ASSET ALLOCATION COMMITTEE VIEWPOINTS Fourth Quarter 2016 These views are informed by a subjective assessment of the relative attractiveness of asset classes and subclasses over a 6- to 18-month horizon. The approach is largely qualitative and valuation based, with attention to a broad scope of potential risks and potential return scenarios. Asset Allocation Bonds neutral Stocks Equities U.S. neutral International Developed neutral Emerging Global Equity neutral Real Assets U.S. Large Cap neutral U.S. Small Cap U.S. Value neutral U.S. Growth International Value neutral International Growth Fixed Income U.S. Investment Grade neutral High Yield U.S. Investment Grade neutral Emerging Markets U.S. Investment Grade neutral Nondollar Explore the themes and thinking behind our decisions. THEMES Global Global growth expectations remain modest and uneven as weak trade weighs on global economies. U.S. growth continues at a modest, yet stable pace while U.K. and European economies face prospects of weaker growth weighed upon by the impacts of Brexit. Broad emerging market economies showing signs of stabilization, with Brazil and Russia expected to see positive growth return in 2017 Divergence persists amongst emerging markets, with a more restrained U.S. Fed providing flexibility for some EM countries to lower interest rates to stimulate growth, while others raise interest rates to defend their currencies and moderate risk of higher inflation Expectations remain for a gradual path of U.S. Fed interest rate increases. Central banks in Europe and Japan continue aggressive monetary measures while the UK expands monetary policy in response to Brexit induced weakness, including corporate bond purchases Increased market expectations for major developed economies to utilize fiscal measures to stimulate growth as the effectiveness of further monetary stimulus appear limited Global interest rates trending modestly above record low levels seen in early July with many developed market interest rates in negative territory amidst benign inflation and increased global uncertainty Global equity markets prove resilient, ending the 3 rd quarter near their highest levels, having rebounded from a weak start to the year and subsequent downturn following Brexit in June U.S. U.S. economic growth expands by a modest 1.4% annualized rate in the 2 nd quarter of 2016, marking the third consecutive quarter of sub 1.5% growth. Strength in consumer spending in the quarter was offset by weakness in inventories, government spending and the housing sector Inflation, as measured by the personal consumption expenditures price index, trending near 1%, while excluding more volatile food & energy prices (1.7%) still remains below the Fed s 2% target. Although recent data showed a moderation in wages, the trend has seen incomes advancing with the improving labor market Growing expectations for the U.S. Federal Reserve to raise rates by the end of this year as members signal resolve to advance interest rate policy normalization as they balance a strong job market with still modest economic growth While rates remain low, expectations for an increase in the Fed funds rate coupled with a recent rise in U.S. LIBOR (London Inter- Bank Offer Rate) raise concerns about bank and corporate funding costs U.S. 10-year Treasury yield trending near 1.6%, modestly above record low levels reached in early July following Brexit as markets anticipate global interest rates will remain lower for longer While corporate leverage has increased, balance sheets, outside of energy-related sectors, remain broadly healthy and provide the corporate sector flexibility in the use of capital to increase capital spending, engage in M&A activity and return capital to shareholders or Current position Movement from previous position Key risks to global markets include the impacts of Brexit and ongoing instability within Europe, sustainability of energy prices, global monetary policy actions, the U.S. presidential election, as well as the growth of populism around the world and its potential impacts on global trade The pace of corporate buybacks has slowed considerably since last year along with corporate profits. Buybacks have been a key support for the equity markets and earnings-per-share growth
U.S. companies are expected to report low-single digit declines in profits in the 3rd quarter, led lower by weakness in the energy and industrials sectors. A decline in the 3rd quarter will mark the 6th consecutive quarter of year-over-year declines - the worst streak since the financial crisis. Earnings growth is expected to return in the 4th quarter of 2016 Europe Growth expectations revised lower as consumer and corporate spending react to the uncertainties of Brexit Economic growth slows in the 2nd quarter of 2016, expanding by a 0.3% quarterly rate (+1.6% year-over-year), weighed on by a slowdown in the French economy European Central Bank (ECB) signals willingness to provide additional support as it continues its aggressive quantitative easing measures, including monthly bond purchases of 80 billion euros which it broadened to include corporate bonds, negative deposit rates and expanded longterm loan programs to banks Bank of England lowers interest rates and expands quantitative easing measures, including purchase of corporate bonds, in response to Brexit related weakness Structural issues remain with high debt levels, stubbornly low inflation and still elevated unemployment. Euro Area unemployment remains above 10%, with Spain and Greece still above 20% Near-term risks remain elevated surrounding the impacts of Brexit, capital adequacy and profitability in the banking sector and political uncertainty surrounding upcoming elections and referendum votes Japan Japanese economic growth expands by a 0.2% quarterly rate (+0.8% year-over-year) in the 2nd quarter of 2016, with modest growth in private sector spending offset by weak exports and capital spending. Abenomics remains challenged by still weak consumption, tepid wage growth, low inflation and new pressures on exports caused by a stronger yen In August Prime Minister Abe announced a 28 trillion-yen stimulus package (nearly 5% of GDP) in his government s latest effort to stimulate growth and inflation Bank of Japan (BOJ) updated its monetary policy strategy in September, refocusing its efforts on targeting yield levels to fend off criticism that its policies were negatively impacting long-term