First Quarter 2014
Stocks see modest gains despite economic and geopolitical concerns
Most of the major indexes recorded modest gains in the quarter and reached new or multiyear highs as investors balanced favorable corporate earnings against economic and geopolitical concerns. The Dow Jones Industrial Average was the only major benchmark to record a loss, while the Standard & Poor's MidCap 400 Index regained market leadership. The utilities sector handily outpaced all other segments within the S&P 500 Index, followed by health care. Consumer discretionary was the only sector to register a loss for the period. Value stocks handily outperformed growth shares for the quarter.
|Index1||First Quarter 2014||Year-to-Date|
|S&P MidCap 400||3.04||3.04|
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Markets pull back to begin 2014
Stocks sold off sharply at the start of the quarter, due in large part to fears of slower growth in emerging markets. Poor data on Chinese manufacturing raised new concerns about the global economy, while investors were also worried by rumored problems in the country's so-called shadow banking system. Market losses accelerated as fears grew over a broader capital flight from emerging markets, brought about by the prospect of higher long-term rates in the U.S. and declining global liquidity as the Federal Reserve reduces its asset purchases. T. Rowe Price's sovereign credit analysts counseled that fears of a new emerging markets contagion were overdone, noting that many emerging markets have adopted prudent economic policies and accumulated ample foreign exchange reserves, which should help insulate them from capital outflows to developed markets.
Corporate earnings help spark rebound
Markets managed a turnaround in February as emerging markets fears subsided and investors turned their focus to corporate earnings. 2013 ended on a stronger note for profits than many had anticipated, with over seven out of 10 companies in the S&P 500 managing to surpass earnings estimates, according to analytical firm FactSet. Revenue growth was much more modest than earnings growth but also managed to exceed expectations. Revenue growth has been the weak spot in corporate earnings, with most corporations relying on cost-savings measures to grow profits in the face of slowly growing final demand.
Investors await spring thaw in U.S. economy
Indeed, U.S. economic signals were mixed throughout much of the period. Data released early in the quarter were generally disappointing, with weak payroll gains, slowing growth in manufacturing activity, a falloff in auto sales, and steep drops in residential construction and home purchases. Many investors appeared willing to attribute much of the economic weakness to the exceptionally cold and snowy winter, however, and data later in the quarter indicated that the economy might enjoy a spring thaw. Some measures of manufacturing and housing activity picked up, and monthly payroll gains returned roughly to their average over the past year.
Geopolitical concerns return to the forefront
After a long period of relative calm international affairs, geopolitical concerns regained investors' attention late in the quarter. The movement of Russian troops into the Crimean region of Ukraine sent markets tumbling in early March. Markets soon stabilized somewhat, but investors remained on edge throughout the final weeks of the quarter as Crimeans voted to secede from Ukraine and Russian troops moved into additional positions along the Ukrainian border. The U.S. and its European allies responded with targeted sanctions and the threat of additional trade actions, which further unnerved investors with the threat of interrupted energy supplies from Russia and other repercussions to the fragile economies of Europe.
Buyouts of public companies boost stock prices but reduce opportunities for investors
One factor supporting stock prices during the quarter was the prospect of further acquisitions, both by competitors sitting on record levels of cash and by private equity firms. Buyouts of public companies in recent years have helped boost stock prices in many instances, but they have also reduced the opportunity set for investors. T. Rowe Price Portfolio Manager Greg McCrickard notes that this is a particular challenge for small-cap investors, as the number of initial public offerings has not kept pace with the decline in listed companies. Several factors have contributed to the decline, including higher regulatory hurdles and costs for taking a company public and the ready availability of venture capital and other private funding sources.
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.
First Quarter 2014
Risk aversion and weak economic data result in lower Treasury yields
Treasury yields across most maturities fell during the first quarter due in part to risk aversion resulting from Russia's annexation of Crimea from Ukraine and concerns about the economic health of some emerging markets. The Treasury yield curve flattened as longer-maturity Treasury bonds experienced the most significant price increases and yield declines. Some weak U.S. economic data also helped boost Treasury prices. At the other end of the risk spectrum, emerging markets debt performed well, rebounding sharply from a sell-off in January.
