Fourth Quarter 2014

Stocks see strong gains but with substantial volatility
Stocks recorded strong returns for the quarter, but markets were volatile after a period of relatively stable gains. After enduring their biggest daily declines in over two years, the Dow Jones Industrial Average and Standard & Poor's 500 Index managed to reach new highs shortly before the end of the quarter. The Nasdaq Composite Index reached its best level since the tech bubble of the late 1990s. Breaking with the pattern for the year as a whole, the smaller-cap benchmarks outperformed for the quarter, and the small-cap Russell 2000 Index joined the other major indexes back in record territory for the first time since the summer. Performance also varied widely among sectors. Utilities and consumer-oriented shares recorded strong gains, while the energy sector performed poorly, falling nearly 11% on a total return basis. Materials and telecommunication services also ended in negative territory for the quarter.

U.S. Stocks
  Total Return
Index Fourth Quarter 2014 Year-to-Date
DJIA    5.20%    10.04%
S&P 500 4.93 13.69
Nasdaq Composite 5.40 13.40
S&P MidCap 400 6.35 9.77
Russell 2000 9.73 4.89
Note: Returns are for the periods ended December 31, 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 grows at fastest pace in over a decade; profits growing even faster
Investors celebrated a string of data indicating that the U.S. economic recovery had finally gained traction. Most encouraging was strength in the labor market, which appeared to be improving at the fastest rate since the 1990s, according to some measures. Better income prospects were reflected in improving consumer confidence and a rise in retail sales, which boosted consumer discretionary and consumer staples shares. In December, the Commerce Department announced its latest estimate that the economy had grown at an annualized pace of 5% in the third quarter, its best showing since the summer of 2003. Corporations continued to leverage even better earnings growth out of the economy. The third-quarter earnings season boosted markets by surprising on the upside, rising 8% for the S&P 500 as a whole over the year before.

Despite evidence of "decoupling," global concerns periodically rock Wall Street
Although pundits talked increasingly of the U.S. having "decoupled" from the global economy, economic reports from overseas periodically rattled Wall Street. Data showed that Italy had fallen back into recession, and even Germany and other stronger "core" economies of Europe were in peril of following. Japan's strong reform-led recovery seemed endangered by a consumption tax hike, and manufacturing data showed that growth in China was slowing more than expected. While an energy-led slowdown in the smaller Russian economy was of less direct consequence, it briefly shocked U.S. and other global markets by creating fears of another emerging markets contagion. Contagion fears of a more literal nature appeared in the Ebola virus, and the alarming news that American nurses had contracted the disease in Dallas seemed to spark a brief but sharp sell-off at the start of the quarter. The prevention of further Ebola infections in the U.S.; dramatic currency intervention by Russia; and hopes for stimulus measures in Europe, Japan, and China helped the market surmount each of these hurdles, bringing many of the major indexes to record highs on December 30.

Turn in oil cycle likely to remain durable
The surprisingly sharp decline in oil prices was another key theme in the quarter. T. Rowe Price energy sector analysts and portfolio managers observe that a sharp increase in North American shale oil production—excess production capacity that was planned in the last decade is coming into play at precisely the wrong time—and OPEC's refusal to cut its own output are two key reasons for the decline in oil prices. In addition, Russia and Venezuela have been forced to sell every drop they extract to support their fragile economies, while Iraq and Libya, which largely halted production in the midst of political conflict, have largely come back online. Meanwhile, the sluggish global economy has resulted in relatively tepid demand growth—as opposed to the world's substantial ongoing demand for oil. T. Rowe Price managers and analysts expect oil prices to remain subdued over the long term, but they believe markets could see some short-term and temporary price volatility due to cyclical factors, such as an unexpected demand spike or a geopolitical crisis.

