The China Syndrome, T. Rowe Price Report - Login Top · PDF fileThe China Syndrome Issue No....
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Issue No. 117 Fall 2012 The China Syndrome As rip-roaring Chinese growth drove global metals prices to record levels over the last 15 years, Rick de los Reyes, a T. Rowe Price metals and mining analyst, frequently visited China. With growth slowing last December, he returned to meet metals traders, real estate firms, and air conditioning fabricators, finding, “No one was panicking. Everyone felt that growth would ramp up again aſter the Chinese New Year.” Not so. Returning aſter that holiday in February, he found, “No bounce back at all. If anything, things had gotten worse.” And since then, the Chinese economy has continued to cycle down. China—having averaged roughly 10% gross domestic product (GDP) growth from 1979 to 2010 with a recent high of almost 12% in 2007—saw its official GDP growth rate fall to 7.6% in the second quarter of this year, with some reports suggesting a lower real rate. Export growth was roughly flat, and construction and industrial output were slowing. Growth expectations for the rest of the year are, if anything, lower. Moreover, China may be at a critical inflection point, marking not only a sharp cyclical downturn, but a struc- tural shiſt to an economy based less on fixed asset investment and more on consumption—one in which annual growth may drop over time to as low as 5%, says Anh Lu, manager of the New Asia Fund. “We expected the slowing,” she says, “but the duration has been a little bit of a surprise. Ten percent growth for three decades is just not sustainable, particu- larly now that China’s per capita GDP is more than $5,000. We don’t think there will be a hard landing, but I’m not optimistic overall. “It’s very hard for economies to go through this sort of adjustment,” she adds. “If the deceleration is too deep, there’s a risk of volatility from a financial system disturbance.” In September, there were signs that Chinese infrastructure investment may be stirring again, including the announcement of a $156 billion government stimulus plan, but Ms. Lu says those projects were long in the works and she doesn’t expect more stimulus soon. at may be bad news for some investors, she says, but perhaps good news in the long run for a badly unbalanced economy. Lower growth in China has profound and far-flung implications for the world, already troubled by Europe’s recession and sluggish U.S. growth. China, which accounted for 6% of the global GDP growth in 1986–1990, was the source of 26% of global growth in 2006–2010. (See chart on page 2.) It is the world’s second-largest economy. Notable sectors at risk range from global commodity and industrial equipment producers to China’s Asian trading partners and global luxury goods makers. At the same time, a [Continued on page 2] 5 Searching for Higher Yields In Emerging Markets 8 U.S. Stocks Forge Upward as Earnings Growth Decelerates 10 Cost Competitiveness Supports U.S. Manufacturing Revival 12 Despite Bleak Backdrop, Europe Beckons 14 Entitlement Programs Pose Fiscal Challenges and Risks 16 Telecom Stocks: Fundamentals, Dividends Drive Leading Sector 17 Investors Cautious but Committed to Retirement Saving 18 Charitable Giving Program Hits $100 Million in Grants T. Rowe Price R eport A Perspective On Financial Topics For Our Investors 19 Equity Market Review Fixed Income Market Review Fund Performance Tables Quarterly Performance Update Send us your comments, questions, ideas: [email protected]
Transcript of The China Syndrome, T. Rowe Price Report - Login Top · PDF fileThe China Syndrome Issue No....
Issue No. 117 Fall 2012The China SyndromeAs rip-roaring Chinese growth drove global metals prices to record levels over the last 15 years, Rick de los Reyes, a T. Rowe Price metals and mining analyst, frequently visited China. With growth slowing last December, he returned to meet metals traders, real estate firms, and air conditioning fabricators, finding, “No one was panicking. Everyone felt that growth would ramp up again after the Chinese New Year.”
Not so. Returning after that holiday in February, he found, “No bounce back at all. If anything, things had gotten worse.”
And since then, the Chinese economy has continued to cycle down.
China—having averaged roughly 10% gross domestic product (GDP) growth from 1979 to 2010 with a recent high of almost 12% in 2007—saw its official GDP growth rate fall to 7.6% in the second quarter of this year, with some reports suggesting a lower real rate. Export growth was roughly flat, and construction and industrial output were slowing. Growth expectations for the rest of the year are, if anything, lower.
Moreover, China may be at a critical inflection point, marking not only a sharp cyclical downturn, but a struc-tural shift to an economy based less on fixed asset investment and more on consumption—one in which annual growth may drop over time to as low as 5%, says Anh Lu, manager of the New Asia Fund.
“We expected the slowing,” she says, “but the duration has been a little bit of a surprise. Ten percent growth for three decades is just not sustainable, particu-larly now that China’s per capita GDP is more than $5,000. We don’t think
there will be a hard landing, but I’m not optimistic overall.
“It’s very hard for economies to go through this sort of adjustment,” she adds. “If the deceleration is too deep, there’s a risk of volatility from a financial system disturbance.”
In September, there were signs that Chinese infrastructure investment may be stirring again, including the announcement of a $156 billion government stimulus plan, but Ms. Lu says those projects were long in the works and she doesn’t expect more stimulus soon. That may be bad news for some investors, she says, but perhaps good news in the long run for a badly unbalanced economy.
Lower growth in China has profound and far-flung implications for the world, already troubled by Europe’s recession and sluggish U.S. growth. China, which accounted for 6% of the global GDP growth in 1986–1990, was the source of 26% of global growth in 2006–2010. (See chart on page 2.) It is the world’s second-largest economy.
Notable sectors at risk range from global commodity and industrial equipment producers to China’s Asian trading partners and global luxury goods makers. At the same time, a
[Continued on page 2]
5 Searching for Higher Yields In Emerging Markets
8 U.S. Stocks Forge Upward as Earnings Growth Decelerates
10 Cost Competitiveness Supports U.S. Manufacturing Revival
12 Despite Bleak Backdrop, Europe Beckons
14 Entitlement Programs Pose Fiscal Challenges and Risks
16 Telecom Stocks: Fundamentals, Dividends Drive Leading Sector
17 Investors Cautious but Committed to Retirement Saving
18 Charitable Giving Program Hits $100 Million in Grants
T. Rowe PriceReportA Perspective On Financial Topics For Our Investors
19 Equity Market Review
Fixed Income Market Review
Fund Performance Tables
Quarterly Performance Update
Send us your comments, questions, ideas:[email protected]
2
World Looks to China for GrowthChina’s Share of Global Gross Domestic Product (GDP) Growth Adjusted for Purchasing Power Parity*
*Purchasing power parity calculations adjust countries’ GDPs for the relative value of their currencies.Source: International Monetary Fund, calculations by International Strategy & Investment as of June 2012.
Con
trib
utio
n to
Glo
bal G
row
th
0
10
20
30
40%
2011–2015 Estimated
2006–20101996–20001986–1990
United StatesEuropean Union
IndiaChina
Regions
more consumption-driven China may offer new opportunities in the retail, Internet, food, and other staples sectors.
The downturn is the logical outcome of China’s panicked response to the 2007–2008 financial crisis—an almost $600 billion stimulus that sent fixed asset investment’s share of the economy to more than 50%, a record. The ensu-ing construction and loan growth binge saw major city home prices more than double from 2000 levels, resulting in so-called ghost towns of vacant apartment blocks and lots of speculative excess.
“There’s still a year’s property inven-tory to burn off,” says Eric Moffett, a T. Rowe Price China property analyst. “Things aren’t likely to turn soon. The new mantra in Beijing is lower growth but higher-quality growth. That’s a big structural change.”
Metals MeltdownWhen Mr. de los Reyes returned from China last February, he wrote his investment colleagues at the firm, warning: “The construction boom is over…Demand for metals is not coming back.”
He now adds, “We’ve seen the best of the commodity cycle. For many metals, China is the only thing that really matters. There may be powerful trading opportunities, but the bottom line is the next decade will not be as good for metals as the last. The days when you could buy any iron or copper stock and watch it go up are over.”
With recent stimulus in China and the United States, Mr. de los Reyes says industrial metals prices could rise in a year-end rally, but “that’s not likely to last. We expect another leg down, and it probably won’t end quickly. Falling commodity prices are self-reinforcing; they can go into a deflationary spiral.”
Indeed, many global commodities, particularly those that go into steel, heavily depend on Chinese demand (see chart on page 3), and the slowdown has been devastating for their prices. Iron ore—China uses 70% of seaborne iron
ore—sold at less than $14 a metric ton in 2002. By 2011, the price hit almost $200. Last summer, it dipped below $100.
Adds Tim Parker, manager of the New Era Fund, which focuses on natural resources, “Keep in mind that it’s not only China. Anytime you have Europe shrinking, the United States
growing slowly, and China flat or down, it’s not a happy time for commodities.”
Nor potentially for leading commodity-producing countries, whose economies—and, in some cases, currencies—had soared on metals exports to China. Australia, Brazil, Indonesia, South Africa, and Canada all are top commodities exporters to China, though China is not the only current buffeting their economies.
About 27% of all Australia exports, for example, go to China, much of it iron ore. (See chart on page 4.) By last summer, the stock of Australia’s largest miner, BHP Billiton, had fallen 43% from its 2011 high. Rio Tinto, another big Australian miner, was down 70% from its 2008 high. For Australia, the impact so far has been dampened by the country’s AAA credit rating attracting global investors seeking a safe haven.
Similarly, the stock of Vale, Brazil’s large iron ore producer, which sends 40% of its ore to China, was off 58% last summer from its 2011 high; Vale at times has accounted for more than 10% of the MSCI Latin America Index. Brazil’s economy could even end up with lower growth in 2012 than the United States, under a 2% rate, says Gonzalo Pángaro, manager of the Emerging Markets Stock Fund.
The China SyndromeContinued from page 1
“ Things aren’t likely to turn soon. The new mantra in Beijing is lower growth but higher-quality growth. That’s a big structural change.”
troweprice.com 3
But Jose Costa Buck, manager of the Latin America Fund, notes Brazil actually is a relatively closed economy. Exports overall make up only about 10% of its economy, he says. “Consumption drives Brazil’s GDP, and consumption is decelerating, so it’s really hard to separate how much of the slowdown in Brazil can be attributed to China.”
In general, the materials sector has a heavier weight among emerging markets economies than in developed markets. But a commodity crash isn’t bad news everywhere in the developing world.
Scott Berg, manager of the Global Large-Cap Stock Fund, notes that certain nations that are net importers of raw materials, such as India and Turkey, benefit. As a result, Mr. Berg this year raised the fund’s exposure to Turkish firms.
Beyond CommodititesThe other two big areas in which the China slowdown is beginning to be felt are among global multinational industrials and China’s Asian trading partners.
Given the Chinese infrastructure slump and the ensuing commodity fall, manufacturers of mining, nuclear power, railway, automation, and electrical equipment are very exposed to China. Peter Bates, a T. Rowe Price industrials analyst, says large U.S. industrials may have only 10% direct China sales but that often has doubled in the last five years, and China overall may account for 30% of many firms’ earnings growth.
For example, U.S.-based Caterpillar last summer announced it was moving 2,300 excavators out of its China inventory to elsewhere in Asia. Mr. Bates says China only accounts directly for about 5% of Caterpillar’s total sales, but it also sells a lot of mining equip-ment around the world so “a third of Caterpillar’s business could be down.”
For such European industrials as Siemens and Atlas Copco, China may matter even more, accounting for as much as 50% of their growth, Mr. Berg says.
“There’s still a lot of business to be done in China, but there needs to be a wave of consolidation,” Mr. Bates says. “The good days when you could double your China business in four years are over. Many industrials have been relying on China, and they’re going to have to turn elsewhere to some degree.”
