Fourth Quarter 2013
Strong gains lead stocks to record highs
Stocks recorded stellar gains in the fourth quarter, bringing the major indexes to record highs or, in the case of the Nasdaq Composite Index, multiyear highs. The quarter's performance pushed the S&P 500 Index to its best year since 1997, while the Dow Jones Industrial Average enjoyed its biggest annual gain since 1995. All 10 S&P 500 sectors recorded positive returns, with only the defensive telecommunication services and utilities segments lagging significantly. Small- and mid-cap stocks surrendered market leadership to large-caps for the quarter but ended with generally stronger gains for the year. Growth stocks moderately outpaced value shares among large-caps, but the opposite held true for the smaller-cap benchmarks.
|Index1||Fourth Quarter 2013||Year-to-Date|
|S&P MidCap 400||8.33||33.50|
Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group.
Economic strength fuels gains
Signs that the U.S. economy had regained some traction following its slowdown in late 2012 and early 2013 were key in driving the market's gains. Healthy payroll growth in October and November caused stocks to jump when the data were released early in the following months, and investors were encouraged to see the unemployment rate finally falling because of job gains rather than as a result of Americans leaving the labor force. The manufacturing sector continued to expand at a healthy pace, while the housing sector seemed to regain momentum amid appealing prices and mortgage rates that remained near historically low levels despite recent increases. In December, revised government data showed that the economy had grown at an annualized rate of 4.1% in the third quarter, a drastic improvement from its nearly flat performance as the year began.
Profits increase, but revenue growth lags
The improving economy allowed for continued growth in corporate profits. Third-quarter earnings reports were generally welcomed by investors as they were released in October and November—Thomson Reuters reported that earnings for the S&P 500 as a whole grew 5.8% over the year ended September 30, a figure that would have been substantially larger if not for some one-time charges to bank earnings. Investors also cheered another round of successful initial public offerings. Revenue growth continued to lag, but hopes for stronger growth in Europe as it emerges from recession and improvement in other export markets fueled optimism for the coming year. Revenues have also been constrained by relatively muted growth in U.S. consumer spending, but T. Rowe Price economists note that recent gains in employee compensation and an improved savings rate set the stage for higher spending in coming months.
Taper tantrum turns into celebration
The Federal Reserve's decision to start making measured changes to its stimulus program also boosted sentiment. On December 18, stocks surged after the Fed announced that in January 2014 it would begin tapering its asset purchases, which have suppressed long-term interest rates and helped spur demand for equities. Market observers said the Fed's decision to gradually reduce its asset purchase program lifted investor sentiment, as the move meant that substantial stimulus was likely to remain in the pipeline for 2014. The central bank also strengthened its commitment to keeping short-term rates near 0%. The positive market reaction may also have simply been a case of "sell on the rumor, buy on the news," as investors had already factored in the prospect of a change in Fed policy. Concerns about higher long-term interest rates diminished the relative appeal of utilities and telecommunication services stocks, however, as their high dividends became less compelling relative to bonds.
Fiscal headwinds diminish
Waning fiscal headwinds also boosted both economic activity and investor sentiment. Markets fell at the start of the quarter as yet another deadlock over the federal budget resulted in a partial government shutdown—and briefly threatened to cause the government to breach its debt limit and possibly default on its obligations. Markets recovered after the impasse was resolved, however, and a bipartisan two-year budget deal in December further boosted sentiment. T. Rowe Price economists note that more favorable fiscal policy may have been one factor behind a healthy increase in November business equipment spending, which had slumped in the middle of the year.
Gains may moderate, highlighting importance of stock selection
T. Rowe Price managers observe that high corporate cash levels might help strengthen the recovery in 2014, especially if companies increase capital spending. Corporations could also devote some of their cash to mergers and acquisitions, which would provide less of a direct economic benefit but help support stock prices. They caution, however, that a better economic environment does not guarantee superior stock market performance, and they would not be surprised to see stock gains moderate in the coming year. While the market's gains were very broadly based in 2013, the importance of identifying individual cases in which a company's potential is not reflected in its stock price may become more important in the new year.
