Monthly Market Wrap-Ups

October 2009

Major U.S. stock indexes hit new highs for the year during October but most finished the month with losses—the first monthly losses since February. Stocks were initially lifted by third-quarter earnings reports that were better than expected. Concerns about the strength and durability of an economic recovery, however, weighed on equities as the month drew to a close.

Large-cap shares held up better than their smaller counterparts. As measured by various Russell indexes, growth stocks performed better than value among large- and mid-cap shares, but small-cap value and growth stocks were more evenly matched during the month. Since reaching their lows in early March, most major U.S. stock indexes have jumped roughly 50% to 65% through the end of October, but they are still well below their 2007 highs. Most sectors in the S&P 500 Index declined, with financials and materials registering significant losses. Industrials and telecommunication services also fell sharply. On the plus side, energy stocks produced strong gains, fueled by the rising price of oil, which breached $80 per barrel. Consumer staples stocks advanced moderately.

The U.S. economy grew at an annual rate of 3.5% in the third quarter, generating a headline-grabbing sequel to the withering 3.8% decline during the preceding year. The turnaround was fueled by an assortment of stimulus measures enacted by the federal government and the nation’s central bank. Consumer spending and residential construction were major contributors, boosted by tax credits for auto and home purchases, while historically lean inventories provided some optimism for continued growth without government stimulus. At such low levels, even modest demand should compel companies to increase production. The Federal Reserve wrapped up its $300 billion Treasury purchase program that has helped hold down borrowing costs since the program commenced in March. The month ended with a record $123 billion in Treasury auctions, a result of staggering federal budget deficits. The new issues found no shortage of demand as bond investors discounted evidence of a growing economy and focused instead on reports of weak consumer spending and confidence.

Against what is shaping up to be a gradual recovery, our investment approach remains unchanged. We continue to construct our equity portfolios with high-quality companies with solid balance sheets, proven management teams, and superior growth and value characteristics that we believe will weather the recession in relatively good condition. We are confident that our philosophy—which is focused on bottom-up stock selection, fundamental research, and adherence to our investment process regardless of short-term market swings—can lead to strong performance over the long term. Rather than trying to forecast short-term stock performance, we prefer to focus on our primary goal of building wealth through prudent stock selection over time.

October 2009

The broadest index of U.S. bond prices recorded its eighth consecutive month of gains in October, though returns were more muted than in recent periods. While most segments of the bond market enjoyed positive returns, long-term Treasury prices declined as yields rose modestly. Municipal bond prices also pulled back as investors appeared to seek higher yields elsewhere and take profits following the strong rally over the past several months. Despite a burst of strength at the end of the period, the U.S. dollar continued to decline against most other major currencies during the month, boosting returns for investors in bonds from developed overseas markets.

October offered investors contradictory signals about whether the economy was on a sustainable path to recovery. Longer-term Treasury yields rose and prices fell in response to a surprising increase in September retail sales, a surge in sales of existing homes, and generally favorable news from the manufacturing sector. The Commerce Department also reported its advanced estimate that gross domestic product had grown at a faster-than-expected annualized rate of 3.5% in the third quarter. The rise in yields was kept in check, however, by news that consumer confidence had turned lower once again, while personal spending had also declined. The Labor Department reported a surprisingly large drop in September payrolls, but moderating jobless claims as October progressed indicated the labor market was continuing to heal.

Investors’ concerns over the impact of massive deficit spending also may have driven volatility in Treasury yields. Investors closely monitored demand at the month’s numerous Treasury auctions in an attempt to gauge the willingness of buyers, including foreign central banks, to absorb the heavy amount of debt issuance necessary to fund the government’s operations. Investors also worried that deficit spending would pose a further threat to the declining U.S. dollar and result in heightened inflation through rising import costs. Current inflation signals remained generally benign, however. Consumer price inflation inched higher in September and remained negative on a year-over-year basis. Prices at the wholesale level fell sharply after a substantial gain the previous month.

Although the Fed’s rate-setting committee did not meet during October, investors appeared to grow increasingly preoccupied with the future direction of Fed policy. Longer-term Treasury yields spiked early in the month, when Fed Chairman Bernanke reiterated that short-term interest rates could not remain near zero indefinitely.

Predicting when the Fed will begin raising rates has become further complicated by the central bank’s unprecedented expansion of its balance sheet—a strategy known as “quantitative easing.” The Fed will eventually need to dispose of the Treasury securities, mortgage-backed securities, and other assets it has acquired in recent months in order to support credit markets and bolster liquidity. But doing so will complicate the central bank’s efforts to control its traditional monetary tool, the federal funds rate. Because of the Fed’s need to sell assets in an orderly fashion, we expect the Fed to raise rates earlier in the economic cycle than would otherwise be the case. Still, we anticipate that the first rate hike is unlikely to come until next summer, when we expect the unemployment rate will finally begin to decline. This should be one factor working in favor of bond investors in coming months.

