

International Averages
  Total Return
MSCI Index Third Quarter 2014 Year-to-Date
EAFE (Europe, Australasia, Far East)    -5.83%    -0.99%
All Country World ex-U.S.A  -5.19 0.39
Europe  -6.98 -1.44
Japan  -2.19 -1.36
All Country Asia ex-Japan  -1.54 4.93
EM (Emerging Markets)  -3.36 2.75
All data are in U.S. dollars as of September 30, 2014. 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

Asia's markets hold up best
Among Asia's developed markets, Japan posted a small loss. However, Japan's economic recovery appears to be stalling following a brief rebound from the second-quarter economic contraction, and other data suggest that exports and industrial production declined. The Bank of Japan is expected to announce an extension of asset purchases at its late-October meeting in an effort to maintain the current pace of monetary expansion into 2015. The Australian market declined nearly 8% due in large part to steep currency exchange losses (-7% versus the dollar) and weakness in materials and commodities prices. Stocks in Hong Kong and New Zealand were 3% and 9% lower, respectively (the New Zealand dollar declined almost 11% versus the greenback).

Performance for emerging markets in the region was mixed. Pakistan, South Korea, and Taiwan posted losses, while India, Indonesia, the Philippines, and Thailand generated solid positive results. China's market was modestly positive. After what appears to be a policy–aided pick-up in the second quarter, recent data points to an economic slowdown in the third –quarter. T. Rowe Price analysts think that longstanding problems with excessive credit and unresolved bad debt will curb sustained growth. The country's 7.5% economic growth target for 2014 looks tenuous and is unlikely to be achievable in 2015.

European markets decline-further monetary easing may be on the horizon
Weak inflation data caused the euro to fall to a two-year low versus the U.S. dollar. The euro also fell against the yen and the British pound late in the period. Declining energy and food prices led to a 0.4% eurozone inflation rate (August), well below the European Central Bank's (ECB) 2% target. These data, coupled with lackluster economic growth projections, will likely prompt the central bank to take further aggressive monetary policy actions. Mario Draghi, the ECB president, has repeatedly said that the central bank would keep interest rates low for as long as it takes to push inflation up toward the 2% level.

Eurozone economic growth slowed in the second quarter. The economies of Germany and Italy contracted (Italy entered its third recession in six years), and France's gross domestic product growth was flat. Leading economic indicators suggest slower growth for the next six months, which reflects a loss in business and consumer confidence. In the UK, now that the Scottish independence referendum is out of the way, investor focus is back on British economic fundamentals and the timing of rate hikes. Better employment statistics and tightening labor market conditions suggest a UK rate hike in early 2015. T. Rowe Price's European analysts are increasingly favoring companies that generate a significant portion of their revenues in U.S. dollars. Euro weakness could hurt the bottom line for U.S.-based multinational companies that generate a significant portion of their revenues in Europe.

Non-U.S. stock valuations remain attractive, but dollar strength is worrisome
While T. Rowe Price portfolio managers remain optimistic about the environment for global equities in the intermediate and longer term, our near–term outlook remains somewhat guarded. Dollar strength will remain a key focus for investors in the coming quarters. Markets have been roiled by political upheaval in Russia and Ukraine, strife in the Middle East, and civil unrest in Hong Kong. At the same time, global growth forecasts are being almost uniformly ratcheted lower, and non-U.S. stock markets just endured their worst quarter since the height of the eurozone crisis. We expect further monetary stimulus in Europe and Japan as growth momentum has moderated. Europe faces headwinds, including high debt loads and unemployment and deflation concerns. European corporate earnings should benefit from a resumption of economic growth, and valuations are currently near historical norms, which is attractive for long-term investors. In Japan, increased domestic consumption, fed by wage inflation, needs to be the next growth engine. T. Rowe Price analysts believe that the Japanese market will benefit if companies transform business practices and governance standards to focus more on growing profits and generating value for shareholders.