Fed patience sends benchmarks to new highs
Markets reached new highs at the end of the quarter, as investors appeared to return their focus to Federal Reserve policy. Stocks surged on December 17, following a statement from policymakers that they would be "patient" before increasing official short-term interest rates. The day also brought news that consumer prices declined 0.3% in November due in large part to the drop in oil prices. The falling inflation data indicated that the Fed has considerable leeway in timing its rate increases, and it may have also reminded investors of the upside to consumer spending from falling prices at the pump.

Rising wages are likely to reduce profit margins but only moderately
While overall inflation has remained tame, T. Rowe Price managers expect that rising wage costs in the U.S. will squeeze record profit margins. Nevertheless, they think the pace of labor cost increases would be manageable, as companies also enjoy modest sales gains. They note that fourth-quarter earnings reports should provide greater clarity on the overall impact on profits of the decline in oil prices, as some firms benefit from increased discretionary spending, particularly on the part of lower-income consumers.

Fourth Quarter 2014

Tumbling commodities prices hit high yield, emerging markets bonds
Falling oil prices took a toll on fixed income sectors with significant exposure to oil- and gas-related industries, including U.S. high yield bonds and emerging markets debt. The U.S. crude oil price declined from about $90 per barrel at the start of the quarter to well below $60 at the end of December, with the slide accelerating after the Organization of the Petroleum Exporting Countries (OPEC) did not cut its production at a late-November meeting. Debt issued by companies in energy-related industries accounts for a large proportion of most high yield bond indexes, so the steep drop in oil prices hit the high yield asset class particularly hard.

The Fed will be "patient"
On the positive side, T. Rowe Price Chief Economist Alan Levenson expects the decline in oil prices—which has translated to lower gasoline prices—to act like a tax cut for U.S. consumers, boosting their discretionary spending and helping support the U.S. economic recovery. In fact, the U.S. economy has displayed more consistent signs of health as gross domestic product grew 5.0% in the third quarter, the fastest pace since the summer of 2003. Following its December policy meeting, the Federal Reserve said that it would remain "patient" on raising interest rates, which helped allay some fears that the signs of economic strength would prompt the Fed to hike rates sooner than expected.

Treasury yield curve flattens
The Fed's initial interest rate increase would negatively affect the prices of shorter-term debt more than longer-maturity bonds, and shorter-term Treasury yields rose in anticipation of the start of the Fed's policy tightening. The yield on the 10-year Treasury note declined significantly amid strong demand for relatively high-yielding safe-haven government debt. The 30-year Treasury "long bond" yield decreased to the lowest levels in over 12 months, contributing to a flattening in the overall Treasury yield curve.

Total Returns
Index Fourth Quarter 2014 Year-to-Date
Barclays U.S. Aggregate Bond Index    1.79%   5.97%
Credit Suisse High Yield Index -1.59 1.86
Barclays Municipal Bond Index 1.37 9.05
Barclays Global Aggregate Ex-U.S. Dollar Government Bond Index -2.99 -3.08
J.P. Morgan Emerging Markets Bond Index Global Diversified -0.55 7.43
Barclays U.S. Mortgage Backed Securities Index 1.79 6.08
Figures of December 31, 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.

Yields on eurozone, Japanese government bonds decline to historic lows
The eurozone economy continued to struggle to grow and avoid deflation. Comments from European Central Bank officials made it appear increasingly likely that the central bank will expand its asset purchase program to include eurozone sovereign bonds, which helped to drive long-term eurozone government bond yields to record lows. However, the strength of the U.S. dollar against the euro (and most other currencies) resulted in negative returns in dollar terms. The Bank of Japan expanded its monetary easing measures, causing the yield on the Japanese 10-year government bond to fall to only 0.31% in December. The greenback also gained against the yen, offsetting the price appreciation on Japanese bonds in terms of U.S. dollars.

Volatility in emerging markets debt and currencies
Emerging markets bonds and currencies experienced considerable country-specific volatility followed by broad selling pressure in early December. Brazilian bonds were particularly volatile as incumbent Dilma Rousseff won the country's presidential election in October. The general malaise in global economic growth contributed to the selling pressure in emerging markets, and the rapid decline in oil prices triggered deep concerns about the health of major commodities exporters such as Russia and Venezuela. Russia's central bank hiked its benchmark lending rate by a staggering 7.5 percentage points in December in an effort to stabilize the plunging ruble.

