First Quarter 2015

Smaller-cap stocks outperform as large-caps retreat from record highs
The large-cap Standard & Poor's (S&P) 500 Index reached all-time highs in the middle of the quarter but gave back much of those gains and ended only modestly higher. The Dow Jones Industrial Average declined slightly in terms of price, though it recorded a modest positive total return thanks to dividends. The technology-oriented Nasdaq Composite performed better and briefly exceeded 5,000 for the first time in 15 years. Smaller-cap stocks performed best, however, helped in part by their lower exposure to foreign markets, which have become more challenging for U.S. firms because of the strong U.S. dollar.

U.S. Stocks
  Total Returns
Index First Quarter 2015 Year-to-Date
DJIA    0.33%    0.33%
S&P 500 0.95 0.95
Nasdaq Composite 3.48 3.48
S&P MidCap 400 5.31 5.31
Russell 2000 4.32 4.32
Note: Returns are for the periods ended March 31, 2015. The returns include dividends based on data compiled by T. Rowe Price, except for the Nasdaq Composite, whose return is principal only.

Stocks stumble at start of quarter on falling oil prices
Stocks fell sharply early in the quarter as the price of oil reached multiyear lows, with a barrel of West Texas Intermediate crude down nearly 60% from its mid-2014 peak. Lower oil and gas revenues weighed heavily on energy stocks, but investors also worried that reduced exploration and production in the nation's new shale reserves would hurt jobs growth in the energy sector, an important source of new hiring in recent years. In addition, reduced capital expenditures by energy companies threaten to weigh on profitability for related industrials firms, such as barge and rail operators.

Oil rebound and better news from Europe foster turnaround
A stabilization and slight rebound in oil prices helped the energy sector in February, and positive news from Europe boosted the broader market. The announcement of a ceasefire in Ukraine helped ease global geopolitical concerns despite reports of continued fighting in the region. U.S. stocks also followed European markets higher on news of a four-month extension of Greece's debt relief package, which seemed to remove any immediate threat that Greece would leave the eurozone.

Hopes for Fed "patience" provide further boost
Hopes that the Federal Reserve would continue to keep interest rates low, supporting stock prices, also boosted sentiment. The S&P 500 Index reached an all-time high in late February following assurances from Fed Chair Janet Yellen that policymakers were not in a hurry to raise interest rates despite growing evidence of strength in the U.S. economy. Although the Fed dropped the reference to remaining "patient" in guiding rates higher following its mid-March meeting, stocks returned to near their highs after Yellen clarified at a later press conference that doing so "doesn't mean we are going to be impatient."

Concerns grow over slowing economy
Markets fell back late in the quarter, however, as some worrisome economic data suggested that stocks faced a greater threat from falling demand than from higher interest rates. Several measures showed a slowdown in the manufacturing sector and declining business spending, while gains in retail sales and the housing sector remained meager despite continued improvement in the labor market. T. Rowe Price Chief U.S. Economist Alan Levenson notes that severe weather and port disruptions on the West Coast have recently weighed on manufacturing output, but he also believes that the stronger U.S. dollar may be to blame—both by reducing exports and dragging down capital expenditures by U.S. multinationals.

Strong dollar weighs heavily on large-caps
T. Rowe Price analysts observe that the strong dollar is taking a disproportionate toll on the earnings of the large-cap companies in the S&P 500, which generate well over one-third of their revenues from overseas. In contrast, the small-cap companies in the Russell 2000 Index source roughly one-fifth of their revenues from foreign sales. In the final quarter of 2014, small-cap companies enjoyed more than three times the earnings growth and over five times the sales growth of their large-cap counterparts.

Increased volatility presents opportunities for patient investors
T. Rowe Price investment analysts also note that the CBOE Volatility Index—a measure of expected volatility for the S&P 500 also known as the "investor fear gauge"—is approaching its historical average after dipping to atypically low levels in recent years. Because heightened volatility creates more opportunities to buy and sell stocks at attractive prices, we believe its recent uptick may create opportunities for long-term investors. The increase coincides with gauges showing falling correlations in the stock market, which may heighten the importance of careful stock selection.