Fed tapering continues
Treasuries rallied despite a reduction in the Federal Reserve's purchases as the central bank scales back its quantitative easing program. Last year, the Fed was buying $45 billion of Treasuries each month as part of its effort to keep long-term interest rates low; however, the central bank reduced its monthly Treasuries purchase amount by $5 billion at each of its last three policy meetings. Although economic data released early in the quarter were weak—the January unemployment report showed that the economy added a disappointing number of jobs to nonfarm payrolls for the second consecutive month—Fed Chair Janet Yellen reiterated that it would take a "significant change" in the economic outlook for the Fed to adjust its tapering plans.
Uncertainty about timing of eventual Fed rate hikes
Yellen also caused a stir in the markets after the Fed's March policy meeting, when she made an impromptu statement implying that the central bank could possibly start raising the federal funds rate as soon as six months after ending its asset purchases. That timeframe would place the start of monetary tightening earlier than markets had anticipated. In a sign that the Fed thinks that the economy is gathering momentum, Yellen expressed clear confidence in the job market, saying that "labor market conditions have continued to improve." T. Rowe Price Chief Economist Alan Levenson believes that the Fed will still likely wait until mid-2015 to raise rates.
|Index1||First Quarter 2014||Year-to-Date|
|Barclays Capital U.S. Aggregate Bond Index||1.84%||1.84%|
|Credit Suisse High Yield Index||3.07||3.07|
|Barclays Capital Municipal Bond Index||3.32||3.32|
|Barclays Capital Global Aggregate Ex-U.S. Dollar Government Bond Index||2.79||2.79|
|J.P. Morgan Emerging Markets Index Plus||3.73||3.73|
|Barclays U.S. Mortgage Backed Securities Index||1.59||1.59|
Sharp rebound in emerging markets debt
Emerging markets bonds had a volatile quarter, dropping more than 1.5% in January before retracing those losses and finishing up more than 3.5%. While several emerging markets currencies sold off rapidly at the beginning of the year, countries including Turkey, India, and Brazil aggressively raised interest rates. This action stabilized the currencies and gave investors the confidence in some developing economies to buy their bonds at attractive levels.
The standoff between Russia and the West over Crimea did not result in a sustained sell-off in emerging markets bonds, and the March announcement of a two-year International Monetary Fund financing package for Ukraine potentially worth up to $18 billion helped boost Ukrainian debt. In South America, Venezuela introduced a new foreign exchange framework and devalued its currency, which should help reduce its large fiscal deficit. Although Standard & Poor's downgraded Brazil's sovereign debt to BBB- from BBB in a move that was largely priced into the market, the rating agency's outlook for the country is stable and the rating is still investment grade.
Good returns for non-U.S. developed market sovereign debt
Non-U.S. developed market government bonds produced good returns, although they significantly lagged emerging markets debt. Fears that weakening growth in emerging markets—particularly China—would weigh on developed-market economies led to more demand for the sovereign bonds of developed countries. In addition, strengthening in the Japanese yen and the euro against the U.S. dollar boosted the returns of yen- and euro-denominated bonds for U.S. investors.
Long-maturity corporate bonds benefit from pension fund demand
Investment-grade corporate bonds posted strong performance as a result of the decline in Treasury yields and narrowing credit spreads, which measure the additional yield that investors demand as compensation for holding a bond with credit risk versus a similar-maturity Treasury security. Longer-term corporate bonds in particular benefited from increasing inflows from pension plans looking to invest equity-market gains in a less-risky, long-term asset class. This trend narrowed the credit spreads on long-maturity corporates even more. Issuers of corporate bonds also continued to benefit from the strong demand, as issuance of investment-grade corporate bonds reached the highest level since the first quarter of 2009. High yield corporate bonds, once again, performed well as the attractive relative yields of the noninvestment-grade asset class and the generally strong financial condition of high yield issuers attracted investors.
