Second Quarter 2014
U.S. stocks gain in quarter despite downdraft in April
After stumbling in early April, U.S. stocks continued their upward trajectory and posted gains in the second quarter of the year. Stocks advanced despite the troubling environment characterized by escalating violence in various corners of the globe, including Russia's seizure of Crimea; slowing growth and credit concerns in China; mixed U.S. economic data; and most recently, an eruption of sectarian violence in Iraq. Stock performance was fairly uniform, with no clear leadership emerging among growth and value shares.
|Index1||Second Quarter 2014||Year-to-Date|
|S&P MidCap 400||4.33||7.50|
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All market caps higher, but sector returns were mixed
Larger- and mid-cap stocks outperformed small-caps during the second quarter-although leadership changed hands in the final month of trading. There was little difference between growth and value stocks in the various market cap segments. Among the S&P 500 sectors, energy was far and away the strongest group, doubling the returns of most of the others in the index. Utilities also delivered impressive results as investors continued their search for income-producing securities in the low-rate environment. Information technology, materials, consumer staples, and health care stocks all performed well. The laggard was the financials sector with a return just over 2% for the period.
U.S. gross domestic product growth revised downward
The Commerce Department sharply lowered its assessment of first-quarter economic growth from an earlier reading of -1.0% on an annualized basis to -2.9%, surprising most analysts who expected a less severe revision. The sluggish reading was attributed to shrinking business inventories, awful winter weather throughout much of the nation, and a decline in health care spending. The first quarter of 2014 was the worst for U.S. gross domestic product performance since the first quarter of 2009. The economy's poor performance was all the more startling since it occurred against the backdrop of an improving labor market and healthy overall business activity.
Many analysts, including T. Rowe Price economists, regard the contraction as an aberration-something of a payback for the unsustainable 3.4% advance in the second half of 2013. T. Rowe Price expects stronger U.S. economic growth in the neighborhood of 3% in the second quarter of this year. Total annual growth of 3% for the year, however, is probably unlikely. If growth falls short of 3% during the next 12 to 18 months, it would be due largely to a shortfall in residential and business fixed investment.
Federal Reserve captures the spotlight so far in 2014
All eyes were on the Federal Reserve and its evolving policy stances during the second quarter of the year. The central bank, under the leadership of Janet Yellen who replaced Ben Bernanke when she was sworn in on February 3, 2014, has been scaling back its quantitative easing program since the beginning of the year. The next step for the Fed will be a widely anticipated ratcheting up of short-term interest rates, but exactly when that will take place is unclear. T. Rowe Price does not expect monetary tightening to occur until around the middle of 2015.
A lot depends on the health of the labor market and the rate of inflation, which has begun to inch up recently. Fed policymakers predicted after their last meeting that the unemployment rate could fall a notch, from 6.1% currently to 6.0% by the end of the year-already below the 6.2% they forecast in March. However, the Fed acknowledged that the figure reflects discouraged job seekers who have stopped looking for work; should they return in force, the decline in unemployment could be more gradual. Regarding inflation, the Fed estimates that consumer prices could rise by 1.5% to 1.6% this year, slightly higher than a previous forecast of 1.4% to 1.6%. Others disagree, however, and think inflation is trending higher than the Fed is stating.
The bull market appears to have further room to run
We don't expect to see a repeat of the expansion in price/earnings multiples that drove stocks last year. Stocks are more likely to be influenced by corporate earnings growth, which we think will continue at a moderate pace through the rest of the year. Valuations are reasonable from a historical perspective, and stock market performance should be more or less in line with the rate of earnings growth. We believe that the bull market that has been taking place over the past five years has further room to run. In many instances, a sharp decline such as the one we witnessed in 2008 has led to a sharp V-shaped, shorter-lived recovery. Stocks have advanced at a more moderate pace since spring 2009, however, which leads us to the view that the upturn in stocks has not yet run its course.
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.
Second Quarter 2014
Falling Treasury yields confound market expectations
Intermediate- and long-term U.S. Treasuries rallied during the quarter, driving their yields significantly lower and confounding market expectations for higher interest rates. The Treasury yield curve flattened as shorter-term rates held relatively steady or ticked upward slightly. The yield on the benchmark 10-year Treasury note fell nearly 20 basis points (a basis point is 0.01 percentage point) over the course of the quarter to finish at 2.53%. The rally in U.S. government debt helped most fixed income sectors generate strong returns.
