Markets & Economy

Quarterly Market Review

Third Quarter 2018
T. Rowe Price

S&P 500 NOTCHES BEST QUARTER IN FIVE YEARS

Stocks recorded solid gains in the third quarter, with the large-cap S&P 500 Index logging its biggest quarterly advance in nearly five years. The small-cap benchmarks lagged the broader market, but all of the major indexes reached new highs. Health care stocks performed best within the S&P 500 Index, while materials and energy shares were barely positive. Growth stocks handily outpaced value shares, largely due to outperformance earlier in the quarter. Trading volumes were muted for much of the summer vacation season, and volatility was generally subdued relative to the previous quarters. The S&P 500 recorded no daily swing of over 1% in either direction over the three months compared with 36 such moves in the first half of the year.

In the middle of the quarter, many media reports noted that the S&P 500 Index had established a record for the longest-running bull market—the length of time since the last decline of 20% or more. Analysts debate whether the bull market that ended with the technology stock crash in 2000 began in 1990 or as early as 1987, however, given that the 1990 decline fell just short of 20%. The “dot-com” bull market of the 1990s was also significantly larger in magnitude.

U.S. Stocks
 

3Q 2018

 

Year-to-Date

 

Dow Jones Industrial Average

9.63%

 

8.83%

 

S&P 500 Index

7.71

 

10.56

 

Nasdaq Composite Index

7.14

 

16.56

 

S&P MidCap 400 Index

3.86

 

7.49

 

Russell 2000 Index

3.58

 

11.51

Past performance cannot guarantee future results.
Note: Returns are for the periods ended September 30, 2018. The returns include dividends based on data compiled by T. Rowe Price, except for the Nasdaq Composite, whose return is principal only. Frank Russell Company (Russell) is the source and owner of the Russell index data contained or reflected in these materials and all trademarks and copyrights related thereto. Russell® is a registered trademark of Russell. Russell is not responsible for the formatting or configuration of these materials or for any inaccuracy in T. Rowe Price Associates’ presentation thereof.

IMPRESSIVE RISE IN CORPORATE PROFITS DRIVES STOCKS HIGHER

A continuing surge in corporate profits appeared to drive much of the market’s advance. According to FactSet, after setting a multiyear record in the first quarter, profit growth for the S&P 500 accelerated a bit further in the second, expanding by 25.0% on a year-over-year basis. Leading technology and Internet-related companies continued to record some of the best gains, and Apple established a market milestone in early August by becoming the first U.S. company with a market capitalization over USD $1 trillion. The tax cuts passed the previous December deserved part of the credit for the rise in corporate profitability, but companies’ topline results were also impressive. FactSet estimates that revenues for the S&P 500 grew by 10.1% on a year-over-year basis in the second quarter, the biggest gain since 2011.

U.S. economic data suggested that firms might enjoy sustained sales growth, though probably not at such an elevated pace. Employers continued to add jobs at a steady rate, keeping the unemployment rate near a two-decade low while weekly jobless claims fell to almost a five-decade trough. Consumer demand remained generally healthy, and the Conference Board reported that its gauge of consumer confidence had reached an 18-year high in August. Gauges of manufacturing and service sector activity also remained elevated. Data on the housing sector were a bit more mixed. Home prices increased in most markets, but sluggish new and existing home sales and a decline in housing permits suggested possible weakness ahead.

SUBDUED INFLATION LIKELY TO KEEP FED PATIENT IN RAISING RATES

In early September, the Labor Department reported that average hourly earnings had increased by 2.9% in August versus the year before, marking the fastest advance since the economic expansion that began nearly a decade ago. However, few signs suggested that the economy was in danger of entering the kind of wage-price spiral that has prompted the Federal Reserve in the past to raise rates dramatically to clamp down on inflation—indeed, broader year-over-year inflation measures moderated in August. Stocks rose late in the quarter after Fed officials met and raised the fed funds rate by a quarter point, as was widely expected, but kept their long-term interest rate outlook roughly steady. In his post-meeting press conference, Fed Chairman Jerome Powell reiterated that inflation remained “low and stable.”

TRADE TENSIONS PERIODICALLY WEIGH ON SENTIMENT

Investors welcomed a series of new deals with Europe, Mexico, and other trading partners throughout the quarter, but the escalating dispute with China periodically roiled Wall Street and may have restrained the market’s gains. The major indexes retreated at the start of the quarter, following reports that the Trump administration was planning to follow through on a threat to impose tariffs on an additional USD $200 billion of imports from China and President Donald Trump stated that tariffs on a further USD $267 billion might be coming—covering essentially all Chinese exports to the U.S. The Chinese responded with tariff threats of their own, and markets wavered over the following weeks as negotiations between the two countries faltered. Eventually, the U.S. imposed a 10% tariff on the original USD $200 billion in targeted goods on September 24, with the tariff rate set to increase to 25% at the end of the year.