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.
Fourth Quarter 2013
Fed tapering announcement reduces uncertainty
The fourth quarter kicked off amid considerable uncertainty about both fiscal policy and the timing of the Federal Reserve's tapering of asset purchases. The partisan gridlock in Washington about the debt ceiling resulted in the early October partial shutdown of the federal government and the potential for a default on Treasuries. However, the Treasury market largely shrugged off the threat of default, as only the yields on Treasury bills maturing in late October and early November temporarily moved significantly higher. The government shutdown likely slowed U.S. economic growth to some degree and probably contributed to the Fed's decision not to announce the taper until December.
By mid-December, when the Fed announced that it would begin to scale back the pace of its purchases of Treasuries and agency mortgage-backed securities (MBS) in January, the yield on the benchmark 10-year Treasury note had already climbed from 2.61% at the beginning of the fourth quarter to about 2.90%. After the Fed eliminated uncertainty about the timing of the taper, Treasury yields seemed to rise as a result of steadily improving economic data as opposed to worries about a slower rate of Fed purchases. The benchmark 10-year Treasury yield climbed over 3.00% after the taper announcement and ended the year at 3.03%. Between the Fed's statement and the end of the year, yields on intermediate-maturity Treasuries rose the most, resulting in a "bump" in that segment of the Treasury yield curve.
Positive economic data
U.S. economic data showed fairly steady improvement over the course of the quarter. The unemployment rate fell to 7.0% in November from 7.3% in October, the Commerce Department revised its estimate of third-quarter gross domestic product growth up to a healthy 4.1% annual rate, and the housing market seemed to be holding up fairly well despite higher mortgage rates. It appears that Janet Yellen, who will replace Ben Bernanke as Fed chair when his current term ends, will inherit an economy that is significantly more vigorous than it was only a year or so ago.
|Index1||Fourth Quarter 2013||Year-to-Date|
|Barclays Capital U.S. Aggregate Bond Index||-0.14%||-2.02%|
|Credit Suisse High Yield Index||3.45||7.53|
|Barclays Capital Municipal Bond Index||0.32||-2.55|
|Barclays Capital Global Aggregate Ex-U.S. Dollar Government Bond Index||-0.72||-3.08|
|J.P. Morgan Emerging Markets Index Plus||0.64||-8.31|
|Barclays U.S. Mortgage Backed Securities Index||-0.42||-1.41|
High yield corporate bonds continue to rally
High yield corporate bonds posted the highest returns by far among the various fixed income asset classes. Despite the move up in yields in recent months, market rates were still quite low, which led investors to turn to noninvestment-grade bonds as a way to earn relatively high yields. In addition, many high yield issuers have refinanced their outstanding bonds to lower their debt-servicing costs and extend their bond maturities. Both of these factors helped noninvestment-grade companies maintain their fundamental financial health, making it likely that high yield default rates will remain low. Another advantage of high yield bonds is that they are less sensitive to changes in interest rates than investment-grade debt, which would help lessen the negative price impact of a further increase in rates. High yield issuers and underwriters took full advantage of the demand for high yield bonds by issuing a record $398 billion of new bonds in 2013, according to J.P. Morgan Chase.
Investment-grade credit spreads narrow
Investment-grade corporate bonds also gained, but their returns were not nearly as impressive as those of high yield debt. Because of their greater sensitivity to changes in interest rates, investment-grade corporates were hurt by the increase in Treasury yields. However, narrowing investment-grade credit spreads more than offset these negative price effects, resulting in an overall gain. Credit spreads measure the additional yield that investors demand to hold a bond with credit risk over a similar-maturity Treasury security. In fact, credit spreads on investment-grade corporates, as measured by the Barclays U.S. Corporate Investment Grade Bond Index, finished the quarter at their narrowest level in over six years.