First Quarter 2015

Volatility in U.S. Treasuries as Fed prepares to tighten
U.S. Treasuries were volatile but finished with gains, marking the fifth consecutive quarter of positive returns for U.S. government debt. In January, the benchmark 10-year Treasury note's yield decreased by 49 basis points (a basis point is 0.01 percentage points) to 1.68%, its lowest level since May 2013. (Bond prices and yields move in opposite directions.) However, in February, Treasuries experienced their sharpest sell-off since the "taper tantrum" in 2013, as the yield on the 10-year note increased by about 40 basis points in approximately three weeks. Treasuries reversed course and rallied again in March, and the 10-year note's yield ended the quarter at 1.94%.

Fed will evaluate data meeting-to-meeting to determine when to raise rates
The Federal Reserve prepared markets for an initial interest rate increase, which appears likely to take place sometime later in 2015. In her semiannual testimony before Congress, Fed Chair Janet Yellen said that the Fed will begin to evaluate an initial interest rate hike on a "meeting-by-meeting basis." In March, the central bank removed the word "patient" from its post-policy meeting statement about the timing of its first interest rate increase, paving the way for it to raise rates. However, T. Rowe Price Chief U.S. Economist Alan Levenson noted that the Fed's newly released projections for economic growth and inflation were both lower than the central bank's forecasts from December, likely justifying a slower trajectory of rate increases.

ECB starts buying eurozone sovereign debt
In January, the European Central Bank (ECB) made the long-awaited announcement that it would expand its asset purchases to include sovereign bonds, committing to buying 60 billion euros of bonds per month beginning in March. By the end of March, the ECB's purchases had driven yields on high-quality eurozone sovereign debt to extremely low levels, with the yield on the 10-year German government bund at only 0.18%. However, the U.S. dollar's remarkable strength against most other currencies continued in the first quarter, dragging returns on non-U.S. developed market debt well into negative territory for U.S.-based investors.

Total Returns
Index First Quarter 2015 Year-to-Date
Barclays U.S. Aggregate Bond Index    1.61%   1.61%
Credit Suisse High Yield Index 2.59 2.59
Barclays Municipal Bond Index 1.01 1.01
Barclays Global Aggregate Ex-U.S. Dollar Government Bond Index -4.63 -4.63
J.P. Morgan Emerging Markets Bond Index Global Diversified 2.01 2.01
Barclays U.S. Mortgage Backed Securities Index 1.06 1.06
Figures of March 31, 2015. Past performance cannot guarantee future results. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.

High yield bonds supported by stabilizing oil prices
Although oil prices were volatile throughout the quarter, their free fall from the second half of 2014 ended, allowing high yield bonds to rebound. Debt from energy-related issuers accounts for a large proportion of most high yield indexes. Solid investor demand for bonds offering more yield as well as a buoyant equities market provided additional support for noninvestment-grade bonds. High yield credit spreads, which measure the additional yield above that of a comparable-maturity Treasury security that investors demand for holding a bond with credit risk, narrowed significantly. In January, Caesars Entertainment Operating Company filed for Chapter 11 bankruptcy protection, a large but widely expected default.

Solid returns for investment-grade corporate debt amid heavy issuance
Investment-grade corporate bonds also broadly generated solid returns, although they lagged high yield bonds. Investors generally preferred newly issued investment-grade corporate debt over bonds trading in the secondary market. Issuance was heavy as companies brought bonds to market to take advantage of the low interest rate environment. Pharmaceutical company Actavis sold $21 billion of debt, the second-largest corporate bond offering ever, to fund its acquisition of Allergan, maker of Botox. U.S. firms have also been rushing to sell new bonds in Europe, where rates are even lower.

Country-specific volatility in emerging markets bonds
Emerging markets debt denominated in U.S. dollars posted positive returns amid considerable country-specific volatility. Moody's downgraded Petrobras, Brazil's huge state-run oil company that has been plagued by a corruption scandal, to below investment grade. By the end of the quarter, however, it appeared that Petrobras would be able to file financial reports accounting for bribes by April 30 and avoid a technical default. Emerging markets bonds denominated in local currencies dropped significantly as most emerging markets currencies fell against the dollar. For example, by mid-March the Brazilian real had lost about 15% against the greenback in 2015, although it later recovered somewhat.