Wall Street surprised many observers by largely taking the new tariffs in stride, with investors apparently calmed by the low 10% level of the initial tariff, which some interpreted as a sign of a willingness to negotiate on the part of the administration. China seemed to offer its own olive branches. In particular, Chinese officials indicated that they would not allow the country’s currency, the yuan, to devalue further. The yuan has declined almost 9% versus the U.S. dollar since April, making China’s goods more competitive on world markets and largely offsetting the impact of a 10% tariff. Chinese officials also announced a series of measures to open China’s markets to foreign goods, such as reducing the time it takes goods to clear customs.

HIGHER INTEREST RATES MAY HURT SMALL-CAPS MOST, BUT THE ASSET CLASS HAS OTHER RELATIVE ADVANTAGES

While corporate profits have yet to feel the sting of tighter monetary policy, the members of T. Rowe Price’s Asset Allocation Committee note that higher interest rates and wage inflation represent potential headwinds to small-cap stocks, in particular. Small-cap companies tend to carry more debt on their balance sheets than large-caps. In addition, higher wages would also tend to hurt the profit margins of domestic small-cap companies more than those of larger-cap multinationals that source more of their labor outside the U.S. Despite these challenges, small-caps remain relatively appealing because they are more closely tied to the domestic economy and are less susceptible to rising trade tensions. Small-cap valuations are also less elevated in comparison to those of large-caps. Finally, small-caps may be the target of takeover offers from large-caps flush with cash recently repatriated from overseas because of tax reform.


The specific securities identified and described above do not necessarily represent securities purchased or sold by T. Rowe Price. This information is not intended to be a recommendation to take any particular investment action and is subject to change. No assumptions should be made that the securities identified and discussed above were or will be profitable.


Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

Overview

INTERNATIONAL EQUITIES POST MODEST GAINS

Non-U.S. stock markets generally rose in the third quarter, although some regions remained under pressure from trade tension and slowing growth. Japanese stocks led gains as exporters reaped the rewards of the yen’s weakness against the U.S. dollar. In Europe, gains were muted by uncertainties related to trade, Brexit, Italian finances, and increasing signs of an economic slowdown. U.S.-China trade friction pressured emerging Asia stocks, while Latin America equities rebounded as risk-related selling ebbed and bargain hunting set in late in the period.

Within the MSCI EAFE Index, which tracks developed markets in Europe, Australasia, and the Far East, the health care, telecommunications services, and energy sectors were the top gainers, while the real estate sector lost the most ground. Growth stocks outperformed their value peers.

International Indexes
     Total Returns

MSCI Index

    

3Q 2018               Year-to-Date

EAFE (Europe, Australasia, Far East)

 

1.42%                    -0.98%           

All Country World ex-U.S.A.

 

0.80                       -2.67             

Europe

 

0.84                       -1.89              

Japan

 

3.81                        1.89                 

All Country Asia ex-Japan

 

-1.45                      -6.03                 

EM (Emerging Markets)

 

-0.95                      -7.39              

All data are in U.S. dollars and represent gross returns, as of September 30, 2018. Past performance cannot guarantee future results.
This chart is shown for illustrative purposes only and does not represent the performance of any specific security. Investors cannot invest in an index.
Source: MSCI.
Note: MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

Regional Recap

EUROPEAN STOCKS TREAD WATER AS ITALIAN BUDGET AND BREXIT FEARS UNSETTLE INVESTORS

Trade tensions, worries about Italy’s commitment to European Union (EU) fiscal mandates, an impasse in Brexit negotiations, and increasing signs of slowing growth kept pressure on European stocks throughout the quarter. Italian stocks suffered significant losses, declining more than 4.27% as Italy’s euroskeptic government struggled to produce a budget that would meet EU austerity demands and fulfill campaign promises to introduce a basic income for the poor, cut taxes, and roll back pension reform by lowering the retirement age. Brexit uncertainty also took a toll. UK stocks lost 1.65% as Prime Minister Theresa May’s Brexit plans came under attack from both hardline Brexiters and EU leaders. In July, some key UK cabinet members resigned to protest her proposal to create an EU–UK free trade zone, covering goods and agriculture. Odds of their hoped-for “hard Brexit” rose, however, after EU leaders rebuffed May’s so-called “Chequers” plan. By the end of the quarter, May declared that Brexit negotiations had reached “an impasse” and called on European leaders to propose an alternative.

TRADE CONCERNS KEEP PRESSURE ON EUROZONE MANUFACTURERS

Sentiment indicators continued to show faltering confidence among European businesses and consumers. Trade concerns have taken a particularly hard toll on manufacturers who are most vulnerable to trade frictions and tariffs. Eurozone manufacturing grew at the slowest pace in two years in September, and new export orders were stagnant for the first time since mid-2013. T. Rowe Price Chief International Economist Nikolaj Schmidt noted a growing divergence between the manufacturing and services sides of the economy and said that overall data are in line with a slowdown in the global manufacturing cycle.