But to where? Mr. Berg points out that the “China slowdown hurts so much around the world because Europe’s frozen and the United States has an uncertain election. If you’re a CEO, why would you hire more people or invest more for the time being?”
Revenues for many global industrials haven’t yet turned downward on China,
in part because this year’s capital spending budgets—say for miners buying equipment—haven’t been pared back. But Mr. Berg expects that to happen in 2013 and 2014.
“The effects haven’t yet worked their way through, but we’re going to look back at 2012 and realize that it was the peak of the capital expenditures cycle,” Mr. de los Reyes says.
Among China’s Asian trading part-ners, South Korea, Japan, Taiwan, and Indonesia are most reliant on China.
As The Wall Street Journal reported last June, “Economies in the region are perching perilously on an increasing dependence on China.…Every major economy in Asia has seen exports to China grow faster than to the rest of the world.”
To be sure, the Chinese downturn
Commodities Markets Depend on China2011 Chinese Consumption as a Share of Global Demand for Key Metals
Source: Macquarie Group.
0
20
40
60
80%
SeaborneIron Ore
Coal CopperLead Zinc Nickel Aluminum
[Continued on page 4]
“ Economies in the region are perching perilously on an increasing dependence on China.…Every major economy in Asia has seen exports to China grow faster than to the rest of the world.”
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is not the only challenge facing these economies. For example, 19% of Japanese exports go to China, particu-larly machinery, automation equip-ment, and mid-level retail goods. But Campbell Gunn, manager of the Japan Fund, says Japan faces more immediate problems, including the waning of its post-tsunami stimulus and the relative strength of the yen.
As with global industrials, the impact of the Chinese downturn on its neighbors started to become evident last summer. By July, Taiwan, South Korea, and Southeast Asian nations were reporting export declines relative to a year earlier.
Additionally, some global luxury goods vendors, increasingly reliant on Asia’s wealthy, started to report by summer’s end that sales were tailing off.
“They’re still relatively robust places, and we’re still constructive on Asia,”
says Mark Edwards, a T. Rowe Price portfolio manager who focuses on the region. “But we’re going to have to be very vigilant. If exports collapse and unemployment rises, the Asian consumer will stop buying.”
China RebalancingChina not only is trying to manage a transition to a lower growth rate but also to an economy based more on consumption than fixed asset investment. As Ms. Lu notes, the latter challenge may be the most difficult, particularly for a society in which speculation in multiple home-ownership has been the storehouse of savings.
Mr. Pángaro adds, “China’s in for a really difficult two to three years with
a lot of policy risk as it tries to shift. If it manages well, it could do well. But it will be very tough.”
Chinese retail growth has slowed. But wage growth is still running 15% a year, and investing in the growing power of the Chinese consumer remains a strong theme. As Mr. Berg puts it, “We’re still talking one of the clearest themes in investing.”
Consumer-related areas of interest include some of the cheaper Chinese department stores, food companies and other staples, health care firms, and particularly, Internet players.
That does not mean that infrastructure and at least one group of commodities—agricultural exports to China—are not of interest to some managers.
Susanta Mazumdar, manager of the Global Infrastructure Fund, says incremental demand for materials,
energy, and industrial machinery may be limited, but “given the country’s big needs, it will remain high at an absolute level.”
A rebalanced China could particularly mean more gas pipeline, renewable energy, water conservation, and urban infrastructure projects, he says, noting that the sector already may be hitting bottom.
Also likely to benefit from consumer spending growth could be agriculture firms all over the world—including U.S. corn exporters and fertilizer firms such as PotashCorp.
The Chinese are following the greater caloric intake path of their already more developed neighbors, Taiwan and South Korea, by eating more processed
food and meat, which in turn raises its grain imports. For example, prices for soybeans, vital for feeding Chinese livestock, were up almost 60% this year by August.
“Everyone has so downgraded China from an economic and earnings perspective that it’s possible there could be a rally in Chinese stocks in the short term,” Ms. Lu says. “But for the next couple of years, we’re going to have to be very careful. The whole process of deleveraging has to play out there, as well a lot of policy decisions, and markets don’t like that level of uncertainty.”
International investing is subject to market risk and risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad. Emerging markets investments are subject to the risk of abrupt and severe price declines.
As of September 30, 2012, stocks mentioned in this article represented 4.72% of the New Era Fund, 1.29% of the Global Large-Cap Stock Fund, 0.76% of the Emerging Markets Stock Fund, and 7.69% of the Latin America Fund. They were not held in the New Asia, the Japan, or the Global Infrastructure Funds.
Vulnerable to ChinaPercentage of Exports to China, 2011
0
5
10
15
20
25
30%
U.S
.
Indo
nesi
a
Bra
zil
Japa
n
S. K
orea
Aus
tral
ia
Source: International Monetary Fund, calculations by International Strategy & Investment.
The China SyndromeContinued from page 3
“ China’s in for a really difficult two to three years with a lot of policy risk as it tries to shift. If it manages well, it could do well. But it will be very tough.”
troweprice.com 5
Searching for Higher Yields In Emerging Markets
A. It’s first and foremost fundamentals. Debt levels in emerging economies have been falling since 2002 while growth rates have far exceeded those for developed countries, so we’ve seen a steady progression of credit upgrades.
Debt now averages 40% of gross domestic product (GDP) in emerging economies compared with 100% or more in developed economies. Their relative merits really came to the fore this year with the continued deterioration in Europe.
What many people forget now is that emerging markets went through a very difficult period in the 1990s. They had massive devaluations and defaults, but that started the process of putting their fiscal and monetary houses in order—paying down debt and restructuring debt. It was not easy for a Brazil or Mexico. But they learned their lessons. So when there was a commodity boom, they saved a lot of that windfall rather than spending it on pet projects.
Emerging market debt has evolved over the past decade from a highly risky asset class to one taking a more prominent role in fixed income portfolios, especially in the current low-yield environment. Mike Conelius, a 24-year veteran with T. Rowe Price and manager of the Emerging Markets Bond Fund, discusses the opportunities and risks.
Q. Emerging markets were a source of global instability 10 years ago but have become the growth engine for the global economy and one of the best-performing investment areas—for debt as well as equities—in the past decade. How did that transformation come about?
Emerging countries also have a benefit that Europe and the U.S. do not have—a younger population with less of a pension burden on the government.
Q. Watching this transformation for many years, what has impressed you the most?
A. What’s impressed me the most is just the persistence of wanting to do the right thing at the government level—the transparency, disclosure, and commitment to fiscal prudence despite having a wave of funds coming to you either from a commodity boom or from capital flows.
There are obviously examples where that’s not the case, but central bank credibility generally is well established in most emerging markets. They want to fight inflation and they have the policy and the tool kit to do that, so I think it’s that maturation of leadership, which is seemingly lost or lacking in parts of the developed world.
Mike Conelius
Investment Viewpoint
Emerging Markets vs. Developed Markets GDP Growth Rates
-6
-4
-2
0
2
4
6
8
10%
’12’11’10’09’08’07’06’05’04’03’02’01
0
5
10
15
20
25
30
35
40
45%
Emerging Markets GDP Growth (left scale) Developed Markets GDP Growth (left scale) Emerging Markets Share of Global GDP (right scale)
Major advanced economies (United States, Germany, France, United Kingdom, Italy, Japan, Canada)Emerging and developing economies
Emerging Markets vs. G7 Public Debt (Percentage of GDP)
0
25
50
75
100
125%
’12’09’06’03’00
Emerging Markets Benefit From Better Economic Fundamentals
[Continued on page 6]
Source: International Monetary Fund as of April 30, 2012. (2012 is estimated.)
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Q. Perhaps reflecting this economic progress, emerging market bond yields are historically low. Do current yields compensate investors for the risks involved?
A. Everything is relative. Yields in developed markets also are extremely low. With all its problems, Spain is yielding around 7%; so 5% or so in markets that are fundamentally sound, though still volatile, isn’t too bad.
Also, there is a wide range of yields available. Brazil is 3% to 4% and even less for short-term debt. Venezuela, always a very challenging country, is yielding 12% to 15%. Ukraine is closer to 10%, and Hungary and Turkey around 7%. So we’re finding higher yields, but mainly we’re finding good value given the risks that we’re taking.
Q. Recently, we’ve seen a deceleration of growth in some key emerging markets, such as China, India, Brazil, and Russia. What impact is that having on their debt markets?
A. It’s less impactful on the debt side than the equity side. Clearly lower growth is a negative for the potential profit margin expansions or price/earnings multiple expansions from an equity investor standpoint.
China, of course, is a key market, and we believe it is managing its way to a soft economic landing.
Also, with growth rotating from an export focus to domestic demand, that creates opportunities. So, rather than buying an oil exporter or a commodities exporter in Brazil, it may be more interesting to focus on domestically oriented companies, whether they’re shopping mall operators or other consumer product companies.
Q. Many emerging markets are big producers or consumers of commodities. Over the past year, we’ve seen price declines in many industrial commodities such as iron and copper,
but oil prices haven’t changed much year-over-year. How has this affected these markets?
A. Well, many countries are net beneficiaries of lower commodity prices, Turkey, for example, as well as smaller countries in the Caribbean. They welcome a lower oil price in particular.
Russia, of course, is a major oil exporter, and we have some exposure to some of the private sector oil companies. We’re relatively underweight in Gazprom, the partly state-owned company, but LUKOIL and other oil companies there are very cost competitive.
And while the Russian domestic economy has slowed, the country is still likely to print 4% growth, so we still like some of those companies.
The other point to keep in mind is in many cases, the emerging government owns either a substantial or 100% stake of some of the key commodity producers and emerging countries tend to be further down the cost curve, so they tend to be more competitive. Venezuela, for example, is very competitive in producing oil.
Corporate Bonds
Q. A burgeoning corporate bond market has developed in emerging markets in recent years alongside the sovereign debt markets. What opportunities does that provide investors?
A. As sovereigns reduced their debt burdens over the past decade, that allowed more companies to come to the capital markets. The emerging corporate bond market is now comparable in size to the U.S. high yield bond market, and about 70% of that index is rated investment grade. Higher growth rates in emerging economies provide a direct benefit to local corporations.
One of the many things that we’re excited about in the corporate area is, because of the historical volatility of emerging countries, the individual companies in many cases are very conservatively leveraged and managed with lots of cash and little debt on the balance sheet, yet they have a greater tailwind for growth. So they offer attractive valuations, relatively high yields, very low debt, and, in many cases, are more competitive than their developed market counterparts.
There is a tier of globally competitive, more resource-focused companies. Vale in Brazil is the world’s largest iron producer. The world’s largest pulp manufacturer is also Brazilian.
Q. How are you investing in the emerging corporate debt markets?
A. We now have about 25% to 30% of assets invested in corporate bonds. We are much more focused on the growth in domestic demand spurred by the burgeoning middle-class consumer, especially in China and Brazil, as well as Russia, India, and Mexico.
Steep Decline in YieldsBond yields have fallen to historic lows since the financial crisis erupted in the fall of 2008.
Category 12/08 12/11 9/12
U.S. High Yield 19.42% 8.35% 6.51%
Emerging Markets 9.47 5.84 4.58
U.S. Corporate Investment Grade 7.50 3.76 2.78
Global Developed Markets (ex-U.S.) 3.04 2.32 1.73
10-Year U.S. Treasury 2.25 1.87 1.62
Sources: Barclays, JPMorgan, and Bloomberg.
Searching for Higher YieldsContinued from page 5
troweprice.com 7
As you build a middle class, you have lots of things happening. People go out to eat in restaurants. You have the formalization of retail. Rather than stalls on the streets of Rio de Janeiro, people go to a mall. And so we invest in a couple of high-income-producing mall operators in Brazil.