The Fed continues to taper…
U.S. economic data released during the quarter were decidedly mixed. Some signs of inflation started to appear, which tamped down worries about deflation. The unemployment rate dropped sharply from 6.7% in March to 6.3% in April. However, first-quarter U.S. gross domestic product (GDP) contracted at a 2.9% annualized rate, the weakest quarterly GDP figure in five years. The Federal Reserve maintained the gradual tapering of its quantitative easing program. T. Rowe Price Chief Economist Alan Levenson thinks that the central bank will base its decision about when to hike rates on labor market improvement and wage pressures.
...While the ECB takes new stimulus measures
The European Central Bank, on the other hand, began preparing markets for additional monetary accommodation and then implemented the actions at its June policy meeting. Although it did not start quantitative easing, the ECB introduced an expanded long-term loan program to encourage banks to increase their lending and also cut its deposit rate to -0.10%, meaning that it will charge banks to keep cash at the central bank. The actions triggered a significant rally in eurozone sovereign debt, with the yield on the 10-year Spanish government bond (not adjusted for exchange rate effects) dropping below the 10-year U.S. Treasury yield.
|Index1||Second Quarter 2014||Year-to-Date|
|Barclays U.S. Aggregate Bond Index||2.04%||3.93%|
|Credit Suisse High Yield Index||2.41||5.55|
|Barclays Municipal Bond Index||2.59||6.00|
|Barclays Global Aggregate Ex-U.S. Dollar Government Bond Index||2.72||5.59|
|J.P. Morgan Emerging Markets Index Plus||4.76||8.66|
|Barclays U.S. Mortgage Backed Securities Index||2.41||4.03|
Rally in emerging markets bonds
The ECB's accommodative actions boosted investors' appetite for riskier debt, which helped extend a strong rally in emerging markets bonds. After a bout of selling pressure at the beginning of the year, emerging markets bonds rebounded vigorously amid investor demand for higher-yielding assets. The rally overcame geopolitical tensions between Ukraine and Russia, a military takeover of Thailand's government, a flare-up of sectarian violence in Iraq, and a potential default on Argentina's sovereign debt. Emerging markets debt denominated in U.S. dollars outperformed local currency bonds as a result of weakness in the currencies of some developing countries.
Valuations of municipal debt become less attractive
Municipal bonds generated strong performance early in the quarter as a combination of light new issuance, steady demand, and declining Treasury yields contributed to returns. As a result, municipal bond valuations became less attractive relative to Treasuries and gains tapered off in June. Puerto Rico once again made headlines by enacting legislation in late June to restructure its public corporations, essentially declaring them bankrupt and causing a sell-off in their bonds. The legislation will not affect Puerto Rico's beleaguered general obligation debt, which rallied immediately after the news.
Record-sized offering and widely expected record default in high yield
High yield corporate bonds slightly outperformed investment-grade corporates amid continued investor demand for yield and the solid fundamental condition of most high yield issuers. In April, the combined cable companies Numericable and Altice completed the largest-ever high yield offering, selling more than $16 billion of debt. Energy Future Holdings (formerly called TXU), a utility that is a major issuer of high yield bonds, filed for bankruptcy in April. Although it was the largest high yield default ever, the market largely anticipated it and reaction was limited.
Treasury rally boosts investment-grade corporate bonds
Investment-grade corporate bonds, which tend to move in tandem with Treasuries to a greater degree than high yield debt, benefited from the Treasuries rally. Strong investor demand and a pickup in merger and acquisition activity also helped push returns higher. Credit spreads on investment-grade corporate bonds, which measure the additional yield that investors demand as compensation for holding a bond with credit risk versus a similar-maturity Treasury security, narrowed to 97 basis points near the end of the quarter, according to data provided by Barclays. The last time that investment-grade credit spreads fell below 100 basis points was in July 2007.
|U.S. Treasury Yields|
|Maturity||March 31, 2013||June 30, 2014|
MBS overcome dwindling demand from the Fed
The agency mortgage-backed securities (MBS) market was able to overcome the lower demand from the Fed, the major buyer in the sector, as a result of trading in lock step with rallying Treasuries as well as the limited amount of new supply reaching the market. Asset-backed securities generated more subdued positive performance amid continued demand for short-term investments with incremental returns over cash.
Emerging markets corporates, local currency sovereigns offer opportunities
In the current environment of low interest rates, tight credit spreads, and low volatility, it is difficult to capitalize on undervalued fixed income sectors. However, we think that some emerging markets corporate bonds represent good value because of their attractive valuations relative to U.S. corporates with similar credit quality. Also, as a result of the growing differentiation in monetary policy and interest rate cycles in emerging markets, there are some interesting opportunities in emerging markets debt denominated in local currencies. However, selectivity is vital for investing success in the bonds and currencies of developing countries.