JAPAN EQUITIES RISE AMID TRADE DEAL OPTIMISM AND AN IMPROVING ECONOMY

Japanese equities outperformed the broad EAFE index, returning 3.81% in U.S. dollar terms. Easing trade tensions and the strengthening global economy helped the performance of many Japanese commodities and manufacturing companies. Japan got a boost from key trade breakthroughs during the quarter. In July, it signed a deal with the European Union that cuts or eliminates tariffs on nearly all goods, and in September, President Trump and Japanese Prime Minister Shinzo Abe agreed to work toward a trade agreement. In return, the U.S. will refrain from imposing tariffs on Japanese autos. Stocks were also helped by the yen’s weakness against the dollar, which boosts profits for exporters. The yen fell 2.48% against the dollar during the quarter.

JAPANESE ECONOMY IMPROVES

Japan’s economy also showed some signs of improvement as second-quarter gross domestic product growth was upgraded to 3% from 1.9%, the fastest since the first quarter of 2016, thanks to strong consumer and business spending. Japan’s Reuters Tankan poll showed manufacturing business confidence hit a seven-month high thanks to ongoing global expansion. The services sector, however, remained under pressure from tepid domestic demand.

EMERGING MARKETS LOSE MORE GROUND

The MSCI Emerging Markets Index fell about 1% for the quarter as higher-risk assets remained under pressure from concerns about trade tensions, political uncertainties, and worries about fiscal imbalances in some key markets. The MSCI Emerging Markets entered a bear market in early September after dropping 20% from its most recent peak, the common definition of a bear market.

Equities in emerging Asia fared worst, dragged lower by trade tension between China and the U.S. Chinese shares fell 7.42%, and Chinese A shares, which are shares of mainland China-based companies, dropped nearly 6.95%.

In Latin America, a rally in Brazilian and Mexican markets was enough to propel the overall MSCI Latin America Index to a 4.85% gain for the quarter. Bargain hunters pushed Brazil’s markets—which had been heavily sold for much of the period—back to positive territory, and stocks ended the period 6.17% higher. In Mexico, markets gained throughout the quarter after President-Elect Andres Manuel Lopez Obrador (AMLO) managed to assuage market fears by promising to uphold market-friendly policies in the aftermath of his landslide victory in Mexico’s July 1 general election. The long-awaited agreement to revise the North American Free Trade Agreement also helped Mexican equities move 6.97% higher for the period.

The Europe, Middle East, and Africa region underperformed the MSCI Emerging Markets Index, weighed down by a nearly 21% drop in Turkish stocks. Throughout the quarter, Turkish assets came under pressure as the country’s central bank—increasingly seen as losing its independence to President Recep Tayyip Erdogan—challenged the market by refusing to raise benchmark interest rates to cool an overheating economy and stop the lira’s collapse. Its greater-than-expected interest rate increase in mid-September, which led Turkish stocks to a more than 20% rally for the month, was not enough to offset the heavy losses for the quarter.

OUTLOOK: GLOBAL GROWTH REMAINS POSITIVE IN 2018

The outlook for global growth remains positive but may have peaked, meaning trade-driven economies could slow. Ongoing trade tensions could exacerbate this slowdown, while a continued dialogue between the U.S. and China could improve the outlook. Idiosyncratic and political risks remain elevated in several key countries that had been at the center of risk-related selling in August. Other challenges to the outlook for global equities include a resurgence of geopolitical tensions, the possibility of central bank policy missteps, and the rising popularity of euroskeptic parties.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

TREASURY YIELDS MOVE HIGHER, BUT 10-YEAR NOTE’S YIELD STAYS BELOW YEAR-TO-DATE HIGH

Treasury yields increased in the third quarter as positive economic news, the prospect of less accommodative central bank monetary policies, and more borrowing by the U.S. government weighed on investor demand for Treasury securities. The yield on the benchmark 10-year Treasury note increased from 2.85% to 3.05% but stayed below the year-to-date closing high of 3.11% it reached in May. The two-year Treasury note’s yield rose to its highest level in 10 years. Bond prices and yields move in opposite directions.

The yield curve continued to flatten during the quarter as short-term Treasury yields increased more than the yields on longer maturities. The yield spread between 2- and 10-year Treasuries narrowed to 24 basis points—0.24 percentage point—at the end of the period, its tightest level since 2007. Two-year yields have generally risen in line with Federal Reserve rate hikes, while longer-term yields have been constrained by demand from insurance companies, pension funds, and overseas buyers. The yield curve is closely watched as an indicator of where relative value exists in the bond market, and an inverted curve—when short-term securities yield more than longer maturities—has often foreshadowed recessions.

Total Returns    

Index

3Q 2018

YTD

Bloomberg Barclays U.S. Aggregate Bond Index

 0.02%

-1.60%

J.P. Morgan Global High Yield Index

 2.19

 1.65

Bloomberg Barclays Municipal Bond Index

-0.15

-0.40

Bloomberg Barclays Global Aggregate Ex-U.S. Dollar Bond Index

-1.74

-3.03

J.P. Morgan Emerging Markets Bond Index Global Diversified

 2.30

-3.04

Bloomberg Barclays U.S. Mortgage Backed Securities Index

-0.12

-1.07

Figures as of September 30, 2018. Past performance cannot guarantee future results. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.
Source: Third-party vendor RIMES.
Bloomberg Index Services Ltd Copyright © 2018, Bloomberg Index Services Ltd. Used with permission.
Information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The index may not be copied, used, or distributed without J.P. Morgan's prior written approval. Copyright © 2018, J.P. Morgan Chase & Co. All rights reserved.