Globally, people eat more protein—more beef and more poultry. Brazil is a leading producer of beef and poultry, and Ukraine as well. That theme is reflected in the portfolio.
Also, young adults move out of their parents’ or grandparents’ home, and so you see more apartments or condo development in China, Brazil, and Mexico. We’re finding opportunities in Chinese property but in second-tier cities that haven’t seen the real estate bubble that Beijing did. Central China Real Estate is one company that we’ve invested in, capitalizing on these trends.
Q. Among the less economically developed “frontier markets,” which ones do you see having the most potential?
A. The Philippines has a real credit momentum behind it in terms of good economic policies, tight fiscal discipline, and improvements on tax collection.
We’re also finding opportunities in Africa and the Middle East, countries such as Iraq, Ghana, and Gabon. Iraq has the potential to become one of the
five largest oil producers in the world given its vast oil reserves.
We have a small position in Mongolia, but it is one of the fastest-growing economies in the world, growing
about 20% per annum. Everyone will be a millionaire in Mongolia, depending on how the government manages its huge resource of wealth. It has massive coal deposits, gold, other natural resources, and very few people. The secular demand from China will certainly support the development of Mongolia. So we own one of the mining companies there.
Frontier markets are exciting and offer diversification, but lately the valuations in some are not as compelling as what we’re finding in corporates. And we always have to keep in mind balancing the liquidity of frontier countries versus corporates.
Q. Where do you see the best opportunities for emerging market debt over the next few years?
A. I would say the corporate markets in Brazil and China. Some of these countries—Brazil, Indonesia, Turkey—are all underrated, so credit upgrades to their sovereigns will also bring upgrades and new capital flows to their corporate markets.
Q. Despite their improved economic profile, emerging markets remain volatile. What are the key risks now?
A. One of the key concerns will be the eventual turn of U.S. interest rates. In the old days, we had the opportunity of buying floating rate debt or fixed rate debt in emerging market sovereigns.
They’ve all done the right thing and locked in long-term, low-yield fixed
rate debt, so if there is a turn in U.S. interest rates, it could dampen returns because emerging market debt is a relatively high-duration (longer-maturity) asset class.
We don’t see inflation as a near-term threat, but we have seen in the past that food inflation, or food-related inflation, can meaningfully affect the local market investments and their currencies.
The fiscal stresses in Europe could also have an impact. Part of the process of Europe fixing itself is bank deleveraging, so banks may be less likely to lend to a company or country in Asia or Latin America. And Europe’s debt problems affect investors’ risk appetite in general, possibly slowing capital flows to emerging markets and, ultimately, credit spreads for emerging market debt.
Q. What’s your general outlook for emerging market debt?
A. I expect these markets to continue to provide investors with relatively attractive yields and diversification benefits, especially against the backdrop of such sluggish growth in the developed world.
Strong capital inflows should continue to support emerging market bond prices. Thanks to their solid credit fundamentals and growth rates relative to highly indebted developed countries, interest in the asset class remains high, even amid this period of heightened risk awareness.
Any near-term weakness stemming from global growth concerns may provide an attractive opportunity for investors who are underweighted in this asset class.
The Emerging Markets Bond Fund had 1.71% of its assets invested in the companies mentioned by Mr. Conelius as of September 30, 2012.
Others and Reserves33%
China4%
Indonesia7%Turkey9%
T. Rowe Price Emerging Markets Bond Fund Geographic Diversification as of June 30, 2012
Brazil14%
Russia14%
Mexico10%
Venezuela9%
T. Rowe Price Emerging Markets Bond FundGeographic Diversification as of September 30, 2012
“ One of the key concerns will be the eventual turn of U.S. interest rates.”
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U.S. Stocks Forge Upward as Earnings Growth DeceleratesEarnings growth for U.S. companies in the S&P 500 Index has decelerated steadily this year to showing virtually no growth in the third quarter. Sales growth also has faltered—at a time when many firms are counting on higher topline revenue to keep the bot-tom line growing. And the 2013 earn-ings outlook is filled with uncertainty.
All in all, it’s not exactly the most encouraging picture for the U.S. stock market. And yet the S&P 500 Index gained 16.4% through the first nine months of 2012, including a 6.4% gain in the third quarter.
To some investors, this might seem like the financial equivalent of making water run uphill. How can the market be so resilient in the face of such a sharp slowdown in revenue and earnings growth?
The answer is fairly simple: relief. Last spring, investors feared an even deeper, more prolonged earnings slowdown, thanks to Europe’s continu-ing financial crisis, unexpectedly weak growth in China, and disappointing U.S. employment reports.
Those worries eased somewhat over the summer, as Europe moved to support sovereign debtors and the U.S. economy showed signs of stabilizing. More recently, the Federal Reserve’s move to stimulate growth boosted sentiment.
“People are clearly feeling better about some of the more extreme risks like a breakup of the eurozone that were out there,” says Rob Bartolo, manager of the Growth Stock Fund. “But I have been a bit surprised by the market’s strength this year given the deterioration in some fundamentals, such as topline revenue growth.”
Cause for WorryIf investors are inclined to worry about earnings, second-quarter results would appear to have given them plenty to fret about. Year-over-year growth in quarterly earnings per share (EPS)
for S&P 500 companies slowed to just 2.3%, down from 7.4% in the first quarter.
Revenue growth was even more sluggish, as sales per share rose just 1.8% in the second quarter year-over-year—the slowest pace since the third quarter of 2009. For every company with a positive revenue outlook, five were negative, according to Thomson Reuters.
And at publication, the consensus was that the downward trend had extended through the third quarter.
Although earnings breadth (the percentage of companies reporting earnings increases) declined overall, the trend was worse for some indus-tries than for others, Mr. Bartolo notes.
The energy and materials sectors, for example, were both hit hard by the declines in oil and other commodity prices seen earlier this year—losses that were only partially reversed in the second quarter.
But technology, consumer-related, and some health care-related indus-tries (biotech and pharmaceuticals, in particular) appear to have held up better. Almost three-quarters of S&P
500 health care companies and almost 70% of the tech companies beat earnings expectations in the second quarter, according to Standard & Poor’s.
Clearing ObstaclesThe market tends to be forward- looking, so its relatively benign reaction to recent earnings disappoint-ments may reflect the fact that 2013 estimates remain stubbornly—perhaps unrealistically—high.
According to Standard & Poor’s, the bottom-up consensus—as of September—was forecasting year-over-year EPS growth of about 13.4% for 2013.
To reach that milestone, however, U.S. companies would have to clear some fairly steep obstacles, including:• Sluggish economic expansion: Typically at this point in the economic cycle, strong topline gains have replaced cost efficiencies as the primary driver of earnings. But that may not happen. “We’re still in the workout period from the credit bubble,” says Alan Levenson, T. Rowe Price’s chief economist.
The Slowdown in Corporate Revenue and EarningsPercentage Change Compared With Prior YearBased on Trailing 12-Month Data, Plotted Quarterly
The highlighted areas between Q4 2007 and Q2 2009 represent the recession. Q2 2012 is based on 99% reported. Q3 EPS estimate is Capital IQ bottom-up consensus; Q3 sales estimate is based on Bloomberg consensus sales growth.Source: Strategas Research Partners.
Earnings
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troweprice.com 9
“We’ve made progress, but the process isn’t finished.” As Europe and China deal with their own problems, the most likely outlook, he says, is for “a slow grind higher in unit sales.” • Wide profit margins: Since the economic recovery began in 2009, economists and analysts have been impressed by the ability of U.S. companies to squeeze double-digit EPS growth out of single-digit sales growth. This productivity surge pushed after-tax profits as a share of gross domestic product (GDP) to a record high last year. That might seem like a positive, not a negative, but with S&P 500 operating margins now over 9.4%—just shy of an all-time record—there does not appear to be much room for additional expansion.• Limited pricing power: In the later stages of past expansions, supply constraints have often given companies leeway to raise prices, at least partially offsetting slower productivity growth. That looks less likely now, as sluggish demand and excess capacity continues to keep inflation largely in check. • Political risk: Much has been written about the looming “fiscal cliff ”—a round of sharp federal tax hikes and spending cuts scheduled to kick in at the end of the year unless leaders in Washington can compromise. But that’s only one of the political cliffhangers facing the market. Others include the U.S. presidential election, leadership changes in China, and Europe’s struggle to create a new governing framework for the euro.
“I can’t remember a time when the outlook has been more policy-dependent,” says Bill Stromberg, T. Rowe Price’s director of global equities. “You can’t ignore the external factors because there are so many of them, and they could have such a sizable impact on growth.”
Grounds for OptimismBut despite the long list of downside
risks, there also are some potential grounds for optimism about the 2013 outlook, T. Rowe Price analysts say.
One simply may be that U.S. GDP forecasts have grown too pessimistic. “Expectations are now extremely low, at least in the economic forecasting community,” Mr. Levenson says. “This raises the odds that the next surprise will be to the upside.”
Possible catalysts include a stronger-than-expected recovery in the U.S. housing market, a better-than-expected resolution of fiscal gridlock in Washington, or an unanticipated upswing in capital spending. Any of these, Mr. Levenson says, could give at least a temporary boost to GDP growth and thus to earnings growth.
Even if the U.S. expansion just con-tinues to putter along, events elsewhere might increase the relative attractive-ness of U.S. equities. “At this point, the U.S. is actually doing better than most of the world,” says Mark Finn, manager of the Value Fund. “People are banking on a continued modest recovery here, and that’s made U.S. equities some-thing of a safe haven.”
Finally, while earnings are a key factor, so are valuations. And by
most metrics, the U.S. stock market appears reasonably priced, if not undervalued—especially compared with today’s ultra-low bond yields.
As of the end of September, the price/earnings ratio on the S&P 500 stood at 12.9 based on expected 12-month earnings—below its 14.9 average since 1985.
These potential positives, however, have to be balanced against the reality that the U.S. and other global developed economies are struggling to maintain growth—a trend that isn’t likely to change soon—while emerging market growth is slowing.
“If good policy choices are made, the global economy and earnings can both continue to grow,” Mr. Stromberg says. “But it probably will not feel robust for several years.”
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9/12’10’05’00’95’9010/86
Pace of Earnings Growth Losing Momentum
Source: The Leuthold Group.
Percentage of Companies Reporting Rising Earnings
6 yrs. of strongearnings breadth
4+ yrs. of strongearnings breadth
2 yrs. of strongearnings breadth
Based on trailing three-month earnings compared with a year earlier, plotted monthly.
56.1%
10
For the past three decades, the default decision for U.S. corporations has been to outsource manufacturing to lower-cost countries. Now, however, that cost-benefit equation is changing.
Rising wage pressures in Asia and other emerging markets, U.S. dollar depreciation, and overex-tended supply lines—a risk brought home by last year’s Japanese tsunami—have encouraged many firms to “in source” factory production back to the U.S.
Further encouraging this trend have been robust gains in U.S. industrial productivity, more flexible labor markets, and lower energy costs (especially compared with America’s leading manufacturing rivals).
The resulting manufacturing renais-sance could contribute materially to U.S. growth over the next decade, producing both investment winners and losers in the process.
But in any case, the United States has become an increasingly attrac-tive platform for manufacturing. As evidence of that, for the first time in several decades, both U.S. and foreign companies are building—or seriously considering—new manufacturing plants in the United States, either to meet U.S. domestic demand or to serve as global export platforms.
While the in-sourcing trend reflects improved U.S. labor cost competi-tiveness, global companies also are focusing on a number of other critical factors—such as greater business pre-dictability, more secure supply chains, and relatively stable political and legal environments—that make the U.S. more appealing for fixed investment.