Second Quarter 2014
Emerging markets outperform following a lackluster first quarter
Non-U.S. stocks posted solid returns in the second quarter, with emerging markets outperforming developed markets overall. In aggregate, developed European markets trailed the returns for developed Asia-Pacific markets. Europe's best-performing countries included Norway, the UK, Belgium, Spain, and Finland, while Ireland and Greece fell sharply. In the Asia-Pacific region, Japan, India, Taiwan, and Hong Kong posted strong gains, but New Zealand posted a small loss and Australia and Indonesia generated modest positive results. We believe the outlook for emerging markets is still attractive for long-term investors. Based on current valuations, emerging markets stocks are trading at a discount to developed markets on an absolute and relative basis and their economic growth, while uneven, should generally outpace most developed markets.
Within the MSCI EAFE index, large-cap stocks significantly outperformed small-caps, and value stocks performed better than growth. The energy sector (+11.6%) was far and away the strongest performer in the EAFE index, followed by utilities, consumer staples, and health care. The weakest sectors in the index-including information technology, industrials and business services, and financials-produced modest gains. The U.S. dollar strengthened against the euro but was weaker versus the Japanese yen and the British pound. While supportive of economic growth, the potential for continued central bank easing policies in Europe and Japan could pressure their currencies lower relative to the U.S. dollar and weigh on returns.
|MSCI Index1||Second Quarter 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||4.34%||5.14%|
|All Country World ex-U.S.||5.25||5.89|
|All Country Asia Ex-Japan||7.30||6.57|
|EM (Emerging Markets)||6.71||6.32|
Developed and emerging Asian markets post strong results
The largest Asian stock markets generated strong second-quarter results, following first-quarter weakness. As China and Japan rallied in the second quarter, sentiment increased and risk aversion declined. Japanese stocks advanced more than 6%, China and Singapore gained almost 6%, Hong Kong was up more than 8%, and India and Taiwan posted double-digit gains. The Japanese economy is making strides toward recovery. Prime Minister Shinzo Abe outlined a series of reforms designed to reinvigorate corporate earnings and position the country for solid economic growth. The plan includes a corporate tax cut, allows more flexibility in the workplace, and eases regulations on the agriculture and health care sectors. T. Rowe Price managers generally favor Japanese companies that can benefit from improving consumer confidence, merger or acquisition activity, and an improving real estate market. In April, China's state council unveiled a "mini-stimulus" campaign after data showed that the economy slowed more than expected. While recent indicators show that the economy has stabilized, growing evidence of a property slowdown has raised the risk that China could miss its 7.5% annual economic growth target.
European markets rally on stimulus measures
European stocks posted good second-quarter gains as economic growth appears to be gradually improving, thanks to receding challenges in the eurozone periphery. However, concerns remain over the slow progress toward economic reforms by some member states, elevated debt loads, high unemployment, and declining inflation. The European Central Bank (ECB) announced further stimulus measures in an attempt to revive growth and spark inflation. Although it did not implement a quantitative easing program, the ECB reduced its benchmark lending rates and announced a targeted longer-term refinancing operation (TLTRO), which allows banks to borrow funds for up to four years at 0.25% and is designed to encourage lending to small and medium-sized businesses. The rate cuts and TLTRO program should help anchor short-term eurozone rates as the Federal Reserve and the Bank of England implement interest rate increases. Although a strong rally following the announcement reflected hopes for more vigorous economic growth, the healing of the vulnerable eurozone economy will take time. Japan has shown how difficult it can be to escape from a protracted period of slow growth, low inflation, and high debt.
Non-U.S. stocks remain attractive
The leading indicators continue to point to a slowly improving macroeconomic picture, especially in Europe. Overall, investor sentiment is generally optimistic and improving. This is somewhat reflected in European stock prices as valuations have continued to rise. Higher prices, coupled with sluggish but improving earnings, lead us to be somewhat cautious in the near term. However, over the long term, we believe that performance will be determined by how well individual companies execute on their plans. Many European companies should benefit from reducing costs and improving their market positions over time. While we remain optimistic about Japan's intermediate-term prospects, we'd become more positive if policymakers would actively implement structural reforms to labor markets, tax and regulatory regimens, and social spending.