FED RAISES RATES FOR THIRD TIME IN 2018, REMOVES “ACCOMMODATIVE” LANGUAGE

As expected, the Federal Reserve’s monetary policy committee raised its short-term lending rate a quarter point to a range of 2.00% to 2.25% at its September meeting, the third rate hike this year. The Fed also issued higher growth forecasts for the remainder of 2018 and 2019 and removed language from its post-meeting statement that described its monetary policy as “accommodative.” Alan Levenson, T. Rowe Price’s chief U.S. economist, said that, despite the revision, monetary policy continues to be accommodative, as the federal funds rate is barely positive in inflation-adjusted terms and remains below the central bank’s neutral rate—the level at which monetary policy neither supports nor restricts economic growth. The Fed’s projections point to one more rate hike in 2018 and three in 2019.

INVESTMENT-GRADE CORPORATES OUTPERFORM TREASURIES; MUNIS LOSE GROUND

Solid corporate earnings reports and steady demand provided support for investment-grade corporate bonds, which produced positive results and were the strongest component of the Bloomberg Barclays U.S. Aggregate Bond Index. Mortgage-backed securities lost ground but held up better than Treasuries, which were the weakest component of the taxable U.S. investment-grade market.

Investment-grade tax-free municipal bonds recorded negative returns amid waning demand but outperformed Treasuries. Below investment-grade munis outperformed higher-quality bonds. Puerto Rico bonds delivered strong results as progress toward a resolution for bondholders sparked a rally in the commonwealth’s debt from distressed levels.

 

Treasury Yields

Maturity

June 30

September 30

3-Month

1.93%

2.19%

6-Month

2.11

2.36

2-Year

2.52

2.81

5-Year

2.73

2.94

10-Year

2.85

3.05

30-Year

2.98

3.19

Source: Federal Reserve Board.

EQUITY RALLY, RISING OIL PRICES CONTRIBUTE TO POSITIVE HIGH YIELD RESULTS

High yield bonds, which tend to be closely linked to equity performance, benefited as stock indexes reached record highs. Below investment-grade debt was also supported by investor demand for securities that are less sensitive to rising interest rates. Issuers in the energy sector, which makes up a significant portion of the high yield bond market, performed well as oil prices reached a four-year high. U.S. sanctions on Iran and the economic crisis in Venezuela reduced global supply growth and contributed to the spike in petroleum prices. High yield bank loans also produced solid returns.

BANK OF ENGLAND, ECB TAKE STEPS TOWARD TIGHTER MONETARY POLICIES

The U.S. dollar strengthened during the period against most currencies, weighing on the returns of nondollar-denominated bonds. The Bank of England (BoE) and the European Central Bank (ECB) took steps away from accommodative monetary policies. The BoE voted to raise its short-term benchmark rate by 25 basis points to 0.75%, while the ECB confirmed that it will reduce the amount of bonds it buys under its quantitative easing program by half—to €15 billion from €30 billion—from October through the end of 2018. Japanese government bond yields reached their highest level since 2016 in early August after the Bank of Japan adopted a wider trading band for the 10-year Japanese government bond. The Italian 10-year government bond yield spiked near month-end after the country’s coalition government agreed to a larger-than-expected 2019 budget deficit, a move that could lead the major credit rating agencies to downgrade Italy’s debt.

EMERGING MARKETS BONDS VOLATILE AMID CURRENCY WEAKNESS

Significant declines in the currencies of Argentina and Turkey contributed to a volatile period for emerging markets bonds. Argentina’s central bank hiked its benchmark interest rate to 60% in an attempt to defend the peso, which lost over 29% against the U.S. dollar for the quarter. However, a loan package from the International Monetary Fund assuaged concerns about the country’s near-term fiscal stability. The Turkish lira declined almost 24% during the quarter, prompting the country’s central bank to raise its main interest rate to 24% from 17.75%.

OUTLOOK: RECENT VOLATILITY MAY PRESENT ATTRACTIVE ENTRY POINTS FOR INVESTORS

In a recent Policy Insights article, T. Rowe Price global fixed income portfolio managers noted that, despite market volatility in recent months, they have not seen signs of contagion leading to a wider risk aversion cycle. Countries that have come under selling pressure have either faced political uncertainty or current account deficits that could become more difficult to finance with U.S. interest rates rising. Although they say it’s too early to call an end to the volatility—considering the risks associated with tariffs and upcoming political events such as midterm elections in the U.S.—there may be some attractive entry points as some countries have potentially been punished unfairly, resulting in valuations that have adjusted well beyond their associated risks.