October 2009

Global markets were modestly lower in October. Growing evidence that the global economy is beginning to recover and better-than-expected earnings reports boosted markets early in the month, but as the period ended, some discouraging data and pessimism about the strength of the recovery more than wiped out those gains. The weakening dollar, rising oil prices, and concerns that stocks were becoming overvalued added to investors’ caution. Most major developed market indexes posted losses, but emerging markets eked out a narrow gain.

Growth and value stocks lost ground, but growth held up better and has outperformed for the year to date. Small-cap stocks declined for the month, the first notable decline since the beginning of the current rally. Within the EAFE index of developed non-U.S. markets, performance was mixed, with more defensive sectors generating positive returns and the more cyclical sectors registering losses. The defensive consumer staples, energy, and health care sectors were the strongest performers, while utilities, information technology, and financials were the laggards. The dollar continued to lose value against the euro and pound sterling but gained against the yen.

The International Monetary Fund (IMF) announced that the global economy was expanding. The IMF projected that economic output would increase by 3.1% in 2010 but warned that the recovery was weak. The IMF also said if the recovery is to sustain itself, countries with large trade surpluses must begin stimulating domestic demand. Jean-Claude Trichet, European Central Bank president, issued a stinging criticism of the world’s largest banks for still engaging in “unfettered speculation and financial gambling” instead of their “traditional role of providing service to the real economy.”

Although data indicated that Europe’s economy was in recovery, the euro’s steep rise presented a challenge for policymakers and investors. Government officials are concerned that the appreciating currency will hurt exports and stifle the region’s economic expansion. Euro zone business confidence reached its highest level in two years, but other data indicated that Germany’s economy, the region’s largest, was losing momentum. The U.K. reported that its economy contracted during third quarter, disappointing investors who had expected it to expand. The less-than-encouraging economic outlook for Europe drove the region’s markets lower, with the exception of the Nordic countries, which increased modestly. Ireland, after announcing that it may have to seek IMF assistance to bolster the government’s finances, posted the largest loss.

Business confidence grew for the second straight quarter in Japan, but the outlook for business spending and profitability remained weak. The new government took office and faced a growing national debt, unemployment, and weakening exports. The outlook in other Pacific Rim countries is more encouraging, and it appears the region’s recovery is well under way and sustainable. Australia became the first G-20 country to raise interest rates since the onset of the financial crisis. Singapore reported strong third-quarter economic growth and revised its forecast higher for 2010.

The global economy is functioning better than might have been expected earlier this year, and recent data are encouraging. Improved liquidity in the credit markets has made a big difference, but an enduring economic recovery will likely come slowly and unevenly. Some countries and regions are already showing signs of sustainable growth. Others are lagging. A few months ago, investors were well compensated for taking bold risks, but we believe that the investment landscape has changed. We are now in a period where economic growth and corporate earnings will need to drive returns. T. Rowe Price portfolio managers are targeting market leaders—companies with healthy balance sheets and access to capital that can take market share from weaker competitors.

October 2009

Emerging markets stocks ended a volatile month little changed but continued to outperform developed markets, which were broadly lower. The emerging Europe, Middle East, and Africa (EMEA) and Latin America regions generated positive returns, while Asia's markets posted a modest decline. Within the emerging markets universe, consumer staples and energy stocks generated the best returns. The weakest sectors were information technology, telecommunication services, and utilities.

Stocks in Latin America continued their ascent in October, and the region retains its status as the best year-to-date performer. Brazilian stocks benefited from the country's relatively resilient economy and strength in commodity prices. Brazil is expected to generate modest economic growth for the full year of 2009 and almost 5% GDP growth in 2010. Mexico, the region's second-largest market, posted a small gain. Mexico's economy is forecast to shrink about 7% in 2009 because exports to the U.S. have declined sharply.

The emerging EMEA region also outperformed the overall emerging markets index. Emerging European markets generated good results led by strong gains in Russia, while markets in the Middle East and Africa were mixed. South Africa, the region's second-largest market, continued to struggle with a growing budget deficit, unemployment approaching 24%, and widespread poverty. It has underperformed for the year to date, while Russia's stock market has nearly doubled in the last 10 months.

The emerging Asia region underperformed the broad emerging markets index. Among the larger markets, South Korea, India, and Taiwan posted losses, but China rallied after a period of consolidation. Exports, an important driver for the Chinese economy, remained weak. However, China's economy is responding to the massive government stimulus. Recent forecasts project GDP growth of more than 8% in 2009, among the highest in the world.

Emerging markets equities have generated exceptional gains in 2009. We remain bullish on the asset class for investors with medium- and longer-term investment time horizons while acknowledging that the pace of gains is unsustainable and results could be volatile in the short term. We expect emerging markets to continue to outpace developed nations because of their higher growth rates and favorable demographics. However, we no longer see the extremely attractive valuations that were available early this year. Our favorite countries for new investments include Brazil, China, and India. At the same time, we are underweight in markets with significant current account deficits, such as South Africa and several Eastern European nations.