Puerto Rico municipal bonds downgraded to noninvestment-grade
Propelled by limited new supply, municipal bonds generated strong returns. All three major credit rating agencies downgraded Puerto Rico's municipal debt to below investment grade. Despite the downgrades, the financially troubled U.S. territory sold $3.5 billion of new municipal debt at a surprisingly low yield. The proceeds from the bond issue will give Puerto Rico more time to improve its fiscal and economic situation.
|U.S. Treasury Yields|
|Maturity||December 31, 2013||March 31, 2014|
Fed tapering weighs on agency MBS
In addition to Treasuries, the Fed has been buying agency mortgage-backed securities (MBS) as part of its quantitative easing measures. Although the central bank's tapering weighed on the agency MBS market, it still managed to post decent performance as Treasury yields declined. Before starting to taper, the central bank was buying $40 billion of agency MBS each month. In March, the Fed bought only $30 billion of agency MBS. There is considerable uncertainty about who will step into the agency MBS market to replace the steadily declining demand from the Fed. Asset-backed securities (ABS) posted muted returns for the quarter.
Attractive relative value in dollar-denominated emerging markets bonds
Within the securitized debt asset class, T. Rowe Price portfolio managers and analysts see attractive relative value in select commercial mortgage-backed securities and ABS. They also like some intermediate-term investment-grade corporate bonds, where credit spreads have not narrowed as much as on long-maturity corporate debt. However, they currently view some emerging markets debt denominated in U.S. dollars as the most compelling opportunity overall. Some emerging markets bonds have sold off to levels that don't reflect their intrinsic value, and debt denominated in dollars would mitigate the effects of future currency volatility.
First Quarter 2014
Developed stock markets finish a volatile first quarter about where they started
Non-U.S. stocks endured a tumultuous first quarter. Developed markets generated mixed results in March, following seesaw returns in January (lower) and February (higher). Emerging market equities began the year with losses in January and February and then posted solid gains in March, but ended the quarter modestly lower. Developed European and Nordic stock markets generated the best gains, benefiting from reduced emphasis on austerity measures and progress on structural reforms in some countries. Developed stock markets in the Asia-Pacific region posted mixed results—Japan and Hong Kong ended lower—that underperformed the broad MSCI Europe, Australasia, and Far East (EAFE) Index. The outlook for emerging economies brightened significantly as the period came to a close, with stocks in Latin America and Asia posting strong advances. However, the emerging Europe region declined largely due to steep losses in Russia, exacerbated by the plunging value of the ruble, which fell more than 6% in the quarter.
Within the EAFE index, small-cap stocks outperformed large-caps, and value stocks slightly outperformed growth shares for the three-month period. The utilities sector (+7%) was far and away the strongest performer followed by health care. Most other sectors produced modest gains or losses, save telecommunication services and consumer discretionary, which each fell about 2%. The U.S. dollar was virtually unchanged versus the euro but weaker versus the Japanese yen and the British pound.
|MSCI Index1||First Quarter 2014||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||0.77%||0.77%|
|All Country World ex-U.S.||0.61||0.61|
|All Country Asia Ex-Japan||-0.68||-0.68|
|EM (Emerging Markets)||-0.37||-0.37|
Asia's largest markets underperformed
Japan's stock market generated banner results in 2013 (+27%), but the 5% first-quarter loss ranked it as Asia's poorest-performer for the year to date. The Japanese economy is making strides toward recovery thanks to the magnitude of its "three arrows" policy. T. Rowe Price managers generally favor Japanese companies that can benefit from improving consumer confidence, merger or acquisition activities, and an improving real estate market. Among the other developed markets in the region, Australia and New Zealand posted solid gains.