Defaults could spike in 2016 if oil price stays low
High-yield bonds lost ground as a result of the selling pressure on debt from energy-related issuers. For most of the quarter, the selling pressure on high yield bonds from companies that rely on oil revenue was most acute on lower-quality securities within the noninvestment-grade universe, but even higher-quality energy-related bonds declined after the OPEC meeting. Mark Vaselkiv, portfolio manager of the T. Rowe Price High Yield Fund, believes that the high yield default rate will remain low in 2015. However, he anticipates a spike in the default rate in 2016 if the price of oil falls further or stays at current levels for an extended period.

Positive returns for investment-grade corporate market
The broad investment-grade corporate bond market, which has less exposure to the energy industry than the high yield market, generated a healthy gain despite a rush of new supply. The rapid pace of new investment-grade corporate debt issuance continued up to the holidays, as companies took advantage of low borrowing costs to sell an annual record of more than $1.5 trillion in new investment-grade bonds in 2014. Medical device manufacturer Medtronic brought $16.5 billion of new bonds to market in the largest issue of the year.

U.S. Treasury Yields
Maturity September 30, 2014 December 31, 2014
3-Month  0.02%  0.04%
6-Month 0.03 0.12
2-Year 0.57 0.67
5-Year 1.76 1.65
10-Year 2.49 2.17
30-Year 3.20 2.75

Municipal bonds, MBS generate healthy returns
The ongoing strong demand for municipal bonds offset an uptick in new supply during the quarter and helped the asset class extend its streak of monthly gains to cover the entire year, marking the first time that has happened in more than two decades. In Detroit, a federal judge approved a plan that will allow the city, a major municipal debt issuer, to exit bankruptcy. Mortgage-backed securities (MBS) also posted solid returns as they benefited from the lack of any significant exposure to the energy sector.

Some opportunities exist in emerging markets bonds, but security selection is critical
The late-quarter selling pressure on almost all emerging markets debt and currencies has created some pockets of attractive relative value in bonds denominated in emerging markets currencies as well as some corporate bonds issued in developing countries. However, country- and issuer-specific risks are elevated in emerging markets, making security and currency analysis and selection essential. We also carefully assess market liquidity when evaluating emerging markets bonds.

Fourth Quarter 2014

Overview

Currency strength leads to losses for U.S. dollar-based investors

Most non-U.S. stock markets posted fourth-quarter losses in U.S. dollar terms due to the further weakening of non-U.S. currencies, particularly the euro and the yen. The yen declined more than 8% versus the dollar, and the euro and British pound sterling each fell about 4%. The appreciating U.S. dollar detracts from returns for dollar-based investors in foreign markets.

Within the EAFE index, growth stocks held up better than value shares, and small-caps outperformed large-caps. From a sector perspective, consumer discretionary and telecommunication services performed best. The worst-performing sectors in the index were energy, materials, and health care.

International Averages
  Total Return
MSCI Index Fourth Quarter 2014 Year-to-Date
EAFE (Europe, Australasia, Far East)    -3.53%    -4.48%
All Country World ex-U.S.A  -3.81 -3.44
Europe  -4.30 -5.68
Japan  -2.40 -3.72
All Country Asia ex-Japan   0.17  5.11
EM (Emerging Markets)  -4.44 -1.82
All data are in U.S. dollars as of December 31, 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, the Japanese economy contracted in the third quarter and slipped into recession (commonly defined as two consecutive quarters of economic contraction). Prime Minister Shinzo Abe is pushing the Bank of Japan (BoJ) to inject more funds into the financial system through purchases of government bonds and other debt instruments, and the central bank intends to introduce more currency depreciation measures—the yen is already at a seven-year low versus the U.S. dollar—to revive growth. However, data showed that inflation slowed for a fourth consecutive month. Core consumer prices rose 0.7% in November, well short of the central bank's 2.0% annual inflation goal. Additionally, industrial production and retail sales declined, which points to further weakness in the economy. The Australian market declined nearly 3.6% due in large part to steep currency exchange losses (more than 6% versus the U.S. dollar) and falling commodities prices. Stocks in Hong Kong and New Zealand each gained about 3%.