 

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

GLOBAL CAPITAL MARKETS ENVIRONMENT

U.S. stocks climbed in the third quarter, lifting major domestic stock indexes to new all-time highs. Strong corporate earnings reports and economic growth—boosted by last year’s tax reform legislation—propelled the market’s advance. The U.S.-China trade dispute continued, with each country threatening and implementing tariffs on various products, but not to the detriment of U.S. equities. On the other hand, the U.S. reached new trade deals with Mexico and with Canada that will replace the North American Free Trade Agreement, while U.S. President Donald Trump and European Commission President Jean-Claude Juncker expressed willingness to work toward “zero tariffs.” Near the end of September, Trump signed a new trade agreement with South Korea.

Large-cap shares easily outpaced their smaller peers. The large-cap S&P 500 Index returned 7.71% versus 3.86% for the S&P MidCap 400 Index and 3.58% for the small-cap Russell 2000 Index. As measured by various Russell indexes, growth stocks outperformed value stocks across all market capitalizations.

In the large-cap universe, as measured by the S&P 500, all sectors produced positive returns. Health care stocks did best, but industrials and business services, telecommunication services, and information technology shares also outpaced the broad market. Materials and real estate stocks were little changed. Energy stocks were also fairly flat, even though Brent oil prices reached four-year highs ahead of a November 4 deadline for U.S. allies to stop purchasing Iranian oil before sanctions take effect. Also, in late September, OPEC and non-OPEC oil‑producing nations met in Algiers but did not agree to increase production.

  S&P 500 Index S&P MidCap 400 Index Russell 2000 Index
3Q 2018 7.71% 3.86% 3.58%
Year-to-Date 10.56 7.49 11.51

Past performance is not a reliable indicator of future performance.
Source: Third-party vendor RIMES, as of September 30, 2018.
Note: Frank Russell Company (“Russell”) is the source and owner of the Russell Index data contained or reflected in these materials and all trademarks and copyrights related thereto. Russell® is a registered trademark of Russell. Russell is not responsible for the formatting or configuration of these materials or for any inaccuracy in T. Rowe Price Associates’ presentation thereof.
Copyright © 2018, S&P Global Market Intelligence (and its affiliates, as applicable). Reproduction of S&P 500 Index and S&P MidCap 400 Index in any form is prohibited except with the prior written permission of S&P Global Market Intelligence (“S&P”). None of S&P, its affiliates or their suppliers guarantee the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions, regardless of the cause or for the results obtained from the use of such information. In no event shall S&P, its affiliates or any of their suppliers be liable for any damages, costs, expenses, legal fees, or losses (including lost income or lost profit and opportunity costs) in connection with any use of S&P information.

Domestic investment-grade bonds produced mixed returns in the third quarter, as interest rates increased across the Treasury yield curve and the Federal Reserve raised short-term rates in late September, which was widely expected. The Bloomberg Barclays U.S. Aggregate Bond Index returned 0.02%. Treasuries declined, while mortgage-backed and municipal securities edged lower. Investment-grade corporate bonds produced decent gains. High yield issues strongly outperformed higher-quality bonds, helped by their lower interest rate sensitivity and by favorable corporate fundamentals. Rising oil prices also benefited issues in the energy sector, which represents a substantial portion of the high yield market. 

  Bloomberg Barclays U.S. Aggregate Bond Index Bloomberg Barclays Municipal Bond Index JPMorgan Global High Yield Index
3Q 2018  0.02% -0.15% 2.19%
Year-to-Date -1.60
-0.40 1.65

Past performance is not a reliable indicator of future performance.
Source: Third-party vendor RIMES, as of September 30, 2018.
Bloomberg Index Services Ltd. Copyright 2018, Bloomberg Index Services Ltd. Used with permission.
Information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright 2018, J.P. Morgan Chase & Co. All rights reserved.

Stocks in developed non-U.S. markets produced gains but substantially lagged U.S. shares, hindered in part by a stronger dollar versus various currencies. The MSCI EAFE Index returned 1.42%. In U.S. dollar terms, developed Asian markets were mixed, but Japanese shares led the region with a gain of almost 4%. Economic data showed that Japan’s economy expanded in the second quarter—reversing course from a first-quarter contraction—thanks in part to a pickup in household and business spending.

European markets were also mixed, with Switzerland, Sweden, and oil producer Norway producing strong returns. In contrast, Italian shares fell more than 4%, as sovereign bond yields climbed due to expectations for increased government spending and a widening budget deficit. UK shares sagged close to 2%, due in part to continued uncertainty about the terms of its withdrawal from the European Union, which is scheduled to take place at the end of March 2019.

Returns in emerging equity markets varied widely, as currencies in some developing markets remained under pressure. The MSCI Emerging Markets Index returned -0.95%. In Asia, Chinese equities lost 7% as U.S.-China trade tensions intensified. Indian stocks fell to a lesser extent, as several defaults by a nonbank financial lender in September hurt investor sentiment. On the plus side, Thailand’s market soared almost 14%, supported by strong economic growth.