Second Quarter 2014
Emerging markets stocks surge as investors bet on global growth
Emerging markets stocks advanced in the second quarter as the improving U.S. economy, another round of stimulus in Europe, and signs of stabilization in China lifted confidence in the global economic outlook. Political turmoil in several countries that rattled financial markets early this year-ranging from a governance crisis in Thailand to Russia's intervention in Ukraine-eased over the period, boosting investors' risk appetite. Elections had a significant impact on performance in several countries. India's stock market repeatedly hit record highs after the country elected a new, reform-minded government in May, while Brazil's market rallied as polls showed growing support for opposition candidates ahead of presidential elections in October. The MSCI Emerging Markets Index posted its biggest quarterly gain since 2012, according to Bloomberg. The index rose to a 13-month high on June 10, but pared some of its gain by month-end as oil prices surged amid concerns that growing instability in Iraq would disrupt global supplies. All 10 sectors in the MSCI index rose. Information technology stocks gained the most, adding more than 11%. Materials stocks added the least, up less than 4%.
|MSCI Index1||Second Quarter 2014||Year-to-Date|
|Emerging Markets (EM)||6.71%||6.32%|
|EM—Europe, Middle East, and Africa
Indian stocks rally on opposition victory; China advances despite property slowdown
- Indian stocks rose more than 12% as the domestic (SENSEX) index reached record levels following the landslide victory of the main opposition Bharatiya Janata Party (BJP) in May. Investors hope that the BJP under Prime Minster Narendra Modi will implement reforms to revive India's economy.
- Chinese stocks gained more than 5%, but the A-share market restricted to domestic investors rose just 2%. In April, China's state council unveiled a "mini-stimulus" campaign after data showed that the economy slowed more than expected. While recent indicators show the economy has stabilized, growing evidence of a property and credit slowdown has raised the risk that China will miss its long-held 7.5% annual gross domestic product (GDP) target.
- Indonesian stocks edged up less than 1% as investors digested recent gains in the country, Asia's best performer year-to-date, and anticipated volatility ahead of the July 9 presidential elections. Philippine stocks rallied as investors bet on stronger economic growth this year despite a first-quarter slowdown. Stocks in Thailand also surged on hopes that the military would accelerate policies to bolster business confidence and revive the economy after it seized power in May.
Brazilian stocks rise as polls show waning support for Rousseff
- Brazilian stocks surged over 7% as polls showed fading support for President Dilma Rousseff, whom critics have faulted for failing to revive Brazil's flagging economy. Her narrowing lead has fueled hopes that a new, more market-friendly government will take power in October elections.
- Mexican stocks advanced. Mexico's central bank unexpectedly cut its benchmark interest rate in June to a record low to help revive a sluggish economy, a month after it slashed its 2014 growth forecast. Despite several months of weak growth, T. Rowe Price analysts believe that Mexico's medium-term outlook is positive due to a more competitive manufacturing sector and major structural reforms passed last year.
- Stocks in Chile, Colombia, and Peru all rose on strong economic growth despite a weaker commodities outlook resulting from China's slowdown. Chile and Peru separately cut their 2014 growth forecasts during the quarter due to weaker metals prices.
Russian stocks surge as Ukraine tension eases; Turkish stocks soar on rate cuts
- Russian stocks rallied more than 10% as tensions in Ukraine subsided following Russia's annexation of the Crimea region in March. The domestic (MICEX) index rose to an eight-month high at the end of June as prospects rose for an end to hostilities between Russia and Ukraine, diminishing the likelihood that the U.S. and Europe would impose more economic sanctions on Russia. Companies most directly affected by economic sanctions surged the most.
- Stocks in Turkey soared more than 15% as the country's central bank unexpectedly lowered one of its policy rates in May, its first interest rate cut in a year, followed by a larger-than-expected cut to its benchmark interest rate in June. The rate cuts raised doubts about the bank's independence from the government, which has frequently called for lower rates, and increased worries that they would harm Turkey's economy by fanning inflation.
- South African stocks advanced despite growing economic stress due to a protracted platinum miners' strike. South Africa's GDP shrank in this year's first quarter in its first quarterly contraction since 2009, raising the likelihood that the economy will slip into recession this year. In June, Standard & Poor's cut its ratings on South Africa's foreign currency and locally denominated debt to just above junk status, while Fitch Ratings lowered its country outlook to negative.
Solid long-term fundamentals offset near-term risks
In recent years, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. 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 due to Fed tapering, which would exacerbate capital outflows; and an unexpected rise in risk aversion due to geopolitical events. Political risk has increased in many countries holding elections in the coming months, though we believe that new governments in some cases will adopt market-oriented reforms.
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. Emerging markets may not outperform developed markets by the same magnitude as they did in the past decade, but we believe that they will resume their role as global leaders over time.