Wave of prepayments on MBS fails to fully materialize
Mortgage-backed securities (MBS), which typically trade in lock step with Treasuries, posted modest positive returns. MBS experienced significant selling pressure at the beginning of the year, when declining mortgage rates and policymaker moves to expand lending triggered expectations for increased levels of residential mortgage refinancing, which causes prepayments on MBS and lowers their value. However, the expected wave of prepayments failed to fully materialize, and the sector recovered in February and March.

U.S. Treasury Yields
Maturity December 31, 2014 March 31, 2015
3-Month    0.04%   0.03%
6-Month 0.12 0.14
2-Year 0.67 0.56
5-Year 1.65 1.37
10-Year 2.17 1.94
30-Year 2.75 2.54

Muted returns for municipal debt
Municipal bonds generated muted gains despite February being the first down month for the asset class since December 2013. Investor demand for tax-free debt was generally strong, helping to offset a resurgence of new issuance. In Puerto Rico, a federal judge struck down the territory's Recovery Act, which would have allowed Puerto Rico's public corporations (such as electric utility PREPA) to restructure their debt. Both Standard & Poor's and Moody's downgraded Puerto Rico's debt, citing an increased risk of default.

Longer-term relative value in locally denominated emerging markets bonds
Although we expect ongoing near-term volatility in emerging markets currencies as markets adjust to the Fed's tightening plans, we think that some emerging markets debt denominated in local currencies offers compelling value for the medium to long term. The dollar may not have much more room to strengthen against the currencies of many developing markets, some of which now appear to be poised for a rebound. At the other end of the risk spectrum, some short-maturity asset-backed securities should benefit from the strengthening U.S. economy and provide solid relative value as alternatives to cash.

First Quarter 2015


Non-U.S. markets post Q1 gains despite U.S. dollar strength
Developed non-U.S. stock markets posted a 5.00% return in U.S. dollar terms for the first quarter as measured by the MSCI Europe, Australasia, and Far East (EAFE) Index thanks to an impressive rally in February. For the quarter, the local currency return for the EAFE Index was 10.97%. In fact, every developed market country logged a first-quarter gain in local currency terms. The euro and British pound sterling declined versus the U.S. dollar, but the yen was little changed. An appreciating U.S. dollar detracts from dollar-based returns for investors in local currency-denominated securities. Indeed, the U.S. Dollar Index—a yardstick for measuring how the dollar is faring relative to the world's other major currencies—hit 100 in mid-March, its highest level since 2003.

In the MSCI EAFE Index, large- and small-cap stocks performed similarly, while growth stocks outperformed value shares. From a sector perspective, health care, consumer discretionary, and information technology performed best. The worst-performing sectors in the index were utilities and energy.

Within emerging markets, Asian stocks generated a solid return; the Europe, Middle East, and Africa region recorded a more modest advance; and Latin America posted losses. Among the largest emerging stock markets, Brazil declined double digits (amid a corruption scandal involving Petrobras), Russia advanced strongly, and China and India returned more than 8% and 5%, respectively.

International Indexes
  Total Return
MSCI Index First Quarter 2015 Year-to-Date
EAFE (Europe, Australasia, Far East)    5.00%    5.00%
All Country World ex-U.S.A 3.59 3.59
Europe 3.58 3.58
Japan   10.34   10.34
All Country Asia ex-Japan 4.90 4.90
EM (Emerging Markets) 2.28 2.28
All data are in U.S. dollars as of March 31, 2015. 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