Performance for emerging markets in the Asia/Pacific region was mixed. China was the strongest performer as the Peoples Bank of China surprised investors and cut interest rates for the first time in two years. Stocks available for foreign investors advanced more than 7%, and China's domestic A-shares market surged more than 35%. T. Rowe Price's Hong Kong-based managers and analysts expect the Chinese economy to slow in 2015 as the government tries to stimulate domestic growth. They also believe that growth elsewhere in the region will pick up in 2015, particularly in countries such as India that have elected reform-minded leaders.

European markets decline—further monetary easing may be on the horizon
Weak inflation data and slowing economic growth caused the euro to fall to a multiyear low versus the U.S. dollar. Economic growth in the eurozone is expected to be about 1% in 2014 and only marginally better in 2015. Deflation remains a significant risk, which is partly due to the plunge in oil prices over the past six months—eurozone inflation was 0.3% in November, well below the European Central Bank's (ECB) 2% annual inflation target. These data will likely prompt the ECB to take further aggressive monetary policy actions in the first quarter of 2015, which may include expanding its asset-purchase program to include government bonds. 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.

Non-U.S. stock valuations remain attractive, but dollar strength is worrisome
T. Rowe Price portfolio managers are optimistic about the environment for global equities in the intermediate and longer term, but potential near-term headwinds include the strengthening U.S. dollar and continued global economic weakness. Valuations in non-U.S. equity markets are neither excessive nor inexpensive. Although some individual stocks and sectors appear to be richly priced, there are opportunities for bottom-up stock selection. Overall, European earnings growth has been disappointing, and Europe's ability to make structural reforms that would improve long-term growth prospects remains uncertain. In Japan, we believe domestic consumption and wage inflation need to be the next growth engines for a sustained recovery. Prime Minister Abe has been pressing corporations to raise wages to support the Japanese consumer and reverse a 20-year cycle of wage and price deflation. Indications of durable economic improvements in Japan, together with corporate tax incentives, would also improve wage growth. In emerging markets, returns have been considerably more reflective of underlying fundamentals at the stock and country level—a positive and overdue development, in our view.

Fourth Quarter 2014

Emerging markets stocks fall in fourth quarter as oil's collapse, ruble sell-off spark risk aversion
Emerging markets stocks fell in the fourth quarter as plunging oil prices and a full-blown currency crisis in Russia sparked a bout of global risk aversion. Oil's decline accelerated in November after the Organization of the Petroleum Exporting Countries (OPEC) resisted production cuts despite falling oil prices. Though cheaper oil is good for consumers and the finances of oil-importing countries, it spells trouble for many commodity-driven emerging markets. Oil's collapse was particularly painful for Russia, whose economy began contracting and whose currency repeatedly fell to record lows during the quarter. The ruble lost roughly 45% against the dollar for the year, making it the second-worst-performing currency in 2014, according to MSCI. Other emerging markets currencies also fell, with those in Turkey, Indonesia, Brazil, and South Africa hitting record or multiyear lows throughout December as investors sold higher-risk assets. The MSCI Emerging Markets Index slid to its lowest level since July 2013 on December 16, when the ruble experienced a dramatic sell-off. However, it pared some of its losses by month-end as investors took comfort from the Federal Reserve's announcement the next day that it would be "patient" in deciding when to raise interest rates.

Slowing global growth contributed to increased risk aversion. Many developing countries reported disappointing economic growth in the third quarter, forcing them to cut their full-year growth targets. Several emerging markets, including Brazil and Russia, face stagflation, or low economic growth coupled with rising inflation. December's release of disappointing purchasing managers' surveys out of Europe and China underscored the weak global economic environment. Eight of the 10 sectors in the MSCI Emerging Markets Index fell, while financials and information technology rose. Energy stocks lost the most, giving up roughly 24% for the quarter.