Emerging markets post impressive gains in March
Except for two of its largest markets—China and South Korea—most emerging markets in the Asia-Pacific region posted solid first-quarter gains. Slowing Chinese economic growth caused investor concern and led to selling in the world's second-largest market. The structural reforms announced by China's new leadership should accelerate in 2014, setting the stage for more balanced economic growth in the years ahead. Chinese policymakers appear willing to tolerate slower near-term growth as they attempt to stimulate long-term domestic consumption. Among the best performers in the region, India, Indonesia, Pakistan, and Thailand all posted banner results in March, and each gained at least 7% in the quarter. The emerging Europe region suffered a greater than 6% decline largely because of Russia's steep losses, due to geopolitical tensions surrounding its takeover of Crimea. Latin American stocks eked out a modest gain in the quarter as every market rallied in March, recouping the losses in January and February.
European markets forge ahead
The European region posted a third consecutive quarterly advance. The 2% gain, albeit modest in the context of a 25% gain last year, reflects growing investor confidence in the region's future. While economic conditions include pockets of weakness, the overall macroeconomic picture is showing signs of improvement. T. Rowe Price economists believe that the European Central Bank may inject more liquidity into the financial system in 2014 via another long-term refinancing operation to bolster economic growth. Dean Tenerelli, portfolio manager of the European Stock Fund, believes that most European economies bottomed in the first half of 2013 and that improved competitiveness can lead the region into real economic recovery. Although Germany and the UK recorded modest losses in the quarter, several markets, including Denmark, Ireland, and Italy, posted double-digit advances.
Non-U.S. stocks remain attractive as longer-term growth prospects improve
In Europe, better economic data suggest that the modest recovery will continue, helped by the gradual easing of austerity measures and stronger U.S. growth. It seems that confidence is returning to European markets, and this should feed into both consumer and corporate spending. Additionally, valuations remain reasonable by several key measures, and many European companies should benefit from reducing costs and improving their market positions over time. While we remain optimistic about the longer-term prospects for Japan's market, we are looking for signs that its policymakers are politically willing and able to address important structural reforms to labor markets, tax and regulatory regimens, and social spending.
We believe emerging markets offer compelling valuation opportunities, given their strong long-term growth prospects. However, the twin tailwinds of a commodity supercycle and double-digit growth in China appear to be fading, and emerging markets are now facing a period of slower growth coupled with tighter global liquidity. These adjustments caused emerging markets to underperform in the past year, but over the longer term, we believe that the secular growth drivers for emerging markets remain in place.
First Quarter 2014
Emerging markets stocks decline due to currency weakness
Emerging markets stocks declined in the first quarter of 2014 as losses in January due to a currency sell-off offset gains in February and March. January's turmoil was sparked by a private survey that showed manufacturing in China unexpectedly contracted to a six-month low, which triggered a flight from risk that hit emerging markets currencies particularly hard. In response to the sell-off, central banks in Brazil, India, South Africa, and Turkey raised their respective benchmark interest rates in January. The rate hikes helped most emerging markets currencies recover by quarter-end, diffusing worries about a destabilizing currency crisis in the developing world.
Political uncertainty in many countries hurt sentiment early in the year as investors weighed the risks of a widening corruption probe in Turkey, a governance crisis in Thailand, and Russia's annexation of Ukraine's Crimea region. However, polling results favoring reform-minded candidates in India, Indonesia, and Brazil—which have elections later this year—lifted their respective stock markets in March. Additionally, several weaker-than-forecast indicators in China in March raised speculation that its government will enact stimulus measures to bolster the economy. The MSCI Emerging Markets Index fell to its lowest level since August 2013 at the end of January but erased most of the drop by quarter-end. Six sectors in the index declined and four rose. Telecommunication services stocks fared the worst, down more than 5%, while information technology stocks added the most, up roughly 4%.
|MSCI Index1||First Quarter 2014||Year-to-Date|
|Emerging Markets (EM)||-0.37%||-0.37%|
|EM—Europe, Middle East, and Africa
China leads Asian markets lower as slowdown worries mount
- Stocks in China fell the most in Asia, falling more than 5%, while its restricted A-share market for foreign investors sank more than 9%. Numerous economic indicators over the quarter suggested that China faces a serious growth slowdown that will make it harder for the government to attain its 7.5% annual expansion target. Recent defaults in China's domestic corporate bond market also highlighted the country's unregulated lending practices, which some fear could set off a broader financial crisis. T. Rowe Price analysts believe that the risks of a financial crisis in China are low but that headline growth will continue slowing in the coming years.