Most manufacturing relocations currently are coming from other developed nations, including Japan, Germany, and Canada. However, some firms also are considering the advantages of in-sourcing production from China and may soon relocate if labor costs in China continue to rise at the current 15% to 20% annual rate. With wages rapidly rising in emerging markets, cost trends favor the United States. Productivity gains and slow wage growth have produced
strong gains in U.S. labor cost com-petitiveness relative to key developed world trading partners, including Germany, Japan, and Canada. (See chart on this page.)
Since 1980, U.S. manufacturing unit costs (wages net of productivity gains) have been essentially flat. This has given company managers more confidence that they can forecast future labor costs and effectively offset wage increases through productivity improvements.
By contrast, labor costs are rising rapidly in many emerging market countries, and these gains are not being offset by productivity growth. While China and other developing countries still have a labor cost advantage versus the United States, firms have less confidence that they can absorb future wage gains there without significant pressure on margins.
U.S. dollar depreciation also has improved U.S. labor cost competitive-ness. The U.S. dollar has fallen signifi-cantly against the euro, even after the impact of the recent European debt crisis. Over the 10-year period ended September 30, 2012, the dollar depreciated 23% against the euro.
Thanks primarily to euro apprecia-tion, German manufacturing per hour compensation costs—which roughly equaled the U.S. in 2000—are now 33% higher. The euro would have to return to parity with the dollar to eliminate this cost differential.
Moreover, the U.S. dollar has depreciated 21% against the Chinese yuan since 2005—at a time when Chinese manufacturing wages have been rising rapidly.
In a report last year, the Boston Consulting Group estimated that after adjusting for productivity, Chinese labor costs are only 30% cheaper than in the United States. After shipping
Cost Competitiveness Supports U.S. Manufacturing RevivalBy Brian Berghuis, Manager, T. Rowe Price Mid-Cap Growth Fund
U.S. Regains Labor Cost Competitiveness
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Sources: U.S. Bureau of Labor Statistics, China National Bureau of Statistics, and Haver Analystics; data analysis by T. Rowe Price.
U.S. Unit Labor Costs Versus Key Trading Partners, Through 2010
Japan S. Korea Germany Canada China
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U.S. GainingCompetitiveness
U.S. Losing Competitiveness
Brian Berghuis
troweprice.com 11
and inventory costs, the advantage drops to single digits, and continued rapid wage growth in China could quickly close the gap.
Beyond Labor CostsThe U.S. reindustrialization renais-sance does not just rest on labor costs.
Thanks to the revolution in drilling technology and the resulting expan-sion in domestic natural gas supplies, the United States and Canada both benefit from relatively low energy costs and better reliability and availability of power.
In addition, transportation and sup-ply chain logistics are easier to manage in the United States, as companies now consider time and proximity to customers as well as cost. As Chinese manufacturers move further inland, lower wage costs may be offset by higher shipping costs and longer delivery times.
And last, real estate costs also are rising rapidly in China. Office rents in Beijing rose 70% in 2011, and Class A office space in that city now costs an average $130/sq. ft. compared with $120/sq. ft. in Manhattan.
These costs are leading many firms to look for space in other Chinese cities or in cheaper Asian countries but may eventually encourage them to relocate back-office functions to the U.S.
Economic BenefitsHiring linked to this manufacturing revival could reduce U.S. unemployment.
Unfortunately, the large decline in U.S. manufacturing employment over the past 30 years has been the result of strong labor productivity gains and the introduction of new technologies, not just outsourcing. (See chart on this page.) This means that any rebound in U.S. manufacturing payrolls is likely to be limited.
However, economic studies suggest that manufacturing growth has a strong employment multiplier effect. Research by the Economic Policy Institute found that for every job created in manufacturing, 2.9 jobs were created in supporting sectors, such as services.
All else being equal, a gain of one million manufacturing jobs (enough
to return U.S. factory employment to the 2007–2010 average) could lower the U.S. unemployment rate to 7.5% from 7.8% in September of this year.
Indirect hiring (using the multiplier of 2.9 to 1) could reduce the U.S. unemployment rate to 5.7%—at or near the current consensus estimate of the lowest unemployment rate consis-tent with stable inflation.
Additionally, academic studies have identified significant gains from the geographic clustering of manufactur-ing and such related functions as
research and development, product design, and marketing. These syner-gies, while hard to quantify, are real and could further enhance the potential economic benefits of U.S. reindustrialization.
While industrial firms are the most obvious beneficiaries of a U.S. manufacturing revival, it also could spark demand for utilities, energy producers, and other sectors. And
if employment growth does result, certain consumer-related companies, such as homebuilders, consumer lenders, and U.S.-focused retailers, may benefit as well.
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20
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Source: U.S. Bureau of Labor Statistics.
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— Employment (left scale)— Productivity (right scale)
The Lost Jobs Aren’t All Coming BackU.S. Manufacturing Employment and Productivity, Through June 2012
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“ ...for the first time in several decades, both U.S. and foreign companies are building—or seriously considering—new manufacturing plants in the United States...”
12
Recession is the watchword of the year in Europe, as each passing month brings grim news of stagnant growth, weaker manufacturing activity, and accelerating levels of the so-called misery index based on unemployment and inflation, which stood at a 15-year high in August.
T. Rowe Price investment managers say these and other negative data indicate an impaired European recovery for years to come. They say the full monetary and fiscal integration of the eurozone could take a decade or more, with numerous hurdles that could cause setbacks.
In late summer, the European Central Bank moved to bolster bank liquidity by agreeing to purchase government debt of countries willing to sign up for a restructuring plan.
T. Rowe Price equity and fixed income managers consider this an encouraging step, along with reforms that European institutions and governments have insti-tuted to confront burgeoning debts and stagnant growth.
“I think this is a key development and has taken down the risk premium in Europe and shows that, once again, Europe will do what is needed to hold the eurozone together,” says Dean Tenerelli, manager of the European Stock Fund. Nonetheless, he says, “we are definitely feeling the economic impact of the austerity measures of all these countries, and I think things could worsen near term as a result.”
Strong CorporationsMr. Tenerelli says that, with the exception of the banking sector, which the firm’s equity managers have largely avoided in Europe’s periphery, a number of high-quality European companies continue to feature stellar balance sheets and solid brand recognition throughout the world.
Moreover, he adds, “while the stock market has come back somewhat in recent months, valuations are at 25-year lows.”
European corporations have made major progress by cutting costs and
strengthening their balance sheets, leading to improved earnings power and cash flow generation. Faced with muted growth in local markets, they increasingly have looked overseas for growth opportunities and today have a large presence in faster-growing emerging markets.
Ray Mills, manager of the Overseas Stock Fund, has about 36% of its assets in Europe (excluding the United Kingdom), agrees. “We’re certainly seeing a crisis right now,” he says. “The countries are in varying degrees of recession or very slow growth. But we have a balanced outlook in that valuations are very supportive, and there are a lot of great companies to invest in.”
Mr. Mills says he has tilted his allocation to northern European countries, particularly Germany and Sweden, where growth is slowing but the export market continues to provide support to corporate revenues.
“I think earnings are going to be challenged to grow very robustly until we get some of these economic issues on the right track,” Mr. Mills says. “That’s why we have a heavy skew toward northern
Europe, particularly among companies that are either very healthy fundamen-tally or leveraged to emerging market growth, even though they sit in Europe.”
Buying OpportunitiesEquity managers say European market volatility has enabled them to buy attractive stocks at a discount over the past several months, including some that even have considerable exposure within Europe.
Earlier this year, Mr. Tenerelli established a position in Tod’s, an Italian, family run business that produces high-end shoes, leather goods, and apparel. While only about 20% of its revenues come from outside Europe, Mr. Tenerelli says the company has a strong balance sheet and a comprehensive investment strategy.
Likewise, Mr. Mills owns shares of Inditex, a Spanish fashion retailer, which has considerable presence in Spain and Italy through its Zara retail stores. “They’ve been able to maintain their sales in those two countries just because they’re executing really well,” he says. “Their costs have come down because
Despite Bleak Backdrop, Europe Beckons
European Stocks Lag U.S. and Emerging MarketsTotal Return Indexed to 100 as of December 31, 2008
Source: Morgan Stanley Capital International based on MSCI Europe, EAFE, U.S., and Emerging Markets Indices.
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— International Developed Markets — Europe — United States
— Emerging Markets
troweprice.com 13
Despite Bleak Backdrop, Europe Beckonssome of their costs are sourced from Europe and North Africa.”
Of course, Tod’s, Inditex, and Swiss watchmaker Swatch, which Mr. Tenerelli owns, also have a growing presence beyond Europe, particularly in China, Brazil, and other emerging markets. These and other growing exporters are benefiting from a weaker euro, which has made their products cheaper to foreign buyers.
“If you’re an exporter and have a strong suite of products, you’re doing well as a result of the euro’s depreciation,” Mr. Tenerelli says.
Many of Mr. Tenerelli’s industrials and business services holdings also have exposure to emerging markets.
Last summer, he bought shares of British valve company Rotork, a high return on investment business with an excellent record of global growth. The company is well positioned to benefit from global energy infrastructure demand.
Likewise, Mr. Mills owns shares of Unilever, a food and personal care firm, which is based in the UK but generates more than half of its revenues from emerging markets.
High Yield BoomOne of the more intriguing investment opportunities these days is in the European high yield corporate bond market, which offers attractive yields and has become a significant asset class.
Indeed, European high yield bonds have been among the top-performing developed market fixed income asset classes in the 12 months through September (in euros), and several T. Rowe Price bond funds have invested in this market.
Michael Della Vedova, a T. Rowe Price manager focused on European high yield bonds, says the supply of these bonds has risen sharply as many European companies have been unable to refinance existing loans amid the continued process of bank deleveraging.
European high yield issuance now is accelerating faster than U.S. high yield issuance. “You’re seeing an increasing number of multinational companies participate in the European high yield market, such as Levi’s and General Motors,” Mr. Della Vedova says.
In addition, he says some marquee names, such as Lufthansa, Renault, and Fiat, have been downgraded in recent
years, prompting them to become major participants in the high yield market.
“In this low-yield environment, many investors are intensifying efforts to bolster returns in order to fund their liabilities,” Mr. Della Vedova says. “Increasingly, investors are moving their allocations away from sovereign bonds to more rewarding areas.”
Nonetheless, the high yield market is often volatile, and risks, of course, include Europe’s unsteady economic and finance climate.
Performance vs. GrowthAs investors have seen in recent years, a spike in investors’ risk aversion stem-ming from Europe’s economic and fiscal problems can outweigh even the most hopeful signs supporting stronger equity performance.
Mr. Mills says he understands this sentiment but notes that many studies have shown there often is no strong correlation between economic growth and stock market returns, particularly in the short run but sometimes also over the long haul.
“For over 100 years, Japan was the fastest-growing economy,” he says. “It also was one of the worst equity markets. So economic growth and market returns don’t always go in lock step.
“At some point, the market will realize that valuations are attractive and that Europe is making enough progress and is on the right path.”
International investing is subject to market risk and risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad. Emerging markets investments are subject to the risk of abrupt and severe price declines.
As of September 30, 2012, Tod’s, Swatch, and Rotork composed 2.26% of the European Stock Fund. Inditex and Unilever composed 1.98% of the Overseas Stock Fund. Levi’s, General Motors, Lufthansa, Renault, and Fiat made up 0.20% of the International Bond Fund.
European High Yield Market Is SoaringGrowth in Market Size 1998 Through September 2012
*As of September 2012.
Source: Credit Suisse.