Emerging markets debt rebounds
The delay in Fed tapering early in the quarter boosted demand for emerging markets debt, as the higher yields offered by the asset class helped it rebound to some degree from its summer sell-off and post a positive quarterly return. With liquidity fears moderating, investors turned their attention to the fact that many emerging economies are in better fiscal condition and carry less debt than most developed countries. Non-U.S. developed market government bonds posted mixed results for the quarter as UK gilts lost ground while eurozone sovereigns gained as the region continued to rebound from its debt crisis.
Credit concerns weigh on munis
Municipal bonds managed to post a positive return as they also recovered from a summer sell-off. However, worries about the credit quality of Puerto Rico, a major municipal debt issuer, and the potential effects of Detroit's bankruptcy continued to weigh on the municipal market and led to cash outflows from the asset class every week during the quarter. Despite the positive fourth-quarter return, the 2013 return for tax-free bonds was the worst calendar year return for the asset class in more than 20 years.
|U.S. Treasury Yields|
|Maturity||September 30, 2013||December 31, 2013|
Agency MBS lose ground
Agency MBS came under significant selling pressure and declined for the quarter because Fed tapering will involve a reduction in the pace of the central bank's purchase of the securities. However, other types of securitized assets that will not be directly affected by the slower pace of Fed purchases performed better. For example, asset-backed securities and commercial mortgage-backed securities (CMBS) posted positive returns even as interest rates rose.
CMBS, emerging markets bonds appear attractive
T. Rowe Price's fixed income analysts have a positive outlook for CMBS, which have underperformed other sectors with credit risk since the summer. The fundamentals of the commercial real estate market continue to improve. Our analysts also like the prospects for emerging markets sovereign debt, which have sold off to levels that appear particularly attractive given the solid fiscal condition of many emerging markets. Emerging markets corporate bonds seem to represent attractive value relative to U.S. corporates, although they do not appear to be quite as cheap as emerging markets government debt. However, the low liquidity in all types of emerging markets debt tempers our enthusiasm about the asset class to some degree.
Fourth Quarter 2013
International markets cap a strong year with solid Q4 gains
Non-U.S. stocks in developed markets surged after the U.S. Federal Reserve unexpectedly announced that it would not begin tapering its asset purchases in mid-September. Subsequently, the European Central Bank cut its key lending rate by a quarter-point in November, signaling that inflation was not a problem and growth was a priority, which helped extend the broad-based international stock market rally through the end of the year. Finally, the Fed's mid-December announcement that it would gradually wind down its large-scale asset purchases beginning in January 2014 cheered investors as it removed an element of uncertainty. European stocks generated strong gains, benefiting from reduced emphasis on austerity measures, progress on structural reforms in some countries, and signs that the region's recession had ended. The largest eurozone markets—Germany, France, and Spain—generated solid fourth-quarter returns. Developed stock markets in the Asia-Pacific region posted mixed results and underperformed the broad MSCI Europe, Australasia, and Far East (EAFE) Index. Conditions in emerging economies were mixed, with many opting for tighter monetary policies to bolster their currencies and contain inflation. Stocks in emerging Asian markets advanced, while emerging Europe and Latin American equities declined.
Within the EAFE index, value shares marginally outperformed growth stocks, while large- and small-caps performed similarly for the three-month period. Stocks in the telecommunication services, information technology, and health care sectors generated above-average performance. While no sector declined, consumer staples and utilities were weakest. The U.S. dollar strengthened versus the yen and weakened against the British pound and the euro.
|MSCI Index1||Fourth Quarter 2013||Year-to-Date|
|EAFE (Europe, Australasia, Far East)||5.75%||23.29%|
|All Country World ex-U.S.||4.81||15.78|
|All Country Asia Ex-Japan||3.42||3.33|
|EM (Emerging Markets)||1.86||-2.27|
Except for Japan, most of Asia's markets were poor performers for the year
Japan's stock market performed well for the year (+27%), but gains were relatively subdued in the fourth quarter (+2%). The Japanese economy edged further toward recovery against a backdrop of highly accommodative monetary policies and other economic stimulus measures. Monetary easing has weakened the yen, lifted the country out of a deflationary slump, and bolstered the performance of the country's world-class exporters. T. Rowe Price managers generally favor companies that can benefit from improving consumer confidence, merger or acquisition activities, and an improving real estate market. Japan's gross domestic product growth is expected to remain above 3% into 2014. Among the other developed markets in the region, Australia and New Zealand posted fourth-quarter losses, while Hong Kong and Singapore advanced 3% and 1%, respectively.