International Averages
  Total Return
MSCI Index Fourth Quarter 2014 Year-to-Date
Emerging Markets (EM) Index    -4.44%    -1.82%
Asia Index  -0.22  5.27
Europe, Middle East, Africa (EMEA) Index -10.09 -14.74
Latin American Index  -13.38 -12.03
All data are in U.S. dollars as of December 31, 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 rally on stimulus hopes; Indian shares decline

  • Chinese stocks advanced roughly 7% while the restricted A-share market for domestic investors surged about 35%. China's third-quarter gross domestic product (GDP) expanded 7.3% year-over-year in the slowest growth since early 2009, and its central bank unexpectedly cut interest rates in November for the first time since 2012. However, signs of a deepening slowdown have raised speculation that China's government will do even more to stimulate the economy in the near term.
  • Indian stocks declined. India's benchmark Sensex Index reached a record high in November after the main opposition won a landslide election in the spring. However, it fell in December as some investors grew cautious about the new government's ability to implement reforms.
  • Southeast Asian stocks were mixed, with Thai stocks shedding roughly 6% while those in Indonesia and the Philippines advanced. Thailand repeatedly cut its annual growth forecasts this year as the country tried to recover from months of popular unrest. Indonesia's economy strengthened over the year, but the recent drop in commodity prices caused a steep selloff in the rupiah in December. The Philippines reported weaker-than-expected GDP growth in the third quarter, but T. Rowe Price analysts believe that the country represents one of Asia's best investment stories due to high economic growth, a current account surplus, easing inflation, and a politically stable environment.

Latin American stocks sink as oil prices plummet

  • Brazilian stocks fell nearly 15% as the drop in oil prices and a growing corruption probe weighed on Petrobras, the state-owned energy company. Brazil's central bank hiked its benchmark rate twice during the quarter in its ongoing struggle against inflation, a task made more difficult by the weakening real, which hit a nine-year low in December.
  • Mexican stocks gave up roughly 12%. Mexico reported its third-quarter GDP grew at a slower-than-expected pace, and the government cut its 2014 growth outlook for the second time this year in November. The country's central bank kept its key interest rate unchanged at a record low 3%.
  • Colombian stocks fell nearly 23%, the most in the region. Colombia's third-quarter GDP growth was the fastest in Latin America, but the government cut its 2015 economic growth target in December to reflect lower prices for crude oil, the country's top export.

Russian stocks drop as sanctions and lower oil weigh on outlook; Turkish stocks rally

  • Russian stocks dropped nearly 33%, the most in the EMEA region, as oil's collapse and the ruble crisis caused investors to sell Russian assets. Russia's economy, already weakened by Ukraine-related sanctions, could shrink as much as 4.7% next year and another 1.1% in 2016 if oil averages $60 per barrel, the country's central bank said in December. Russian GDP shrank in November in the first monthly contraction in five years, signaling that the country was already entering a recession.
  • Turkish stocks advanced nearly 12% as the drop in oil prices lifted the country's economic outlook. Lower oil prices are positive for Turkey, a net energy importer, by shrinking its import bill and reducing its sizable current account deficit.
  • South African stocks added nearly 3% as oil's decline eased inflation pressures on the economy. However, South Africa's current account deficit shrank less than expected in the third quarter, the government reported in December, disappointing investors who hoped that cheaper oil prices would help narrow the gap. The rand sank to a six-year low on the news.

Solid long-term 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. Additionally, most emerging markets are still expanding faster than developed ones and offer solid growth opportunities for long-term investors. Since China's slowdown and the end of the global commodities boom, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. Going forward, we anticipate more divergence in the performance of countries and companies than we've seen in the past 15 years, and we believe that careful stock selection will be crucial for producing good returns over time.