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Entitlement spending, and the urgency of expenditure-limiting reforms, has become a central issue in this year’s election campaign. It is an important topic for debate: Outlays for Social Security, Medicare, and Medicaid together account for 42% of federal government spending (about $1.5 trillion), compared with 35% ($482 billion) 20 years ago.
The medical benefits programs (currently 21% of federal spending) have been the primary driver in that trend. They have consistently grown faster than the economy as well, rising from 3.2% of our gross domestic product (GDP) in 1992 to 4.9% this year. This is an important metric because GDP not only represents the value of what our economy produces, but also of the income that this production generates—income that is available to pay for government outlays, including entitlements.
Entitlements’ rising call on national income seems likely to persist into the future, as medical cost inflation rises faster than that in the broader economy and as retiring baby boomers swell the ranks of benefits recipients. But this trend cannot continue indefi-nitely. If it did, entitlement outlays (driven primarily by medical care) would eventually consume 100% of GDP.
Long before that, policymakers will have to address the rising cost of entitlements in order to limit the mounting strains that they exert on the federal budget and the government’s outstanding debt.
Our starting point is not favorable: The Congressional Budget Office (CBO) estimated that the federal budget deficit for the 2012 fiscal year ended September 30 was $1.1 trillion (7.3% of GDP) and that our public
debt stood at 72.8% of GDP. From there, the CBO projects that the com-bined cost of Social Security, Medicare, and Medicaid (based on their current design) will roughly double over the next decade, to $3 trillion in 2022.
This represents an estimated rise of two percentage points of GDP (to 12% in 2022), which will be tacked on to total spending, the budget deficit, and stock of debt, barring offsetting changes in other parts of the budget.
A Formidable ChallengeAs it happens, there will be room under current law to accommodate these rising entitlement costs, at least for a few years, but only if we take the plunge off the “fiscal cliff ” approaching January 1.
The 10-year, $1.2 trillion across-the-board cuts to discretionary spending mandated by last year’s Budget Control Act are scheduled to take effect then. If that is actually enacted, the CBO estimates that total discretionary spending would fall from 8.3% in 2012 to a post-World War II low of 5.6%
10 years later—sufficient to offset the projected rise in entitlements.
Nonetheless, total federal outlays, including interest on the debt and other mandatory spending (such as the large entitlement programs and other forms of income support) would reach a nadir at 21.3% of GDP in 2018–2019 (compared with a post-World War II average of just under 20%) before resuming their entitlements-driven rise thereafter.
The tax increase portion of the fiscal cliff would boost federal revenues, helping to defer the entitlements squeeze even further into the future. The scheduled expiration of the Bush-era income tax cuts, along with increases in estate and gift tax rates, would raise federal government revenues by an average of 1.3% of GDP over the next 10 years, lifting them to roughly 20% of GDP. This compares with 15.5% currently and a long-term average of 18%.
Under this scenario, the budget deficit would shrink to 1.4% of GDP in
Economic Perspective
Entitlement Programs Pose Fiscal Challenges and Risks By Alan Levenson, T. Rowe Price Chief Economist
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Entitlements’ Rising Share of Federal Outlays
Source: Congressional Budget Office. Projections for 2012–2022 reflect T. Rowe Price estimates based on CBO data and assume extension of current tax rates except for the top income tax brackets and discretionary spending by the federal government grows in line with nominal GDP.
Percent of Total Outlays
troweprice.com 15
2017 before beginning to widen again, as the influence of growing medical benefits resurfaces. Debt would fall to roughly 65% of GDP in 2022 and perhaps a bit further before beginning to increase as outlays for Medicare and Medicaid rise, with little scope to cut other expenditures further relative to the size of the economy.
Not Realistic This scenario is the most sanguine that can be extracted from the CBO projections. Unfortunately, it is not the most realistic.
Instead, suppose that the across-the-board spending cuts are deferred and that federal discretionary spending grows in line with nominal GDP, as it has historically. In this case, total outlays would rise to 24.8% of GDP in 2022, two percentage points higher than with the currently mandated spending in force.
Suppose further that the current tax rates for incomes below $250,000 were made permanent, with only the upper income tax rates (along with rates on investment income) rising on schedule next year.
In this case, revenues would rise to 18.8% of GDP in 2022, roughly 1.5 percentage points lower than with full expiration of the Bush-era tax cuts.
The result: The budget deficit would be roughly 6% of GDP in 2022, and total outstanding debt would rise to 90%. And, as noted, entitlement spending would continue to grow faster than the economy thereafter, reinforcing these unsustainable debt and deficit dynamics.
Under this scenario, debt would be on a path to grow faster than the economy indefinitely. As we are seeing in other developed economies, rising public debt burdens undermine economic performance.
Right now, the U.S. Treasury is able to finance large annual deficits and outstanding debt at low interest rates, but this will not always be the case—if only because rates will rise as the economy recovers. The larger the debt, the greater the ultimate impact on total interest expense as rates rise.
Foreign investors, who own over 40% of outstanding Treasury debt, might become less enthusiastic owners. This could put upward
pressure on interest rates, possibly restraining domestic growth, and downward pressure on the dollar, tending to spur inflation.
A lack of fiscal discipline now would put the Federal Reserve in a tight spot when it eventually needs to raise interest rates and renormalize its balance sheet. And the risk of finan-cial repression—forcing banks and other large funding sources through legislation or regulation to buy more Treasury debt—would rise. This would reduce funding for private investment, also restraining the economy.
A Balanced Solution Even if we accept that our federal budget is on a dangerous and unsus-tainable path, there are sharp and legitimate differences of opinion as to how to close the gap. But this analysis calls for a compromise: One-sided solutions are not politically feasible.
Without further entitlement reform or restraint in discretionary spending (relative to nominal GDP), revenues would have to rise to over 20% of GDP early in the 2020s—and keep rising in order to contain the budget deficit and stabilize the debt.
The broad population will not accept paying an ever-rising share of income in taxes to fund entitlements. But neither will it likely accept the cuts in defense and other discretionary spending that would be required to put the budget on a sustainable path without raising revenues beyond their historical average of 18% of GDP.
An acceptable compromise is likely to entail reform of the tax code that generates revenues in excess of the historical average; entitlement reform that reduces the growth in Social Security, Medicare, and Medicaid outlays; and slower growth in defense and non-entitlement discretionary spending.
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Upward Pressure on Debt Won’t Be Reduced Easily
Source: Congressional Budget Office. Projections for 2012–2022 reflect T. Rowe Price estimates based on CBO data and assume extension of current tax rates except for the top income tax brackets and discretionary spending by the federal government grows in line with nominal GDP.
Federal Debt Held by the Public Percent of GDP
16
their cash flows,” Mr. Martino says.Another attractive telecom area
involves companies that own cellphone towers and lease space for wireless antennas, such as American Tower, Crown Castle International, and an Indonesia firm, Protelindo, which account for more than 10% of the fund.
“These are real estate companies with long-term contracts providing steady, escalating income,” he says. “They are well positioned to leverage the buildout of wireless.”
Barbell ApproachWhile Mr. Martino’s portfolio is fairly concentrated—with a little more than 50 stocks—it goes far beyond telecom.
His portfolio is unusually bifurcated—with roughly half in these relatively stable global telecom investments and half in more growth-oriented and potentially volatile media and technology stocks. The latter ranges from such well-known U.S.-based firms as Apple, Google, and Qualcomm to Chinese online media companies Baidu, Sina, and Tencent Holdings, which make up more than 9% of the fund.
The connection between the portfolio’s
Spurred by low interest rates and solid fundamentals, telecommunications led U.S. large-cap sectors in performance this year through September.
“Investors have been chasing dividend yields as never before,” says Dan Martino, manager of the Media & Telecommunications Fund. “Telecom stocks offer stable fundamentals and historically high relative dividend yields at a time of uncertainty and low interest rates.”
Investors’ quest for dividend yield via telecoms backed off some in the third quarter as investors’ risk appetite returned to the market, but, with the 10-year Treasury rate around 1.6%, “telecom yields remain very attractive,” he says.
Telecom stock prices have moved up as the 10-year Treasury rate fell. “Tell me where the 10-year Treasury rate is headed, and I will tell you my outlook on telecom sector equities,” he says.
In the telecom portion of the fund, however, Mr. Martino pays as close attention to valuations as yields. “You have to be careful with high-dividend stocks—not all dividends are created equal,” he says, noting that the prices of such high-yielding U.S. phone companies as Verizon and AT&T are now relatively high.
By contrast, he says, there are better values among such international wireless providers as Vodafone, which owns 45% of Verizon, and China Unicom and such U.S. cable franchises as Comcast and Time Warner. Cable firms offer lower yields but at much cheaper multiples of their cash flows. And instead of paying out the highest dividends, some are rewarding investors by buying back stock.
“If you take two companies, one with a 3% yield and another with a 7% yield, you really don’t know much about the companies—until you dig deeper into the fundamentals to see what’s driving
two strategies? “We spend a lot of time thinking about infrastructure, understanding the companies building it, and focusing on the innovations taking place atop the infrastructure,” he says. “The most important trend—the growth of wired and wireless broadband—is driving opportunities. We go anywhere on the growth-value spectrum and in the world to leverage what we see in telecom.”
Mr. Martino notes, for example, that while U.S. smartphone penetration has reached about 60%, it’s only about 10% in China. Similarly, only 20% of advertising has yet to shift to the Internet, but that is growing rapidly each year.
“Broadband buildout is a tailwind driving so much innovation, market disruption, and investment opportuni-ties,” he says, “in e-commerce, travel, recruiting, and advertising—almost every area. This is a historically unprecedented time, and it’s going to provide interesting opportunities for a long time.”
To keep up, along with relying on the firm’s fundamental research analysis, Mr. Martino also regularly convenes panels of college students to check out how they’re using media.
“They’re on the bleeding edge for trends that will become mainstream,” he says. “I’m not all that much older, and it’s amazing to me how dramatically different their media use is. They’re always connected. TV isn’t that important. They can’t live without their smartphones.”
Due to its concentration on specific industries and exposures to mid-cap stocks and foreign securities, the Media & Telecommunications Fund’s share price could be more volatile than that of a fund with a broader investment mandate.
As of September 30, 2012, stocks mentioned by Mr. Martino made up 58.1% of fund assets.
Telecom Stocks: Fundamentals, Dividends Drive Leading Sector
Performance Spotlight
Strong Telecom PerformanceAs of September 30, 2012
S&P 500 TelecommunicationServices SectorS&P 500 Index
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2012 Total Return
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Source: T. Rowe Price. Standard & Poor’s.
troweprice.com 17
By contrast, the survey reveals that about two-thirds of investors with access to a 401(k) are contributing 10% or less of their salaries to their plan.
When asked what percentage of their salaries they would ideally save for retirement each year, a significant number—42%—said less than the 15% benchmark. Just as troubling, a little less than one-third of survey respondents are not sure how much they are currently contributing to their retirement plan.
“It’s good that most people are saving,” Ms. Fahlund says, “but the survey under-scores that most are not sure what their savings goal should be. They need to gradually boost their retirement savings amount, and many need to become more fully engaged in the savings process—the sooner the better.”
Postcrisis Investor SentimentThe survey also examined how the 2008 financial crisis and stock market melt-down affected investors’ attitudes toward investing. About half claim to have about the same tolerance for investment risk as they had before the crisis, 30% say they
Despite the crosscurrents of volatile global financial markets, a struggling U.S. economy, and political uncertainty, investors remain focused on saving for retirement, a new T. Rowe Price survey suggests. In the wake of the financial crisis, however, many have a reduced appetite for risk.