interest rates. Governor Kuroda also pledged to allow inflation to overshoot their 2% target in hopes to reassure the markets of their commitment Markets have become increasingly skeptical of Prime Minister Abe and the BoJ s progress on increasing inflation and economic growth which conversely has resulted in a stronger yen and weaker corporate profitability Emerging Markets Broad emerging market economies showing signs of stabilization, with Russia and Brazil expected to return to positive growth in 2017 following protracted recessions Divergence persists across emerging market countries in terms of economic conditions, monetary and fiscal policy flexibility, dependence upon commodity exports and progress toward structural reforms Most emerging markets currencies have rebounded from lows reached at the start of the year supported by a rebound in commodity prices and diminished concerns over the pace of U.S. Fed interest rate increases Citing inflation risk, the Mexican central bank raised interest rates following the peso s fall to record low levels with its decline accelerated by fears over the potential outcome of the U.S. election After expanding by 6.9% in 2015, China s economy slows to 6.7% year-over-year growth in the 1st half of 2016. Chinese policymakers set economic growth target of 6.5% to 7.0% for 2016, while pledging to use fiscal and monetary policy to achieve their growth targets ASSET ALLOCATION Neutral Between Stocks and Bonds We are neutral stocks relative to bonds. While equity markets have experienced two major selloffs in the first half of the year, they have thus far managed to rebound amidst a weak backdrop of global growth and earnings. At current levels, valuations are trending above historical averages with profit margins declining and earnings growth not expected to improve until the 4th quarter of this year; however, low but durable economic growth should be supportive of most sectors. We expect modest returns from bonds as the current low-yield environment offers a weak foundation and rising interest rates should be a headwind once rates begin to rise, although the timing is uncertain. Monetary policies of global central banks are expected to remain accommodative for some time to come as they seek to support growth, which should moderate downside risks to bonds. Additionally, we expect the pace of rising U.S. interest rates to be gradual as growth remains subdued and demand for U.S. bonds persists with U.S. yields amongst the highest across developed markets that are now more widely experiencing negative yields. Our global growth expectations remain modest over the next several quarters, weighed on by increased uncertainty resulting from Brexit and further evidence of declining global trade activity. Gradual improvement in U.S. economic activity is supported by solid private sector demand, reinforced by low unemployment and increasing wages. Japanese growth has remained tepid and uneven despite aggressive fiscal and monetary stimulus and has become increasingly vulnerable to a stronger yen. Modestly improving growth in Europe to be impacted by Brexit as the EU works to stabilize its partnership. Emerging markets showing signs of stabilization as growth in China has steadied, new leadership in Brazil has revived prospects for reform and the Brazilian and Russian economies are expected to return to positive growth next year. U.S. corporate earnings growth continues to be hampered by weakness in the energy and materials sectors with 3rd quarter 2016 year-over-year growth expected to decline for the sixth straight quarter. Consensus estimates forecast a rebound in earnings in the 4th quarter of this year. While credit fundamentals remain stable outside of energy-related sectors, broad measures of leverage have trended higher as companies have issued debt to fund M&A activity and return capital to shareholders. 2
EQUITIES Favor International Over U.S. We reduced our overweight to international stocks relative to U.S. stocks as the prospects for improved earnings growth have moderated with lowered global growth and trade expectations. However, relative valuations favor international equities although disparate across regions and sectors. Major international developed market countries remain supported by aggressive quantitative easing measures. The uncertainties created by Britain s decision to leave the EU are likely to impact corporate and consumer spending within Europe for an extended period weighing further on already low levels of economic growth. Following the instability caused by Brexit there has been increasing calls for expanded fiscal spending, although it remains uncertain about the willingness and ability for many highly indebted developed countries to pursue these measures. Emerging markets are showing signs of stabilization amidst higher commodity prices and more benign expectations for a stronger dollar and higher interest rates. Developed market efforts to expand fiscal spending and reduce austerity measures could provide support for emerging markets if it were to create sustainable trade and demand for commodities. Favor Emerging Over Developed Markets We are modestly overweight emerging markets stocks relative to developed markets based upon more attractive valuations. While emerging markets equity valuations remain below their long-term historical averages relative to developed markets, weak global trade and continued oversupply concerns in the commodities sector remain near-term risks. Although off low levels seen at the start of the year, weak commodity prices may continue to weigh on commodity-dependent exporting countries while consumer driven and service-oriented economies benefit. Expectations for a slower pace of U.S. Fed interest rate increases could provide near-term support, lessening concerns of capital outflows. Favor Global Equity Over Real Assets We increased our underweight to real assets equities as we remain cautious on the prospects for energy and commodity prices given continued concerns over supply and demand imbalances. Despite OPEC s (Organization of Petroleum Exporting Countries) announcement in September of plans to limit production, the ability of that accord to be upheld remains uncertain. Further, the rise in oil prices following the announcement is likely to be challenged by additional supply as U.S. producers respond to rising prices with increased production. U.S. shale producers