In emerging Europe, Russian shares advanced more than 6% amid rising oil prices, whereas stocks in Turkey plunged more than 20% due to lira weakness, surging sovereign bond yields, news of an economic deceleration in the second quarter, and deteriorating U.S.-Turkey relations. In Latin America, Mexican shares rose almost 7% and the peso strengthened about 5% versus the dollar, as political uncertainty dissipated following the July 1 presidential election and as the country reached a new trade agreement with the U.S. Brazilian shares rose 6% despite heightened political uncertainty ahead of October’s elections. Argentine stocks fell over 9%, and the peso plunged more than 29%, even though the government reached an agreement with the International Monetary Fund for a three-year, USD $57 billion bailout package in exchange for austerity measures.

  MSCI EAFE Index MSCI Emerging Markets Index
3Q 2018 1.42%
-0.95%
Year-to-Date -0.98
-7.39

Past performance cannot guarantee future results.
Source: Third-party vendor RIMES, as of September 30, 2018.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

Bonds in developed non-U.S. markets declined in dollar terms, as rising interest rates in some countries weighed on bond prices and a stronger greenback against some major currencies reduced returns to U.S. investors. In the eurozone, political concerns kept Italian government bonds under pressure during the quarter. On the monetary policy front, the European Central Bank reiterated plans to end its bond-buying program at the end of 2018 and to keep rates on hold “at least through the summer of 2019.” In the UK, the central bank raised short-term rates in early August for the first time this year, driving bond yields higher, while the British pound fell more than 1% versus the dollar amid ongoing Brexit-related concerns. In Japan, the yield curve steepened in the wake of the Bank of Japan’s late-July announcement that it would allow the 10-year government bond yield target to fluctuate in a wider range. The yen, meanwhile, declined about 2.5% versus the dollar.

Emerging markets bonds were mixed in the third quarter. Dollar-denominated emerging markets debt produced solid returns, but local-currency bonds declined due to weakness among key currencies, such as the Turkish lira, the Indian rupee, the Brazilian real, and the South African rand. Central banks in various countries, such as Russia, were forced to raise short-term interest rates in an attempt to shore up their currencies or to keep inflation from rising.

  Bloomberg Barclays Global Aggregate Ex-U.S. Dollar Bond Index JPMorgan Emerging Markets Bond Index Global Diversified  JPMorgan GBI-EM Global Diversified Index
3Q 2018 -1.74% 2.30% -1.83%
Year-to-Date -3.03 -3.04 -8.15

Past performance cannot guarantee future results.
Source: Third-party vendor RIMES, as of September 30, 2018.
Bloomberg Index Services Ltd. Copyright 2018, Bloomberg Index Services Ltd. Used with permission.
Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright 2018, J.P. Morgan Chase & Co. All rights reserved.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

EMERGING MARKETS STOCKS DECLINE IN Q3 AS TRADE TENSIONS, RISING U.S. RATES DENT RISK APPETITE

Emerging markets stocks declined in the third quarter of 2018 as the U.S.-China trade dispute and a stronger dollar and rising interest rates in the U.S. dampened risk appetite. After eking out a modest gain in July, emerging markets stocks retreated in August as financial crises in Argentina and Turkey fueled a currency sell-off across the developing world. Though both countries’ financial woes stemmed from domestic developments, their problems underscored the dependency of many emerging markets sovereigns and companies on overseas funding and their vulnerability to a rising U.S. dollar. Meanwhile, the U.S.-China trade battle intensified as each country imposed previously threatened tariffs on the other’s imports. The MSCI Emerging Markets Index entered a bear market in early September after dropping 20% from its most recent peak, the common definition of a bear market. Five out of 11 sectors in the index rose and six declined. Energy stocks performed the best, while consumer discretionary stocks slid the most.

International Indexes
     Total Returns

MSCI Index

    

3Q 2018               Year-to-Date

Emerging Markets (EM)

 

-0.95%                    -7.39%           

EM Asia

 

-1.68                        -6.53             

EM Europe, Middle East, and Africa (EMEA)

 

-1.41                      -12.04              

EM Latin America

 

4.85                         -6.67                 

All data are in U.S. dollars as of September 30, 2018. Past performance cannot guarantee future results.
This table is shown for illustrative purposes only and does not represent the performance of any specific security. Investors cannot invest directly in an index.
Source: MSCI.
Note: MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

CHINESE STOCKS DROP AS TRADE BATTLE DEEPENS; INDIAN STOCKS DECLINE ON CREDIT CRUNCH FEARS

  • Chinese stocks fell as U.S. dollar-denominated shares and yuan-denominated A shares each shed about 7%. The U.S.-China trade battle weighed on sentiment after the Trump administration made good on its threat to impose tariffs on USD $200 billion in Chinese goods at the end of September. The latest round of tariffs—which are set to increase from 10% to 25% on January 1 and come on top of USD $50 billion worth of Chinese imports already tariffed—threatens China’s ability to meet its economic growth targets, believes T. Rowe Price fixed income portfolio manager Andrew Keirle.
  • Indian stocks declined after a steep drop in September, when a string of defaults at a major infrastructure lender raised alarm about rising leverage at other nonbank financial companies. Concerns that rising oil prices would worsen India’s current account deficit and stoke inflation drove weakness in the rupee, which has lost about 12% of its value versus the dollar this year.
  • Southeast Asian stocks advanced, led by Thailand’s nearly 14% gain, as most economies in the region reported stronger second-quarter economic growth. Even so, Southeast Asia proved vulnerable to August’s currency sell-off: In September, Indonesia’s central bank raised its benchmark interest rate for the fifth time since May to prop up the rupiah, which has dropped 9% this year, while the Philippines’ central bank hiked its key rate by half a percentage point to its highest level since 2011 to combat inflation. Central banks in Thailand and Malaysia, however, left their respective rates unchanged during the quarter.