Among investors age 21 to 50, 72% say that saving for retirement is their top financial goal. At the same time, these investors also are focused on maintaining or improving their current lifestyles (50%), creating or adding to an emer-gency fund (36%), paying off debt such as credit cards (34%), and saving for their children’s college expenses (27%).
Competing financial priorities present a stark challenge for investors, especially during hard economic times, says T. Rowe Price senior financial planner Christine Fahlund. But Ms. Fahlund is encouraged that relatively younger investors have their priorities straight. “Retirement savings must come first for younger investors,” she says. “This survey shows that they recognize the importance of saving for retirement. Saving early in one’s adulthood increases the compound-ing of earnings over a decades-long period. That can significantly improve the chances that younger investors will be prepared for retirement. Trying to make up later on for lost savings time can be very difficult.”
Not Saving EnoughAlthough investors give priority to retirement saving, the survey indicates that most people are not saving enough. Based on the firm’s earlier research, T. Rowe Price financial planners recom-mend that investors strive to save at least 15% of their annual income, including any employer contributions to a workplace retirement plan such as a 401(k), in order to have a reasonable possibility of living comfortably in retirement.
have a lower tolerance for risk, and 19% report a higher tolerance.
Interest in investing in stocks, long a staple of retirement investing, appears to have taken a hit. While 61% of investors surveyed still consider equity investing important for retirement success, many (37%) are refraining from investing in stocks. Among the key factors cited: the slow pace of the U.S. economic recovery, general market volatility, political uncertainty, and rising health care costs.
Among fixed income investors, about three-quarters are only somewhat or not at all willing to take on more risk to obtain a potentially higher yield.
While the financial crisis may have made many investors more risk averse, about half say that their current invest-ment portfolio is allocated about the same as it was before the crisis, while 31% say that they are investing more conservatively and 16% report investing less conservatively.
Aside from investment strategy, the crisis appears to have ushered in a new era of financial prudence. About 45%
Investors Cautious but Committed to Retirement Saving
Personal Finance
Investors’ Key Retirement Planning Concerns: Percentage Citing These Factors*
*Based on a survey of 850 respondents between ages 21 and 50 who have at least 1 investment account, surveyed online in August 2012. Source: Harris Interactive for T. Rowe Price.
0 10 20 30 40 50 60 70 80%
Health Care Costs
Taxes
Social Security
Long-Term Care
Running Out of Money
Housing Values
Personal Debt
Inflation
[Continued on page 18]
18
of investors report that they are saving more now than they were before the crisis, while only 19% say they are saving less.
For those who have abandoned or significantly reduced their equity allocation, Ms. Fahlund cautions, “Over the long term, the stock market has historically provided superior returns relative to other asset classes. Younger investors in particular have an important ally on their side—time.
However fresh the crisis might linger in their minds, they would be well served to remember that because they are investing for decades, they should actually be taking advantage of down markets by increasing their equity
exposure when stock prices appear attractive.”
Other ConcernsAmong investors planning for retirement, their primary concern, cited by three-quarters of them, is health care costs, followed by rising taxes, Social Security availability, and inflation. (See chart on page 17.) The possibility of outliving one’s retirement savings was also cited by about half.
Interestingly, only 16% of the inves-tors believe they will receive full Social Security benefits as the program is currently structured. The remaining 84% expect to receive either reduced benefits (48%) or no benefits at all (36%). This
group says they plan to save more and work longer as a result.
“Much has been reported about the viability of Social Security funding for future generations,” Ms. Fahlund says. “Still, the lack of confidence that many investors have in the program is troubling because Social Security has been an important leg of the retirement stool for decades, along with savings, and, until recently, pensions.
“Hopefully, their concern that they may have to rely solely on their investments in retirement becomes another motivating force that encourages them to save as much as they can. Many aspects of their financial future are unknown, so investors need to focus on what they can control, which is the amount they save on a monthly basis.
“Whatever financial winds are swirling around them,” Ms. Fahlund adds, “inves-tors who take charge of their retirement savings programs and keep their eye on the ball will most likely be the ones who enjoy the kind of retirement we all aspire to have.”
Investor SurveyContinued from page 17
The T. Rowe Price Program for Charitable GivingSM, a national donor-advised fund offering convenience and flexibility for managing your philan-thropy, surpassed the $100 million mark in grants this year.
To open an account, donors make an initial $10,000 minimum contribution of cash or publicly traded securities; subsequent contributions require a minimum of $500.
Contributions are invested among six pools of T. Rowe Price funds, ranging from conservative strategies for those seeking capital preservation to more aggressive strategies geared toward growth opportunities. All pools are subject to market risk, including possible loss of principal.
While charitable deductions can be claimed for the year in which contribu-tions are made to the Program, donors can recommend grants to charitable organizations at any time; the minimum grant is $100. Prior to granting, con-tributions remain invested, potentially enabling larger grants in the future.
Gifts of long-term appreciated securities are valued at the current market value and are not subject to capital gains taxes when donated to the Program, increasing the value of the gift and the charitable tax deduction.
Donors can manage their accounts online by making grant recommenda-tions, changing investment allocations, researching charitable organizations, and reviewing account information.
An educational Web tool, available at ProgramForGiving.org/givingtool, helps users evaluate the benefits of establishing an account with the Program.
To see how current donors are using the Program to benefit their favorite charities, watch the video at ProgramForGiving.org/video.
The T. Rowe Price Program for Charitable Giving is an independent, nonprofit corporation founded by T. Rowe Price to assist individuals with planning and managing their charitable giving. The Program has contracted with various T. Rowe Price companies to provide operational recordkeeping and investment management services.
“ Interestingly, only 16%...believe they will receive full Social Security benefits as the program is currently structured. The remaining 84% expect to receive either reduced benefits...or no benefits at all.”
Charitable Giving Program Hits $100 Million in Grants
September 30, 2012T. Rowe Price Quarterly Performance Update
troweprice.com 19
Large-cap U.S. stock indexes climbed to levels not seen since late 2007 despite muted domestic economic growth, a eurozone recession, and a slowdown in emerging economies. Equities were lifted by strong but slowing corporate earnings growth and central bank pledges to purchase assets to suppress interest rates. In September, the European Central Bank (ECB) president unveiled a plan for the ECB to buy sovereign short-term debt of troubled countries that seek formal financial assistance and agree to implement reforms. Also, the Federal Reserve announced a third round of quantitative easing—informally called QE3—that targets agency mortgage-backed securities (MBS).
Corporate Earnings and Central Bank Asset Purchases Lift Equities
Emerging Markets and U.S. Energy Shares OutperformLarge-cap shares outpaced their smaller counterparts. As measured by various Russell indexes, value stocks narrowly outperformed growth stocks across all market capitalizations.
In the U.S. stock market, as measured by the Wilshire 5000 Total Market Index, energy stocks fared best as oil prices climbed, in part, because of renewed geopolitical tensions over Iran’s nuclear program and a pickup in global oil demand. The telecommunication services, consumer discretionary, and health care sectors also produced strong returns. Materials, financials, and infor-mation technology shares performed mostly in line with the broad market. Consumer staples and industrials and business services stocks trailed with milder gains. Utilities were flat.
Equities in developed non-U.S. coun-tries narrowly outperformed U.S. shares, as stronger currencies versus the U.S. dollar lifted local stock market returns in dollar terms. In Europe, Nordic markets fared best, but many eurozone markets also did well, helped by the ECB’s conditional offer to purchase euro-zone debt. Most developed Asian markets did well, but Japanese shares were flat.
Emerging markets equities surpassed shares in developed markets as inves-tors embraced risk despite decelerating growth in developing economies. Equities in emerging Europe were among the top performers. Latin American markets lagged.
Equity Review
U.S. Stock Market Performance
Total Returns for Periods EndedSeptember 30, 2012
move bars up 300 pts.
S&P 500 IndexS&P MidCap 400 IndexNASDAQ Composite Index (Principal Return)Russell 2000 Index
0
10
20
30
40%
1 Year3 Months
6.3
5
5.4
4
6.1
7
5.2
5
30
.20
28
.54
29
.02
31
.91
3 Months 1 YearS & P 500 Stock Index 11.29 10.16 S & P Midcap 400 Index 13.12 17.78Nasdaq Composite Index (Principal Return) 12.3 11.6Russell 2000 Index 11.29 13.35
International Stock Market Performance
Total Returns for Periods EndedSeptember 30, 2012
move bars up 300 pts.
MSCI EAFE Index(Europe, Australasia, Far East)MSCI Emerging Markets Index
3 Months 1 YearMSCI EAFE Index -13.75 6.38MSCI Emerging Markets Index -8.29 23.480.94 2.45
55.2 81.55
0
4
8
12
16
20%
MSCI Emerging Markets Index
MSCI EAFE Index
1 Year3 Months6
.98
7.8
9
14
.33 1
7.3
3
Performance of Wilshire 5000 Series
Total Returns for Periods Ended September 30, 2012,Ranked by Highest to Lowest Quarterly Return
1 Year3 Months
0 5 10 15 20 25 30 35%
1 Year
3 Months
Utilities
Industrials and Business Services
Consumer Staples
Information Technology
Financials
Materials
Health Care
Consumer Discretionary
Telecommunication Services
Energy
Performance of Wilshire 5000 Series 3 Months 1 YearInformation Technology 10.51 61.91Materials 8.90 55.73Consumer Discretionary 7.87 48.61Health Care 7.86 23.31Telecomm Services 7.54 12.78Utilities 6.85 13.12Energy 6.55 22.92Industrials and Business Services 5.53 22.55Consumer Staples 5.35 15.08Financials -2.30 14.68
9.81
8.13
7.72
6.41
6.31
6.06
5.97
3.82
3.50
0.52
26.79
34.32
34.37
31.90
30.04
34.27
29.25
24.39
29.80
13.71
20
Fixed Income Review
High Yield and Emerging Markets Bonds OutperformU.S. bonds produced positive returns. The Federal Reserve projected that short-term rates will remain low until mid-2015. The Fed also initiated an open-ended policy of purchasing $40 billion of agency MBS every month—and offered to continue purchasing assets if the labor market outlook does not improve substantially.
High yield securities produced strong returns. In the investment-grade universe, corporate bonds did best. Municipal, asset-backed, and agency MBS trailed with smaller gains. Treasuries were flat.
Government bonds in developed non-U.S. markets produced good returns. Bonds in peripheral eurozone countries were among the best performers, helped by a stronger euro versus the dollar. Japanese bonds also did well, as the yen strengthened and the Bank of Japan increased the size of its asset purchase program in its continuing attempt to fight deflation.
Emerging markets debt surpassed bonds in developed non-U.S. markets. U.S. dollar-denominated debt outpaced bonds denominated in local currencies, though the latter were helped by the appreciation of many emerging markets currencies versus the dollar.
1 Year3 Months
U.S. Bond Market Performance
Total Returns for Periods EndedSeptember 30, 2012
move bars up 300 pts.
Barclays U.S. Aggregate Bond IndexBarclays Municipal Bond IndexCredit Suisse High Yield Index
0
4
8
12
16
20%
Credit Suisse High Yield Index
Barclays Municipal Bond Index
Barclays U.S. Aggregate Bond Index
4.2
7
8.3
2
5.6
7
5.6
7
3 Months 1 YearBarclays Capital U.S. Aggregate Index 3.49 9.5Barclays Capital Municipal Bond Index 2.03 9.61Credit Suisse High Yield Index 0.21 26.91
1.5
8
5.1
6
17
.92
2.3
2
International Bond Market Performance
Total Returns for Periods EndedSeptember 30, 2012
move bars up 300 pts.