Emerging markets across the Asia-Pacific region posted mixed fourth-quarter and 12-month results and lagged developed markets by a wide margin. China's new leadership announced structural reforms, which could accelerate in 2014 and pave the way for more balanced economic growth in the years ahead. Tighter credit and monetary policies indicate that Chinese policymakers are willing to tolerate slower GDP growth (in the mid-7% range) in the near term as they try to rebalance the economy's growth drivers and stimulate domestic consumption. China's 4% gain in the fourth quarter accounted for almost all of 2013's return—three-month and full-year results in South Korea and Malaysia were similar. India's market rallied 10% in the fourth quarter but fell 4% for the year. Indonesia and Thailand were the region's poorest performers in the quarter (down 5% and 10%, respectively) and for the year. The only standout market in Asia was Pakistan, which gained 13% in the quarter and 36% for the year.
European markets extended their strong 2013 gains in the fourth quarter
The European region rallied, posting back-to-back strong quarterly advances to end the year ahead nearly 26%. Several of Europe's largest markets advanced more than 10% in the fourth quarter. An inconsistent recovery is underway in Europe, with notable weakness in France and Italy. The ECB cut its main policy rate to 0.25% in November amid concerns about low inflation. The ECB's balance sheet has contracted as banks pay back emergency loans from 2011 and 2012 and the euro has risen versus the dollar. T. Rowe Price economists believe that the ECB may inject more liquidity into the financial system in early 2014 via another long-term refinancing operation to foster GDP growth. Nevertheless, sentiment is improving, and stocks in the region have climbed on hopes that the economic expansion will gain momentum. "Corporate earnings are still depressed due to a lack of demand and production," says Dean Tenerelli, portfolio manager of the European Stock Fund. "Europe is trading below its long-term cyclically adjusted price/earnings ratio by a significant amount." He believes that most European economies bottomed in the first half of 2013 and competitiveness improvements in Europe can lead the region into real economic recovery
Non-U.S. stock valuations remain attractive
Many developed stock markets surged in the past year amid improved corporate and economic fundamentals. Valuations, while still reasonable, are less appealing than they were six months ago, which tempers our near-term expectations for equities. In Europe, slimmed-down companies appear poised to rebound as the economy recovers from a protracted recession. Despite Europe's modest economic prospects, the risk/reward ratio appears more attractive there than in most other developed markets. While we remain optimistic about the 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 regimes, and social spending. We believe that emerging markets offer compelling valuations, given their underperformance and strong long-term growth prospects. China appears to have achieved a soft landing, and the country features a number of inexpensive opportunities. Our outlook is more guarded in other key markets—including Brazil, India, and Indonesia—where inflation remains a concern and reforms are needed. Our focus is on bottom-up stock selection and on owning companies that can generate the best risk-adjusted returns wherever we can find them.
Fourth Quarter 2013
Emerging markets stocks advance in Q4 despite looming Fed tapering
Emerging markets stocks rose in the final quarter of 2013 driven by a rally in October amid optimism that the Federal Reserve would maintain the pace of its monetary stimulus. However, emerging markets stocks fell in November and December as growing signs of strength in the U.S. economy raised speculation that the Fed would start reducing its stimulus sooner than thought. Disappointing economic data across the developing world also curbed investors' risk appetite as the quarter progressed. Many countries reported weaker-than-expected growth in the third quarter, leading several to cut their 2013 economic forecasts. A devastating typhoon in the Philippines and political crises in Thailand and Turkey further dampened emerging markets' appeal. The MSCI Emerging Markets Index hit a five-month high on October 22 but drifted lower for the rest of the quarter. Eight sectors in the index rose while two—energy and consumer staples—declined. The information technology sector was the top performer, gaining more than 7%.