MEXICAN STOCKS GAIN AS TRADE ACCORD NEARS COMPLETION; BRAZILIAN STOCKS RISE ON BARGAIN HUNTING

  • Mexican stocks added nearly 7% as optimism grew that the country would reach a new trade agreement with the U.S. to replace the North America Free Trade Agreement (NAFTA) after more than a year of negotiations. The new accord between the U.S., Canada, and Mexico was announced on September 30 and essentially preserves NAFTA with a few modest tweaks, according to Bloomberg.
  • Brazilian stocks rose roughly 6%, aided by a September rally as bargain-seeking investors took advantage of cheaper valuations afforded by previous months’ declines. Though Brazil reported its economy grew slightly in the second quarter, other data showed its economy remained weak. Uncertainty about the outcome of Brazil’s October 7 general election and whether the next president would press on with fiscal reforms drove sentiment during the quarter.
  • Andean stock markets declined amid worries that trade disruptions would hurt the region’s commodity-driven economies by dampening global growth and raw materials demand. Economic growth is picking up in all three countries in 2018 and should exceed 4% in Peru over the next two years, the International Monetary Fund (IMF) wrote in July. Higher commodity prices and strong U.S. growth have benefited economies in the region, but trade tensions have increased downside risks to the outlook, the IMF added.

RUSSIAN STOCKS GAIN ON BULLISH OIL FORECASTS; TURKISH STOCKS SLIDE AS CURRENCY CRATERS

  • Russian stocks rose almost 7% as rising crude oil prices offset the threat of more U.S. sanctions. Forecasts that Brent crude oil prices will soon hit USD $100 a barrel for the first time since 2014 lifted the outlook for Russia, for which oil is the chief export. Russian assets also got a boost after the country’s central bank raised its key rate in September for the first time since 2014 and extended its suspension of foreign currency purchases until year-end.
  • South African stocks gave up roughly 7% as its economic outlook remained grim. South Africa entered its first recession since 2009 in the second quarter after activity shrank a worse-than-expected 0.7% from the first quarter, when the economy contracted a steeper than initially reported 2.6%. The poor data underscored the challenges facing newly elected President Cyril Ramaphosa, who promised to turn around South Africa’s ailing economy.
  • Turkish stocks slumped almost 21% as investors dumped the country’s assets amid deteriorating relations with the U.S. and concerns that President Recep Tayyip Erdogan’s unorthodox policy views were undermining the central bank’s ability to fight inflation. The lira hit record lows during the quarter and is down nearly 37% against the dollar this year, increasing worries about Turkey’s large dollar-denominated debt burden.

SOLID FUNDAMENTALS IN EMERGING MARKETS OFFSET NEAR-TERM RISKS

We are optimistic about the longer-term outlook for emerging markets. Most developing countries have smaller current account deficits, larger foreign exchange reserves, and more flexible currencies than they did in previous decades, reducing the risk of a financial crisis. Compared with developed markets, most emerging markets have more attractive demographics and a stronger tailwind from rising consumption. Emerging markets stocks remain attractively valued relative to developed markets stocks.

Near-term headwinds include a rise in U.S. protectionism and a faster-than-expected pace of rate hikes by the Federal Reserve. However, we believe that emerging markets will be able to withstand a gradual tightening of U.S. monetary policy given that their financial positions have broadly improved in recent years. Economic growth has slowed but remains stable in most emerging markets, and corporate earnings have begun to recover after years of disappointing performance. Nevertheless, we believe that careful stock selection will be crucial for producing good long-term returns as emerging markets continue to show wide dispersion in the performance of individual countries and companies.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

Tax-free municipal bonds posted slight losses in the third quarter of 2018 as a positive technical environment featuring relatively low new issuance could not offset the negative price effects of increasing Treasury yields. Tax-exempt municipal debt underperformed taxable bonds over the period, with the Bloomberg Barclays Municipal Bond Index returning -0.15% versus 0.02% for the Bloomberg Barclays U.S. Aggregate Bond Index. However, high yield municipal debt outperformed both investment-grade munis and investment-grade taxable bonds, returning 0.76% for the quarter as price appreciation for high yield tobacco and certain Puerto Rico issuers continued to boost the overall high yield municipal index’s return.