J.P. Morgan Emerging Markets Bond Index Global
Barclays Global Aggregate ex USD Bond Index
0
6
12
18
24%
J.P. Morgan Emerging Markets Bond Index Global
Barclays Global Aggregate ex USD Bond Index
1 Year3 Months
5.6
7
5.6
7
4.3
7
4.8
0
Barclays Capital Global Aggregate Ex-USD Index JP Morgan Emerging Markets Bond Index-Global3 Months -2.43 1.161 Year 1.89 17.9
20
.59
6.7
6
-1.65 4.1611.84 29.15
Trends in Interest Rates
Credit Suisse High Yield Index*
Barclays Municipal Bond Index*
90-Day Treasury Bills
Barclays U.S. Aggregate Bond Index*
6.57%
0.09%1.60%2.16%
*Yield-to-worst
9/10-3
0
3
6
9
12
15
18
21%Credit Suisse High Yield Index*
Barclays Capital Muni Bond*
Barclays Capital U.S. Aggregate Index*
90-day Treasury Bill
9/129/119/109/099/089/079/069/059/049/039/02
Stock and Bond Market Performance
Total Returns for Periods Ended September 30, 2012Unlike stocks, U.S. government bonds are guaranteed as to the timely payment of interest and principal.
move bars up 300 pts.
S&P MidCap 400 IndexS&P 500 Index
Russell 2000 Index
NASDAQ Composite Index (Principal Return) Barclays U.S.
Aggregate Bond Index
MSCI EAFE IndexCredit Suisse High Yield IndexBarclays Municipal Bond Index
1 Year3 Months
1.58 2.32
28.54 29.02
14.33
6.988.32
30.20
0
7
14
21
28
35%
1 Year3 Months
5.16
17.92
31.91
5.44 6.17 5.254.27
6.35
Performance Summary
troweprice.com 21
Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended September 30, 2012
The performance information presented here includes changes in principal value, reinvested dividends, and capital gain distributions. Current performance may be higher or lower than the quoted past performance, which cannot guarantee future results. Share price, principal value, yield, and return will vary, and you may have a gain or loss when you sell your shares. To obtain the most recent month-end performance, call us at 1-800-225-5132 or visit our website. The performance information shown does not reflect the deduction of redemption fees (if applicable); if it did, the performance would be lower. Call 1-800-225-5132 to request a prospectus or summary prospectus; each includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. Funds are placed in alphabetical order in each category. To learn more about each fund’s objective and risk/reward potential, visit troweprice.com/mutualfunds.
Ticker Symbol
3 Months 1 Year 3 Years 5 Years
10 Years or Since
Inception1Inception
DateRedemption
Fee
Redemption Fee
PeriodExpense
RatioExpense Ratio
as of DateSTOCK FUNDS Domestic
Blue Chip Growth TRBCX 6.34% 31.58% 14.97% 2.57% 8.76% 6/30/93 0.77% 12/31/11Capital Appreciation PRWCX 5.35 23.88 11.66 4.81 9.71 6/30/86 0.73 12/31/11Capital Opportunity PRCOX 6.32 30.05 12.32 1.12 8.33 11/30/94 0.77 12/31/11Diversified Mid-Cap Growth PRDMX 4.36 27.51 14.09 2.67 6.86 12/31/03 1.00 12/31/11Diversified Small-Cap Growth PRDSX 5.76 31.69 17.79 5.57 10.93 6/30/97 1.0% 90 days 1.05 12/31/11Dividend Growth PRDGX 5.64 27.98 12.21 1.99 8.10 12/30/92 0.68 12/31/11Equity Income PRFDX 6.32 28.90 11.48 0.55 7.97 10/31/85 0.68 12/31/11Equity Index 500 PREIX 6.27 29.85 12.90 0.84 7.74 3/30/90 0.5 90 days 0.30 12/31/11Extended Equity Market Index PEXMX 6.05 30.89 14.08 2.71 10.90 1/30/98 0.5 90 days 0.42 12/31/11Financial Services PRISX 7.93 37.85 5.47 -4.07 5.13 9/30/96 0.98 12/31/11Growth & Income PRGIX 5.74 26.40 11.21 0.98 7.57 12/21/82 0.71 12/31/11Growth Stock PRGFX 6.07 32.20 14.95 2.50 9.23 4/11/50 0.70 12/31/11Health Sciences PRHSX 8.36 47.93 22.85 11.20 14.69 12/29/95 0.82 12/31/11Media & Telecommunications PRMTX 9.34 34.21 20.06 7.07 19.84 10/13/93 0.83 12/31/11Mid-Cap Growth2 RPMGX 4.07 24.18 14.13 4.20 12.28 6/30/92 0.80 12/31/11Mid-Cap Value2 TRMCX 8.32 27.36 10.83 3.54 11.43 6/28/96 0.81 12/31/11New America Growth PRWAX 5.10 23.85 12.40 3.96 10.09 9/30/85 0.81 12/31/11New Era PRNEX 9.93 15.88 4.63 -3.45 12.14 1/20/69 0.67 12/31/11New Horizons PRNHX 4.76 33.49 20.90 7.08 13.76 6/3/60 0.81 12/31/11Real Assets PRAFX 7.08 17.37 – – 6.67 7/28/10 2.0 90 days 0.90 12/31/11Real Estate TRREX 0.15 32.11 20.53 1.86 11.86 10/31/97 1.0 90 days 0.78 12/31/11Science & Technology PRSCX 1.76 11.98 9.06 1.72 10.10 9/30/87 0.90 12/31/11Small-Cap Stock OTCFX 4.98 35.45 17.25 5.88 11.11 6/1/56 0.92 12/31/11Small-Cap Value PRSVX 4.91 31.13 13.87 3.98 11.43 6/30/88 1.0 90 days 0.97 12/31/11Tax-Efficient Equity3 PREFX 12/29/00 1.0 365 days 1.03 2/29/12
Returns before taxes 5.13 26.53 13.97 2.01 9.11Returns after taxes on distributions – 26.50 13.95 2.00 9.10Returns after taxes on distributions and sale of fund shares – 17.29 12.08 1.72 8.12
Total Equity Market Index POMIX 6.26 30.11 13.01 1.27 8.48 1/30/98 0.5 90 days 0.41 12/31/11U.S. Large-Cap Core TRULX 6.80 29.99 12.41 – 15.80 6/26/09 1.53† 12/31/11Value TRVLX 8.13 30.76 11.42 0.53 8.72 9/30/94 0.85 12/31/11
1 If a fund has less than 10 years of performance history, its since-inception return is shown. 2 Closed to new investors except for a direct rollover from a retirement plan into a T. Rowe Price IRA invested in this fund.3 The returns presented reflect the return before taxes; the return after taxes on dividends and capital gain distributions; and the return after taxes on dividends, capital gain
distributions, and gains (or losses) from redemptions of shares held for 1-, 5-, and 10-year or since-inception periods, as applicable. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. The after-tax returns reflect the rates applicable to ordinary and qualified dividends and capital gains effective in 2003. During periods when a fund incurs a loss, the post-liquidation after-tax return may exceed the fund’s other returns because the loss generates a tax benefit that is factored into the result. An investor’s actual after-tax return will likely differ from those shown and depend on his or her tax situation. Past before- and after-tax returns do not necessarily indicate future performance.
† This fund currently operates under a contractual expense limitation that may be lower than the expense ratio shown in the table above; for information about the expense limitation, including its expiration date, please see the fund’s prospectus.
BENCH- MARKS Domestic Stock
S&P 500 Index 6.35% 30.20% 13.20% 1.05% 8.01%S&P MidCap 400 Index 5.44 28.54 14.33 3.83 10.77NASDAQ Composite Index (Principal Return) 6.17 29.02 13.66 2.90 10.27Russell 2000 Index 5.25 31.91 12.99 2.21 10.17Lipper IndexesLarge-Cap Core Funds 5.88 26.89 10.86 0.31 6.73Equity Income Funds 5.60 26.78 11.77 0.26 7.68Small-Cap Core Funds 5.83 28.06 12.42 2.44 9.99
Performance Summary Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended September 30, 2012
22
Ticker Symbol
3 Months 1 Year 3 Years 5 Years
10 Years or Since
Inception1Inception
DateRedemption
Fee
Redemption Fee
PeriodExpense
Ratio
Expense Ratio
as of DateSTOCK FUNDS International/Global
Africa & Middle East TRAMX 7.21% 19.46% 2.31% -4.79% -3.61% 9/4/07 2.0% 90 days 1.50% 10/31/11Emerging Europe TREMX 9.16 16.37 5.22 -8.23 14.90 8/31/00 2.0 90 days 1.45 10/31/11Emerging Markets Stock PRMSX 8.37 18.87 5.62 -3.37 16.04 3/31/95 2.0 90 days 1.26 10/31/11European Stock PRESX 8.87 24.59 4.84 -2.54 9.78 2/28/90 2.0 90 days 1.01 10/31/11Global Infrastructure TRGFX 4.70 16.47 – – 4.62 1/27/10 2.0 90 days 1.86† 10/31/11Global Large-Cap Stock RPGEX 8.02 26.26 8.15 – 22.13 10/27/08 2.0 90 days 1.40† 10/31/11Global Real Estate TRGRX 5.09 30.61 14.30 – 20.16 10/27/08 2.0 90 days 1.78† 12/31/11Global Stock PRGSX 6.09 20.74 5.87 -5.18 8.10 12/29/95 2.0 90 days 0.87 10/31/11Global Technology PRGTX 7.06 29.67 15.50 7.22 15.01 9/29/00 0.98 12/31/11International Discovery PRIDX 7.86 21.49 8.57 -1.01 14.88 12/30/88 2.0 90 days 1.23 10/31/11International Equity Index PIEQX 6.67 15.55 2.28 -4.91 8.31 11/30/00 2.0 90 days 0.50 10/31/11International Growth & Income TRIGX 5.49 14.92 2.84 -5.10 8.90 12/21/98 2.0 90 days 0.87 10/31/11International Stock PRITX 6.88 19.68 5.96 -2.21 8.59 5/9/80 2.0 90 days 0.85 10/31/11Japan PRJPX 0.52 4.91 2.94 -5.94 3.89 12/30/91 2.0 90 days 1.12 10/31/11Latin America PRLAX 7.40 10.65 1.57 -1.52 23.01 12/29/93 2.0 90 days 1.25 10/31/11New Asia PRASX 7.71 22.87 11.25 1.04 18.17 9/28/90 2.0 90 days 0.96 10/31/11Overseas Stock TROSX 6.93 18.31 4.50 -3.96 -1.57 12/29/06 2.0 90 days 0.88 10/31/11
BENCH- MARKS International/Global Stock
MSCI EAFE Index 6.98% 14.33% 2.59% -4.77% 8.69%Lipper AveragesEmerging Markets Funds 6.86 15.93 4.45 -2.83 15.66International Large-Cap Core Funds 6.44 15.37 2.17 -4.95 7.78International Large-Cap Growth Funds 6.58 17.56 3.91 -4.04 8.30International Small/Mid-Cap Growth Funds 8.91 18.67 8.44 -2.56 12.51
BOND FUNDS Domestic Tax-Free4
California Tax-Free Bond PRXCX 2.85% 10.37% 6.47% 5.80% 4.69% 9/15/86 0.51% 2/29/12Georgia Tax-Free Bond GTFBX 2.63 9.09 5.80 5.46 4.50 3/31/93 0.56 2/29/12Maryland Short-Term Tax-Free Bond PRMDX 0.40 1.35 1.23 2.30 2.13 1/29/93 0.53 2/29/12
Maryland Tax-Free Bond MDXBX 2.57 9.26 6.23 5.88 4.69 3/31/87 0.46 2/29/12New Jersey Tax-Free Bond NJTFX 2.75 9.72 6.12 5.61 4.68 4/30/91 0.53 2/29/12New York Tax-Free Bond PRNYX 2.96 9.57 6.15 5.67 4.65 8/28/86 0.51 2/29/12Summit Municipal Income PRINX 3.26 11.26 7.01 6.22 5.33 10/29/93 0.50 10/31/11Summit Municipal Intermediate PRSMX 1.97 7.07 5.16 5.61 4.46 10/29/93 0.50 10/31/11Tax-Free High Yield PRFHX 3.37 13.99 8.67 5.60 5.48 3/1/85 2.0% 90 days 0.68 2/29/12Tax-Free Income PRTAX 2.81 9.93 6.23 5.92 4.91 10/26/76 0.52 2/29/12Tax-Free Short-Intermediate PRFSX 0.77 3.30 3.14 4.07 3.23 12/23/83 0.50 2/29/12Virginia Tax-Free Bond PRVAX 2.51 8.68 5.88 5.85 4.72 4/30/91 0.48 2/29/12
4 Some income from the tax-free funds may be subject to state and local taxes and the federal alternative minimum tax.
All mutual funds are subject to market risk, including possible loss of principal. Funds that invest overseas generally carry more risk than funds that invest strictly in U.S. assets due to factors such as currency risk, geographic risk, and emerging markets risk. Funds that invest in fixed income securities are subject to credit risk and liquidity risk, with high yield securities having a greater risk of default than higher-quality securities.5 The market value of shares is not guaranteed by the U.S. government.
