Quarterly Market Wrap-Ups

Fourth Quarter 2009

U.S. stocks ended the quarter with solid gains and capped off a winning year following earlier weakness. The major stock indexes were close to their highs for the year as 2009 came to an end. All S&P 500 sectors delivered positive returns for the year, although financials was negative during the past three months. The rebound in U.S. equities—a comeback of historic proportions from the March trough—provided a welcome relief for investors who suffered devastating losses in 2008.

The Commerce Department lowered its assessment of economic growth in the third quarter of 2009 from an annualized rate of 2.8% to 2.2%.The contributing factors included restrained consumer spending, weak commercial real estate construction, soft business investment in equipment and software, and a reduction in inventories by corporations. Despite the downward revision, most economists believe the economy finished the year on a stronger note. The upturn in the third quarter ended a record four consecutive quarters of economic contraction, the worst performance since the Great Depression. Notwithstanding the improvement in recent months, few analysts expect the unemployment rate to fall much below 10% anytime soon. The housing picture brightened somewhat as sales of existing homes surged near the end of the year. The strength in home sales, however, was attributed to an extraordinary level of government support rather than to market forces.

The Federal Open Market Committee held its last meeting of the year in December and decided to keep short-term interest rates at their record low level for an “extended period.” According to the nation's central bank, the economy has “continued to pick up” and “deterioration in the labor market is abating.” However, concerns remain about “restrained” consumer demand, sluggish wage growth, and tight credit. The Federal Reserve will wait for improvements in those problem areas before embarking on a policy of higher short-term rates. The U.S. dollar strengthened slightly, while the price of gold slipped below $1,100 per ounce after reaching an all-time high above $1,200.

Large-cap shares led the way in the fourth quarter, followed by mid- and small-cap stocks, respectively. As measured by various Russell indexes, both growth and value stocks were strong during the period, although growth outperformed value overall. Since reaching their lows in early March, most major U.S. stock indexes have rebounded sharply, but they are still well below their 2007 highs. Most sectors in the S&P 500 Index rose during the last three months of the year, with information technology, consumer discretionary, health care, and materials stocks powering the market. Financials were down.

The biggest concern for 2010 is the pace of the economic recovery. It’s important that signs of a sustained economic improvement begin to emerge. The equity market’s performance in 2009 was driven not only by earnings but also by the expectation of future earnings. To the extent that earnings in 2010 are strong, they could serve as a platform to propel the market higher. If those earnings don’t materialize, stocks will face a significant headwind in the months ahead. We have just experienced a rally of historic proportions from a bear market bottom. The major question now is whether or not the returns of the past nine months are sustainable into 2010. Our view is that stock market gains going forward are likely to be more restrained. We are finding more opportunities in larger-cap stocks than we have seen in some time, particularly among some of the higher-quality companies that did not fully participate in last year’s rally. We are attempting to identify companies with stable earnings and cash flow compared with the riskier areas of the market that performed extraordinarily well in recent months. We believe 2010 should be a year of decent growth, but the strength of the economy this year could be the key to overall performance as the year evolves.

Fourth Quarter 2009

Bond prices managed a narrow overall gain in the fourth quarter, as signs of economic recovery caused a drop in government bond prices but also fostered gains in riskier issues. Long-term Treasury bonds, which are particularly sensitive to changes in interest rate and inflation expectations, were the worst performers. Investment-grade corporate issues registered small gains, but high yield bonds fared very well as investors anticipated improved balance sheets resulting from the more favorable economic environment. The strengthening U.S. economy led to a sharp rise in the U.S. dollar at the end of the period, which weighed on returns for investors in developed markets overseas.

Evidence accumulated during the final quarter of 2009 that the economy was emerging from the “Great Recession” that began in late 2007. Most encouraging—and most overdue, in the eyes of many—were signs of healing in the labor market. Although the unemployment rate surged to 10.2% in October, employers cut only 11,000 jobs in November, which helped bring the unemployment rate back to 10% and raised hopes that outright growth in employment might resume early in the new year. Clearing skies in the labor market may have helped consumers grow a bit more optimistic, as demonstrated by gains in gauges of consumer sentiment and a generally favorable holiday shopping season.

Other parts of the economy also appeared to be gaining their footing, although pockets of weakness remained. Manufacturing activity increased, in part because a weak dollar helped exporters become more competitive overseas. Data on the housing sector generally were encouraging, with home sales and prices continuing to recover from lows reached earlier in the year. The fourth quarter brought official confirmation that the economy had indeed grown in the previous three months, although the pace of growth was steadily revised downward, from an annualized rate of 3.5% to 2.2%. Still, most economists expected that growth would continue and, in fact, accelerate in the final quarter.

What was good news for the economy overall was less favorable for investors in longer-term government securities. While short-term Treasury yields remained anchored near zero by the federal funds rate, long-term yields rose substantially. This caused long-term bond prices to fall and resulted in a historically steep yield curve by the end of the period, a sign that investors expected much more stringent monetary policy in the future. Federal Reserve officials appeared to take pains to urge investors not to jump to conclusions, however, making repeated assurances that the federal funds rate would remain “exceptionally low...for an extended period.”