- Indian shares advanced, driven by optimism that the main opposition Bharatiya Janata Party (BJP) will take power after national elections scheduled for April and May and push through economic reforms. T. Rowe Price analysts caution that while the BJP may win the most seats in parliament, it remains unclear if it will win enough to form a stable coalition that gives it a clear reform mandate.
- Indonesian stocks surged more than 21%, lifted by improving economic fundamentals and strong corporate earnings growth. In March, the country's domestic benchmark reached its highest level since June 2013 after the main opposition party named the popular governor of Jakarta as its presidential candidate. A recovery in the rupiah, last year's worst-performing Asian currency, also restored some confidence in the country's outlook.
Brazilian stocks gain on presidential poll results
- Brazilian stocks advanced even as its economy struggled with mild stagflation, or weak growth combined with rising prices. Brazil's central bank raised its benchmark rate twice during the quarter to fight inflation. Separately, Standard & Poor's cut Brazil's sovereign credit rating to one notch above junk status, citing the country's weak growth outlook, rising debt, and widening deficit. Despite the weak economy, Brazil's market rallied in March after a poll showed a drop in President Dilma Rousseff's approval rating ahead of presidential elections in October, raising the prospect of an opposition victory.
- Mexican stocks fell. Mexico's government forecast economic growth of 3.9% this year versus last year's 1.1% pace, a four-year low amid downturns in manufacturing and home building. After a disappointing 2013, T. Rowe Price investment professionals believe Mexico's economy will significantly benefit from productivity gains from sweeping reforms that the government has enacted in the past 18 months.
- Colombian stocks rose, aided by a rally in March. Colombia's economy expanded at a surprisingly strong 4.9% in last year's fourth quarter, bringing full-year GDP growth to 4.3%.
Russian stocks slump on Ukraine crisis
- Russian stocks fell the most among EMEA countries as investors worried that the Ukraine crisis could lead to a prolonged standoff with western countries following Russia's annexation of Crimea. The domestic Micex Index touched its lowest level since 2009 in mid-March before a referendum in Crimea on whether the region should join Russia. Fitch Ratings and Standard & Poor's cut their credit rating outlooks on Russia to negative, citing the impact of sanctions on Russia's flagging economy.
- Turkish stocks advanced, thanks to a March rally in the days preceding local elections at month-end. The results solidified the ruling AKP party's hold on power and dispelled some of the uncertainty that has weighed on Turkey since a corruption probe erupted in late 2013, sending the domestic stock index to its highest level since last December. T. Rowe Price analysts believe that continued political tension and weaker reform momentum will define the outlook for Turkey, which faces more election uncertainty into 2015. S&P cut its outlook for Turkey's credit rating to negative from stable, citing the growing risk of a "hard economic landing" and "a policy environment [that] is becoming less predictable."
- South African stocks advanced as its currency recovered from heavy selling pressure in recent months. Its central bank boosted its key interest rate in January for the first time since 2008 to defend its currency. The country's finance minister reduced the estimate for 2014 economic growth to 2.7% from 3.0% in February, underscoring the weak growth outlook.
Solid long-term fundamentals offset near-term risks
We believe that emerging markets stocks are an attractive asset class for long-term investors, but they should invest gradually and have realistic expectations. Emerging markets may not outperform developed markets by the wide margin achieved over the past decade, but they should resume their role as global leaders over time. 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. Additionally, most emerging markets today have stronger financial positions, larger foreign exchange reserves, and more flexible foreign exchange policies.
Near-term risks for emerging markets include: a worse-than-expected economic slowdown in China or a breakdown in its financial system; a further rise in investors' risk aversion; and a sharp rise in U.S. interest rates due to Federal Reserve tapering, which would exacerbate capital outflows. Political uncertainties have risen in many developing countries that have elections in the coming months, although we believe that new governments in some countries will bring market-oriented reforms. 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 crucial for long-term outperformance.