Japan emerges from a brief recession
Japan's economy emerged from a six-month, tax increase-induced recession in the fourth quarter, yet two-thirds of Japanese business leaders plan to reduce capital investment as reported in the "Tankan" business survey released by the Bank of Japan (BoJ) at the end of March. The central bank is pumping trillions of yen into the economy in an attempt to suppress interest rates, stimulate inflation, and stabilize the yen versus other currencies. However, business sentiment remains weak as the BoJ's aggressive stimulus measures have driven up food and industrial materials costs, while weakening purchasing power, which has dampened domestic consumption. Union employees saw better wage increases after annual labor talks ended, but overall, incomes have continued to decline over the past few years. Japan's fourth-quarter economic growth was revised lower to 1.5% from a previous 2.2% estimate, which may force the BoJ to deploy additional stimulus later this year to meet its 2% inflation target. Thus far, Tokyo's mix of monetary policy and economic reforms has yet to drive steady growth in corporate earnings, wages, and business investment.

Chinese economic growth and inflation declined more than expected, said People's Bank of China's (PBoC) Governor Zhou Xiaochuan. Preliminary first-quarter data showed that China's economy continued to slow after its weakest expansion (7.4%) in more than a decade last year. The central bank lowered the minimum down payment requirement for second-home buyers to lift the property market. The PBoC reduced lending and deposit interest rates in March, due to concerns about the country's slumping property market, slowing economic growth, and deflationary pressures. Performance for other emerging markets in the Asia/Pacific region was mixed.

The ECB comes through with QE, setting the stage for a eurozone recovery
The European Central Bank's (ECB) quantitative easing (QE) program began in March and was the equity market's cue for a liftoff. The central bank expanded its asset purchases to include bonds of eurozone governments, agencies, and European institutions. The total size of the QE program, €1.1 trillion ($1.2 trillion), was much larger than most had anticipated. The ECB will buy €60 billion of bonds per month through at least September 2016. Stocks in Europe advanced almost 12% in local currency terms for the quarter.

Although T. Rowe Price sovereign analysts think that the QE program alone will not solve the eurozone's entrenched problems, they believe it should allow the 19-nation bloc to produce better growth in the second half of 2015. They also believe the ECB's action could encourage investors to seek riskier assets and support corporate investment as companies issue bonds to take advantage of low interest rates.

Non-U.S. stocks offer pockets of opportunity for stock pickers
T. Rowe Price portfolio managers remain optimistic about the investment environment for global equities in the intermediate and longer terms. However, they anticipate that growth in developed markets will continue in a stop-and-start fashion. The difficult, long-term adjustments that are needed for many markets in Europe and Japan to become more competitive are only in their early stages. T. Rowe Price managers are confident that Europe offers long-term growth potential, but the near-term outlook for the region is concerning due to disappointing corporate earnings. Lower European stock valuations reflect these worries. In Japan, we remain encouraged by the changes taking place at the corporate level, including the newfound focus on return on equity, improvements in corporate governance, and generally improving returns for shareholders. In emerging markets, returns have become considerably more reflective of underlying fundamentals at the stock and country level, which we view as a positive development. Although some individual stocks and sectors appear to be richly priced, there are opportunities for bottom-up stock selection.

First Quarter 2015

Emerging markets stocks rise in Q1 as Fed signals rate hike is not imminent
Emerging markets stocks rose in the first quarter of 2015 as the Federal Reserve's repeated reassurances that it was in no rush to raise interest rates boosted investors' risk appetite. A February peace deal to end the nearly year-old Ukraine crisis also raised hopes that the U.S. and Europe may roll back sanctions on Russia if the truce holds. Finally, several interest rate cuts across the emerging universe and news of the European Central Bank's highly anticipated large-scale quantitative easing program buoyed demand for riskier assets. Against these tailwinds, however, evidence of slowing growth mounted in many countries. China announced a 7% economic growth target for 2015, down from last year's 7.5% goal, and Brazil and Russia are expected to fall into recession this year. A strong U.S. dollar contributed to losses in many markets whose currencies weakened against the dollar. For example, shares in Brazil, Mexico, and Malaysia rose for the quarter in local currency but fell when converted into dollars. Seven sectors in the MSCI Emerging Markets Index rose and three fell. Information technology stocks fared best, up 8.5%, while utilities fell the most, down roughly 3%.