The Treasury yield curve steepened significantly over the period as long-term yields rose substantially, while short-term yields remained anchored at very low levels.

Perhaps the single best indicator of the progress made in the credit markets in 2009 has been the precipitous drop in yields of higher-risk bonds relative to those of Treasuries with similar maturities—a relationship known as the yield spread. With spreads having fallen so far, however, they have less room to contract in 2010, meaning that price gains for credit-sensitive issues are likely to be more muted. For this reason, we expect the coming year to be more of a “coupon-clipping” environment, in which dividend income provides the lion’s share of total return for bond investors.

Fourth Quarter 2009

After slipping early in the quarter, global stock markets rallied and ended the year with a healthy gain. Many markets reached their highest levels since the start of the worldwide financial crisis in September 2008. Despite some scares—the default of Dubai World and a financial crisis in Greece—investors showed increased confidence and sought out riskier assets. Although most markets advanced, fourth—quarter returns were not as strong as those posted during the third quarter. Worldwide business and consumer confidence levels rose, but they are far below pre-crisis levels, reflecting fears that the recovery is fragile and could be derailed. Higher levels of confidence prevailed in emerging markets, which turned in a strong quarterly performance and handily beat developed market indexes.

European markets were mixed. Norway, the U.K., and Switzerland were the strongest performers, while Greece, Finland, and Austria were the laggards. The possibility of resurgent deflation drove Japan's markets into negative territory. Singapore and Australia posted the best returns of the developed Asian markets.

Growth and value stocks advanced, but growth outperformed. Small-cap stocks, benefiting from investors' renewed appetite for risk, added to their earlier gains. Within the EAFE index of developed non-U.S. markets, materials, consumer staples, and energy were the strongest performing sectors. The laggards—financials, information technology, and utilities—posted losses. The dollar gained against the euro and the yen but weakened versus the British pound.

The global economy is growing again, and the fastest rates of growth are in emerging markets. T. Rowe Price portfolio managers are finding attractive opportunities in developed non-U.S. markets, particularly among those developed-market companies that have exposure to the rapid growth occurring in emerging markets. In this environment, companies that have strong balance sheets and can finance growing sales at the expense of their competitors should do well. Strong fundamental research and stock picking will be critical to investment success.

Fourth Quarter 2009

Emerging markets stocks continued to rally in the fourth quarter, adding to robust gains for the year. Stocks in emerging markets handily outperformed those in the developed world for the quarter and the year. Latin American equities—powered by the strength of Brazil’s market—gained more than 12% in the fourth quarter, helping the region post an extraordinary 104% return for the past 12 months. Emerging markets in Asia and the Europe, Middle East, and Africa (EMEA) regions also posted outstanding gains for the quarter and the year. Within the emerging markets universe, every sector posted positive fourth-quarter returns. Consumer staples, materials, and health care stocks were the strongest performers, while the weakest sectors, telecommunication services and industrials and business services, generated modest single-digit returns. For the year, the top sectors—consumer discretionary, information technology, and materials—gained more than 100%. In 2009, the worst-performing sectors were telecommunication services and health care, although they advanced 27% and 42%, respectively.

Stocks in Latin America continued to surge in the quarter. Brazil, the region’s largest market, generated a 13% gain, bringing the commodity-oriented market’s 12-month advance to 129%. The country’s economy is expected to post modest economic growth for 2009 and to grow approximately 5% in 2010. Mexico, the region's second-largest market, performed a little better than the overall region for the three-month period. Mexican policymakers are focused on stimulating their economy, and prospects have brightened significantly for 2010. The Mexican peso has strengthened markedly against the dollar in recent months.

The emerging EMEA region generated strong results for the quarter, led by double-digit gains in Poland and Russia. In the Turkish market, which rose nearly 20% in December, investors appeared to be encouraged by the country’s improving economic outlook and prospects for a domestic recovery buoyed by historically low interest rates. Russia, the region’s largest market and best performer for the year, was up almost 105%. After a lackluster result in 2008, Russian stocks benefited from rising oil prices and the resurgent economy.

Emerging Asia markets generated a strong fourth-quarter result, led by a sharp advance in tiny Sri Lanka and far-larger components the Philippines and China. India also posted impressive returns and outperformed the region's advance. China’s massive government spending is propping up its economy—coupled with broadening export and domestic consumption demand—and is being well received by international investors. The Chinese market remains heavily dependent on exports to fuel its growth. However, it is laying a solid foundation for consumer-driven gains. In India, economic gains appear to be sustainable, and its stock market advanced nearly 103% for the year.

Emerging markets equities generated exceptionally good returns in 2009. We remain bullish on the asset class for investors with medium- and long-term investment horizons, while acknowledging that the pace of this year’s advance is unsustainable, and results could be volatile in the short term. We expect developing markets to continue to outpace developed nations over time because of their higher growth rates and favorable demographics. 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.