Third Quarter 2014

Emerging markets stocks post quarterly decline amid September sell-off
Emerging markets stocks fell in the third quarter as a sell–off in September erased gains from the prior two months. September's drop, which snapped seven straight months of gains for the asset class, came as signs of a stronger U.S. economy and expectations for higher interest rates diminished the appeal of emerging markets. Though most investors don't expect the U.S. Federal Reserve to raise interest rates until mid–2015, many have begun rotating out of emerging markets assets in favor of less–risky U.S. assets. Currency weakness also reduced the attractiveness of emerging markets assets as anticipation of higher U.S. rates caused the dollar to rally. Nearly all currencies fell against the dollar. The declines were biggest in developing countries with a poor growth outlook like Russia and Brazil, whose currencies posted double–digit losses for the quarter. Protests in Hong Kong also curbed risk appetite as investors worried that the unrest could provoke a harsh response from Beijing and destabilize a leading financial center. Eight of the 10 sectors in the MSCI Emerging Markets Index fell, while telecommunication services and health care advanced.

International Averages
  Total Return
MSCI Index Third Quarter 2014 Year-to-Date
Emerging Markets (EM) Index    -3.36%    2.75%
Asia Index  -1.41 5.89
Europe, Middle East, Africa (EMEA) Index  -7.79 5.95
Latin American Index  -5.44 0.85
All data are in U.S. dollars as of September 30, 2014. 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 advance despite slowdown; Indian stocks gain

  • Chinese stocks rose slightly, but the A -share market restricted to domestic investors surged more than 17%. Despite the gains, data over the quarter showed that China's economy was losing steam even after the government implemented targeted stimulus measures earlier this year. T. Rowe Price analysts think that China's longstanding problems with excessive credit and unresolved bad debt will curb any sustained growth pickup in the future.
  • Indian stocks advanced as the domestic Sensex index repeatedly hit records during the quarter following the landslide victory of Narendra Modi's Bharatiya Janata party in May. Additionally, India's gross domestic product (GDP) grew at a better–than–expected 5.7% rate in the June quarter from a year ago, its fiscal and current account deficits improved, and Standard & Poor's raised its outlook on India's credit rating to stable from negative.
  • Stocks across Southeast Asia advanced. Thai stocks rose as investors welcomed the political stability ushered in by the new army–led government, which seized power in May; Philippine stocks gained on strong economic growth; and Indonesian stocks rose on reform optimism after Joko Widodo won a tightly contested presidential election in July.

Brazilian stocks fall on Rousseff reelection speculation; Mexican stocks strengthen

  • Brazilian stocks slumped more than 8% due to September's sell-off after polls showed a greater chance of President Dilma Rousseff winning reelection in October, dampening speculation that a new government will take power and implement more market-friendly policies. Separately, data showed that Brazil fell into a recession in the year's first half, and Moody's cut its credit outlook on Brazil to negative.
  • Mexican stocks advanced as data over the quarter indicated that its economy was improving after a sluggish start this year. In September, Mexico's government cut its 2015 GDP growth forecast to 3.7%, which would still exceed this year's expected 2.7% pace.
  • Chilean stocks retreated amid slower economic growth arising from weaker commodity prices. Chile's economy grew at its slowest pace in the second quarter since the 2009 recession, leading the government to lower its full–year GDP growth forecast in September.

Russian stocks plummet on Ukraine crisis; Turkish stocks fall on current account worry

  • Russian stocks tumbled 15% as investors continued to shun Russian assets in response to the ongoing Ukraine crisis and international sanctions. The ruble repeatedly fell to record lows over the quarter, triggering reports that Russia was considering capital controls. T. Rowe Price analysts believe that Russia's government won't implement system-wide capital controls but could resort to more subtle forms of controls, like delaying dividend payments, to stanch investor outflows.
  • Turkish stocks fell sharply as the currency weakened and investors worried about the impact of higher U.S. rates on its economy. Turkey's GDP grew at a worse-than-expected 2.1% annualized pace in the second quarter, which officials said may cause it to miss its 4% growth target this year.
  • South African stocks sagged as the economic outlook remained poor after a five-month long platinum mining strike earlier this year. Although the country avoided a recession in the first half, it still suffers from high inflation, soaring unemployment, and anemic growth. In July, Moody's warned that South Africa's credit rating was at risk due to the strike, and in August, the agency downgraded its ratings on the country's four biggest banks.

Solid long-term fundamentals offset near term risks
In recent years, we have noted significant dispersion in the returns of emerging markets stocks. Emerging markets appear cheap in aggregate, but valuations vary widely by country and sector. Generally, those areas that are expensive deserve to be expensive, and those that are cheap deserve to be cheap. 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 as the Fed ends tapering; and an unexpected bout of risk aversion due to geopolitical events.

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.