International Averages
  Total Returns
MSCI Index First Quarter 2015 Year-to-Date
Emerging Markets (EM) Index     2.28%    2.28%
Asia Index  5.26 5.26
Europe, Middle East, Africa (EMEA) Index  2.02 2.02
Latin American Index -9.49 -9.49
All data are in U.S. dollars as of March 31, 2015. 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 soar to seven-year high; Indian stocks rise as lower oil tames inflation

  • China's A share market for domestic investors climbed more than 18%, while a broader measure of Chinese stocks posted slimmer gains. The Shanghai Composite Index, China's main domestic benchmark, rose to a seven-year high on March 31 as domestic investors bet that the government would roll out more stimulus measures to revive the slowing economy.
  • Indian stocks rose as reform expectations and falling oil prices benefited the country's economic outlook. Lower oil has helped contain inflation and lower India's import bill, allowing its government to reduce costly fuel subsidies, and the central bank cut interest rates twice over the quarter as inflation fell faster than expected.
  • Southeast Asian stocks were mostly positive. The Philippines led advances with a roughly 10% gain, while Malaysia was the sole decliner. Domestic stock benchmarks in Indonesia and the Philippines hit record highs in February after Fed Chair Janet Yellen's testimony reassured investors that a U.S. rate hike was not imminent. Outside of the Philippines, however, growth across the region remained subdued. Central banks in Indonesia and Thailand cut interest rates during the quarter.

Brazilian stocks drop on economic woes; Mexico's central bank sees worsening outlook

  • Brazilian stocks lost nearly 15% amid a steady stream of bad economic news. Brazil's gross domestic product (GDP) shrank 0.2% in last year's final quarter from a year earlier and grew just 0.1% in 2014 from 2013, its statistics agency reported in March. Brazil also received a blow in February when Moody's cut the credit rating on state oil producer Petrobras to junk, raising the possibility that the country's sovereign credit rating was at risk.
  • Mexican stocks declined a relatively mild 2%. The drop in oil prices has weighed heavily on Mexico's economic outlook, forcing its government to cut infrastructure projects and other spending. In March, Mexico's central bank left interest rates at a record low for the sixth straight meeting and cautioned that its economy was weak and growth prospects have deteriorated. The peso sank to a record low that month, which led the bank to intervene to support the currency.
  • Stocks in Colombia and Peru fell while those in Chile edged higher, as weakness in oil and other commodities weighed on their resource-driven economies. In March, Chile reported that its economy grew 1.9% in 2014, a five-year low; Peru's finance minister cut his 2015 GDP growth forecast for the second time this year; and Colombia reported that its economy grew at a weaker-than-expected pace in last year's fourth quarter.

Russian stocks rally as Ukraine crisis eases; Turkish stocks fall

  • Russian stocks soared more than 18% as the Ukraine crisis receded from the front burner for most investors and crude oil prices stabilized. Hopes of a lasting truce in Ukraine-which would reduce the risk of more sanctions on Russia's already weak economy—drove a rally in the ruble, which gained more than 3% against the dollar and was the quarter's best-performing currency.
  • Turkish stocks sank nearly 16% as a feud between the country's central bankers and politicians over monetary policy shook investor confidence. Turkey's central bank twice reduced its various policy rates early this year. However, the rate cuts failed to appease government officials who had called for steeper reductions to stimulate the economy and raised doubts about the central bank's independence from political pressure. The lira fell to a record low versus the dollar during the quarter, which exacerbated Turkey's losses.
  • South African stocks advanced slightly as falling oil prices lifted expectations that borrowing costs would not increase in the country, a net oil importer. Indeed, South Africa's central bank left its key interest rate unchanged during the quarter, but its surprisingly hawkish statement after its March decision led many to believe that it will start raising rates in the coming months.

Solid 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. Finally, most emerging markets are still expanding faster than developed ones and offer solid growth opportunities for long-term investors. In recent years, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. We anticipate more divergence in the performance of countries and companies than we have seen in the past 15 years, and we believe that careful stock selection will be crucial for producing good returns over time.