have become a larger contributor to global oil supply and with their increased efficiency can now operate profitably at lower price levels. Demand for industrial metals is expected to remain subdued as China struggles to maintain growth levels while shifting its economy away from its dependence on industrial production and exports to one more balanced by domestic consumption. Fundamentals for developed market REITs remain broadly positive, supported by modestly improving economic environments and limited supply. REIT valuations trending modestly higher relative to broader equities and they remain sensitive to rising interest rates; however, they may be supported near-term if U.S. Fed interest rate policy normalization proceeds at a modest pace. Inflation expectations remain subdued as global growth expectations remain low, while U.S. yields trend near record low levels. Favor Large-Cap Over Small-Cap We further reduced our underweight to U.S. small-cap stocks relative to large-caps as relative valuations have moved to levels closer to their historical averages. While relative valuations are now more attractive, heightened market volatility and expectations for weaker relative earnings growth may present headwinds for small-cap stocks. We are modestly overweight small-cap stocks outside the U.S. as efforts to improve domestic economies are supported by aggressive quantitative easing measures, including low and negative interest rates which should support credit growth, and potential for expanded policy measures post-brexit. Favor U.S. Growth over U.S. Value We are overweight to growth stocks relative to value stocks based upon more attractive valuations and our expectations for a protracted environment of low economic growth. Growth sectors tend to be less dependent upon the level of economic growth and have historically outperformed when growth is scarce. Additionally, fundamentals are likely to remain challenged for many cyclical sectors within value, particularly energy and financials, which tend to be reliant upon stronger economic growth, higher interest rates and commodity demand. Favor International Value Over International Growth We are modestly overweight to international value stocks relative to growth stocks as sectors within growth, such as consumer staples have become increasingly expensive. Broad international value sector valuations remain attractive; however, major sectors within value including financials and energy continue to face headwinds. FIXED INCOME Favor High Yield over U.S. Investment Grade We initiated an overweight to high yield bonds relative to U.S. investment grade bonds. High yield bonds offer an attractive risk-to-return alternative to investment grade bonds given the yield advantage, as well as less downside risk versus equities. High yield bonds have recovered from low levels seen earlier in the year supported by rising oil and gas prices. However, the current credit cycle, which has extended since the financial crisis, is showing signs of aging with leverage increasing, weakening corporate profitability and rising default rates, albeit still low versus historical averages and with a concentration in commodity-related sectors. Favor Emerging Markets over U.S. Investment Grade We initiated an overweight to emerging markets bonds relative to U.S. investment grade bonds. Emerging markets bonds offer attractive yields relative to other fixed income alternatives and are supported by improving fundamentals. Emerging markets should benefit from continued aggressive monetary easing policies by major central banks, a slower path of U.S. Fed interest rate increases and stabilization in commodity prices. Although, considerable disparity exists amongst emerging markets countries in their fiscal positions, political stability, and progress toward reforms. Favor U.S. Investment Grade over Nondollar We initiated an underweight to nondollar bonds relative to U.S. investment grade bonds taking advantage of the recent strength in foreign currencies while seeking to reduce 3
exposure to low yielding bond markets. Aggressive quantitative easing measures by the ECB and Bank of Japan have resulted in negative yields extending out bond maturities, resulting in an unattractive risk-return trade-off. With the effectiveness of monetary policies in these countries appearing limited, downside risk to their markets has increased. The prospects for the U.S. dollar versus other developed market currencies appear balanced. While the dollar is supported by higher relative U.S. interest rates, the ability for the U.S. Fed to aggressively raise interest rates against a background of weak global growth appears limited. Although vulnerable to further quantitative easing, the euro is supported by a current account surplus and the significant strength seen in the yen yearto-date may be susceptible to further policy actions by the BoJ. 4
T. Rowe Price focuses on delivering investment management excellence and retirement services that investors can rely on now and over the long term. To learn more, please visit troweprice.com. IMPORTANT INFORMATION This report represents the views of the T. Rowe Price Asset Allocation Committee only and are subject to change without notice; these views may not reflect the opinion of all T. Rowe Price portfolio managers. 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 as of September 30, 2016, and may have changed since that time. There are inherent risks associated with investing in the stock market, including possible loss of principal, and investors must be willing to accept them. The stocks of larger companies generally have lower risk and potential return than the stocks of smaller companies. Since small companies often have limited product lines, markets, or financial resources, investing in them involves more risk than investments primarily in large, established companies. The value approach carries the risk that a stock judged to be undervalued is actually appropriately priced. International investing involves unique risks, including currency fluctuation. Bond yields and prices will vary with interest rate changes. Investments in emerging markets are subject to abrupt and severe price declines, and should be regarded as speculative. High yield, lower-rated bonds generally involve greater risk to principal than investments in higher-rated securities. T. Rowe Price Investment Services, Inc. C1FEON7DQ_US 10/16 2016-US-26759