|MSCI Index1||Fourth Quarter 2013||Year-to-Date|
|Emerging Markets (EM)||1.86%||-2.27%|
|EM—Europe, Middle East, and Africa
India leads Asia on reform hopes; Southeast Asia declines
Indian stocks added more than 10% and ranked among Asia's best performers. Indian stock markets rallied in October after the country's new central bank chief raised investor confidence with unexpected measures to curb inflation and support growth. Additionally, India's benchmark indexes reached record highs in December after a strong showing by the main opposition party in state elections raised hopes that a reform-minded party will replace the current coalition government in national elections next year. Stocks in China posted a smaller gain, though the restricted A-share market for domestic investors declined. In November, China convened a meeting of top political leaders to outline the government's economic priorities for the next decade. Details from the meeting—known as the Third Plenum—suggest that the leadership's appetite for economic reform has exceeded most analysts' expectations. Stocks in Indonesia, the Philippines, and Thailand posted hefty declines. Investors worried about signs of slowing growth and lofty valuations in these markets and, in Indonesia's case, a record current account deficit exacerbated by a weak currency.
Brazil falls as stagflation weighs; Mexico gains as economy recovers
Brazilian stocks fell as the country continued to grapple with stagflation, a troubling environment marked by slow growth and rising prices. In November, Brazil's central bank raised the benchmark interest rate for the sixth straight time to 10% to fight inflation, and the economy shrank in the third quarter in its weakest quarterly performance since 2009. In contrast, Mexico advanced more than 8%. Its economy picked up in the third quarter after slowing sharply in the year's first half. Additionally, Mexico's congress passed a landmark energy bill opening up the oil and gas industries to private investment. The bill, which ends a 75-year-long state energy monopoly, is expected to boost Mexico's oil output and economy over the long term. Stocks in Chile and Colombia fell, while Peruvian stocks rose. Peru's economy likely expanded by more than 5% in 2013, its finance minister said in December. The expected growth rate would mark a drop from last year's 6.3% pace, when Peru was one of Latin America's fastest-growing markets.
Russia, South Africa gain despite troubled economies; Turkey sinks in corruption probe
Russian stocks advanced, but the country continues to struggle with a slowing economy marked by weak external demand, high inflation, and a poor business climate. T. Rowe Price investment managers see little reform progress or diversification from Russia's oil-based economy in the near term. Given the risk of weaker oil prices, we favor consumer-driven businesses, which are supported by Russia's low unemployment rate and increasing real wages. South African stocks added more than 2%, but here, too, we have a cautious view in light of high inflation, unemployment near 25%, and widespread labor unrest. Turkey sank more than 14% and was the EMEA region's worst performer as a widening political corruption probe heightened the country's political instability. Our investment managers believe that Turkey is in the midst of a serious political crisis that will continue to pressure its stock market and currency in the near term, possibly triggering a downgrade or a recession, but eventually lead to a good buying opportunity.
Solid long-term fundamentals offset near-term worries
Looking ahead, we believe that stock selection will take on more importance for emerging markets investors. In recent years, we have noted significant dispersion in the returns of emerging markets stocks even within the same country and industry. Over time, we expect this trend to continue, particularly with the end of the global commodities boom and runaway growth in China. Now that these longtime growth tailwinds have faded, we believe that investing in the right companies and in the right countries will be crucial for long-term outperformance.
Some analysts have recently speculated that consumer-driven growth in emerging markets is a thesis that has already played out in the investing world. On the contrary, we believe that we are in the early stages of a multiyear growth cycle driven by rising consumption in emerging countries. We remain confident that emerging markets stocks are an attractive asset class over the medium to longer term. Stocks across the developing world are trading at a significant discount relative to their valuation history and their developed market peers, making current valuations compelling for patient investors. We believe that the solid fundamentals underpinning the companies in which we invest are intact despite the recent disappointing performance of many emerging markets.