ECONOMY AND INTEREST RATES

In early September, the Labor Department reported that average hourly earnings had increased by 2.9% in August versus the year before, marking the fastest advance in the economic expansion that began nearly a decade ago. However, few signs suggested that the economy was in danger of entering the kind of wage—price spiral that has prompted the Federal Reserve in the past to raise rates dramatically to clamp down on inflation—indeed, broader year-over-year inflation measures moderated in August. Federal Reserve officials met in September and raised the federal funds rate by a quarter point, as was widely expected, but kept their long-term interest rate outlook roughly steady. In his post-meeting press conference, Fed Chairman Jerome Powell reiterated that inflation remained “low and stable.”

Municipal yields increased with shorter-term rates rising more than longer-term yields, resulting in a flattening of the municipal yield curve. Treasury yields also increased, and the Treasury yield curve flattened over the quarter. In September, the yield on the two-year Treasury note, which is closely correlated with the Fed’s monetary policy decisions, reached its highest level since 2008. At the end of the quarter, high-quality 30-year muni yields matched the 30-year Treasury bond yield. Municipals offer relative value for many fixed income investors on an after-tax basis.

As an illustration of their relative attractiveness, on September 30, 2018, the 3.19% yield offered by a 30-year tax-free general obligation (GO) bond rated AAA was the same as the 3.19% pretax yield offered by a 30-year Treasury bond. Including the 3.8% net investment income tax that took effect in 2013 as part of the Affordable Care Act (ACA), the top marginal federal tax rate (after tax reform) stood at 40.8%. An investor in this tax bracket would need to invest in a taxable bond of similar credit quality and maturity yielding about 5.39% to receive the same after-tax income as that generated by the municipal bond. (To calculate a municipal bond’s taxable-equivalent yield, divide the yield by the quantity of 1.00 minus your federal tax bracket expressed as a decimal—in this case, 1.00-0.408, or 0.592.)

MUNICIPAL MARKET NEWS

Total municipal bond issuance for the quarter was about USD $84 billion, according to The Bond Buyer, which was about 9% lower than in the same period in 2017. A steep drop in refundings accounted for most of the decline in issuance from the third quarter of last year. The new tax law enacted at the end of 2017 eliminated the tax benefits of advance refundings, which had allowed issuers to refinance existing debt with new bonds.

Generally, fundamentals for municipal issuers remain solid, and most issuers in the USD $3.8 trillion municipal bond market have been fiscally responsible. State and local governments, in general, have been cautious about adding to indebtedness since the 2008–2009 financial crisis, and a strengthening economy has helped tax revenues rebound. Over 60% of the market, as measured by the Bloomberg Barclays Municipal Bond Index, is AAA or AA rated.

Although the market is overwhelmingly high quality, many states and municipalities are grappling with underfunded pensions and other post-employment benefit (OPEB) obligations. New reporting rules from the Governmental Accounting Standards Board are bringing greater transparency to state and local governments’ pension funding gaps, long-term risks that investors often overlooked in the past.

Bonds from some troubled municipal issuers, including Illinois and New Jersey, outperformed the broad muni market in the third quarter as investors’ demand for yield remained strong. Debt issued by Illinois gained support when credit rating agency Moody’s Investors Service changed its outlook for the state to stable from negative. Puerto Rico’s municipal bonds—particularly its uninsured debt with high yield ratings—posted another quarter of strong gains. In the third quarter, a federal judge upheld the authority of the commonwealth’s fiscal oversight board to impose budgetary restrictions on the island’s government, boosting Puerto Rico’s bond prices. In addition, a preliminary deal was reached to restructure the territory’s COFINA bonds, which are backed by sales tax revenues.

Most major investment-grade segments of the municipal market recorded modest losses in the second quarter. Revenue bonds performed approximately the same as GO debt, and prerefunded bonds posted slight declines in line with the broad muni market. We continue to favor bonds backed by a dedicated revenue stream over GOs, as we consider revenue bonds to be largely insulated from the pension funding concerns facing state and local governments. Across our municipal platform, we have an overweight to the higher-yielding health care and transportation revenue-backed sectors. Within revenue bonds, the leasing and resource recovery subsectors generated the best results by posting positive returns, while the housing subsector held up worst. High yield tobacco debt rose slightly and outperformed the investment-grade market.

OUTLOOK

We believe that the municipal bond market remains a high-quality market that offers good opportunities for long-term investors seeking tax-free income. While the uncertainty around the long-term impact of tax reform and the increased chance of rising yields represent near-term headwinds for broad muni market performance, we believe that fundamentals are sound overall, and global economic uncertainties could spur demand for the asset class.

As the Fed continues on the path to interest rate normalization, muni bond yields are likely to increase along with Treasury yields—although probably not to the same extent. While higher yields pressure bond prices, munis should be less susceptible to slowly rising rates than Treasuries given their attractive tax-equivalent yields and the steady demand for tax-exempt income.

While we believe that many states deserve high credit ratings and will be able to continue servicing their debts, we have longer-term concerns about significant funding shortfalls for pensions and OPEB obligations in some jurisdictions. Although few large plans are at risk of insolvency in the near term, the magnitude of unfunded liabilities is becoming more conspicuous in a few states. Ultimately, we believe that independent credit research is our greatest strength and will remain an asset for our investors as we navigate the current market environment.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

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