Performance Summary
troweprice.com 23
Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended September 30, 2012
Ticker Symbol
3 Months 1 Year 3 Years 5 Years
10 Years or Since
Inception1Inception
DateRedemption
Fee
Redemption Fee
PeriodExpense
Ratio
Expense Ratio
as of DateBOND FUNDS Domestic Taxable
Corporate Income PRPIX 4.12% 12.04% 9.57% 7.66% 7.08% 10/31/95 0.65% 5/31/12Floating Rate PRFRX 2.41 9.13 – – 4.50 7/29/11 2.0% 90 days 1.48† 5/31/12GNMA5 PRGMX 1.10 4.22 5.51 6.20 4.83 11/26/85 0.62 5/31/12High Yield2 PRHYX 4.43 19.23 11.74 8.01 9.42 12/31/84 2.0 90 days 0.75 5/31/12Inflation Protected Bond PRIPX 1.99 8.36 8.71 7.47 6.40 10/31/02 0.56 5/31/12New Income PRCIX 2.39 6.87 6.58 7.05 5.74 8/31/73 0.63 5/31/12Short-Term Bond PRWBX 0.89 2.94 2.66 3.81 3.52 3/2/84 0.53 5/31/12Strategic Income PRSNX 3.47 11.86 7.64 – 11.52 12/15/08 0.94† 5/31/12Summit GNMA5 PRSUX 1.17 4.33 5.54 6.32 4.90 10/29/93 0.64 10/31/11U.S. Bond Enhanced Index PBDIX 1.85 5.50 6.11 6.65 5.24 11/30/00 0.5 90 days 0.30 10/31/11U.S. Treasury Intermediate5 PRTIX 0.80 4.02 6.42 7.49 4.93 9/29/89 0.49 5/31/12U.S. Treasury Long-Term5 PRULX 0.03 5.85 11.49 11.18 7.36 9/29/89 0.55 5/31/12
BENCH- MARKS Domestic Bond
Barclays U.S. Aggregate Bond Index 1.58% 5.16% 6.19% 6.53% 5.32%Barclays Municipal Bond Index 2.32 8.32 5.99 6.06 5.03Credit Suisse High Yield Index 4.27 17.92 12.55 8.62 10.54Lipper AveragesShort Investment Grade Debt Funds 1.34 3.65 3.19 3.00 3.05Corporate Debt Funds A-Rated 2.63 7.70 7.26 6.65 5.43GNMA Funds 1.24 3.77 5.39 6.28 4.69High Yield Bond Funds 4.29 17.53 11.37 7.08 9.23Short Municipal Debt Funds 0.48 1.80 1.84 2.35 2.18Intermediate Municipal Debt Funds 1.99 6.92 4.97 4.93 3.89General Municipal Debt Funds 2.78 10.25 6.13 5.17 4.27
BOND FUNDS International/Global
Emerging Markets Bond PREMX 7.15% 21.23% 11.19% 8.78% 12.67% 12/30/94 2.0% 90 days 0.94% 12/31/11Emerging Markets Corporate Bond TRECX 6.00 – – – 8.53 5/24/12 2.0 90 days 1.26† 5/24/12Emerging Markets Local Currency Bond PRELX 4.81 13.17 – – 2.38 5/26/11 2.0 90 days 2.03† 12/31/11
International Bond RPIBX 4.69 6.28 4.17 5.40 6.82 9/10/86 2.0 90 days 0.83 12/31/11
BENCH- MARKS International/Global Bond
Barclays Global Aggregate ex USD Bond Index 4.37% 4.80% 4.28% 5.98% 7.30%J. P. Morgan Emerging Markets Bond Index Global 6.76 20.59 12.27 10.32 12.51Lipper AveragesEmerging Markets Debt Funds 6.45 18.86 10.65 8.58 12.62International Income Funds 4.46 6.88 5.19 6.41 6.79
Ticker Symbol
7-Day Yield
7-Day Yield Without Waiver
3 Months 1 Year 3 Years 5 Years
10 Years or Since
Inception1Inception
DateExpense
Ratio
Expense Ratio
as of DateMONEY MARKET Tax-Free6
California Tax-Free Money PCTXX 0.01% -0.36% 0.00% 0.01% 0.01% 0.51% 1.10% 9/15/86 0.69% 2/29/12Maryland Tax-Free Money TMDXX 0.01 -0.41 0.00 0.01 0.01 0.55 1.14 3/30/01 0.57 2/29/12New York Tax-Free Money NYTXX 0.01 -0.33 0.00 0.01 0.01 0.53 1.12 8/28/86 0.66 2/29/12Summit Municipal Money Market TRSXX 0.01 -0.24 0.00 0.01 0.01 0.61 1.24 10/29/93 0.45 10/31/11Tax-Exempt Money PTEXX 0.01 -0.33 0.00 0.01 0.02 0.58 1.19 4/8/81 0.49 2/29/12
Taxable6
Prime Reserve PRRXX 0.01% -0.27% 0.00% 0.01% 0.01% 0.79% 1.64% 1/26/76 0.56% 5/31/12Summit Cash Reserves TSCXX 0.01 -0.17 0.00 0.01 0.01 0.84 1.75 10/29/93 0.45 10/31/11U.S. Treasury Money PRTXX 0.01 -0.27 0.00 0.01 0.01 0.49 1.40 6/28/82 0.44 5/31/12
An investment in the money market funds is not insured or guaranteed by the FDIC or any other government agency. Although the funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the funds. Money fund yields more closely reflect current earnings than do total returns. 6 In an effort to maintain a zero or positive net yield for the fund, T. Rowe Price has voluntarily waived all or a portion of the management fee it is entitled to receive from
the fund. A fee waiver has the effect of increasing the fund’s net yield. The 7-day yield without waiver represents what the yield would have been if we were not waiving our management fee. This voluntary waiver is in addition to any contractual expense ratio limitation in effect for the fund and may be amended or terminated at any time without prior notice. Please see the prospectus for more details.
Performance Summary Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended September 30, 2012
24
Editor: Steven E. Norwitz Associate Editor: Robert BenjaminStaff Writers: Steven Heilbronner and William MontagueEditorial Board: Christine Fahlund, Alan Levenson, Brian Brennan, Darrell Riley, Tom Siedell, Brian Sullam, and Jerome Tuccille
Charts and examples in this issue showing investment performance (excluding those in the Performance Update section) are for illustrative purposes only and do not reflect the performance of any T. Rowe Price fund or security. A manager’s view of the attractiveness of a company may change, and the fund could sell the holding at any time. This material should not be deemed a recommendation to buy or sell shares of any of the securities discussed. Past performance cannot guarantee future results.T. Rowe Price Investment Services, Inc., Distributor. Copyright © 2012 by T. Rowe Price Associates, Inc. All Rights Reserved.04779_UD 124373M00-064 10/12
Ticker Symbol
7-Day Yield
3 Months 1 Year 3 Years 5 Years
10 Years or Since
Inception1Inception
DateRedemption
Fee
Redemption Fee
PeriodExpense
Ratio
Expense Ratio
as of DateASSET ALLOCATION
Balanced RPBAX 5.32% 20.07% 9.76% 2.99% 7.87% 12/31/39 0.69% 12/31/11Personal Strategy Balanced TRPBX 5.85 21.38 10.14 3.51 8.60 7/29/94 0.87 5/31/12Personal Strategy Growth TRSGX 6.72 25.28 10.95 1.73 8.89 7/29/94 0.93 5/31/12Personal Strategy Income PRSIX 4.80 16.98 8.73 4.45 7.68 7/29/94 0.78 5/31/12Retirement 2005 TRRFX 4.42 16.22 8.69 3.68 5.78 2/27/04 0.59 5/31/12Retirement 2010 TRRAX 4.78 17.98 9.26 3.12 8.20 9/30/02 0.61 5/31/12Retirement 2015 TRRGX 5.28 19.92 9.81 2.76 5.93 2/27/04 0.66 5/31/12Retirement 2020 TRRBX 5.64 21.81 10.28 2.30 8.77 9/30/02 0.70 5/31/12Retirement 2025 TRRHX 5.95 23.04 10.49 1.87 5.91 2/27/04 0.73 5/31/12Retirement 2030 TRRCX 6.29 24.46 10.79 1.54 9.08 9/30/02 0.75 5/31/12Retirement 2035 TRRJX 6.44 25.23 10.88 1.32 5.81 2/27/04 0.77 5/31/12Retirement 2040 TRRDX 6.48 25.59 10.89 1.34 9.01 9/30/02 0.78 5/31/12Retirement 2045 TRRKX 6.47 25.45 10.88 1.33 5.64 5/31/05 0.78 5/31/12Retirement 2050 TRRMX 6.51 25.49 10.87 1.33 2.83 12/29/06 0.78 5/31/12Retirement 2055 TRRNX 6.48 25.47 10.91 1.33 2.82 12/29/06 0.78 5/31/12Retirement Income TRRIX 3.95 14.36 7.72 3.87 6.84 9/30/02 0.57 5/31/12Spectrum Growth PRSGX 6.57 26.81 11.30 0.87 9.55 6/29/90 0.80 12/31/11Spectrum Income RPSIX 3.75 13.05 8.25 6.49 7.49 6/29/90 0.69 12/31/11Spectrum International PSILX 7.02 19.04 5.52 -2.45 9.93 12/31/96 2.0% 90 days 0.96 12/31/11
T. ROWE PRICE NO-LOAD VARIABLE ANNUITY7
Blue Chip Growth Portfolio 6.13% 30.58% 14.31% 1.96% 7.97% 12/29/00 0.85% 12/31/11Equity Income Portfolio 6.24 28.28 10.81 -0.16 7.19 3/31/94 0.85 12/31/11Equity Index 500 Portfolio 6.18 29.26 12.23 0.11 7.03 12/29/00 0.40 12/31/11Health Sciences Portfolio 8.19 46.11 21.65 10.14 13.54 12/29/00 0.95 12/31/11International Stock Portfolio 6.63 18.74 5.06 -3.17 7.65 3/31/94 1.05 12/31/11Limited-Term Bond Portfolio 0.96 2.19 2.01 3.13 2.91 5/13/94 0.75 12/31/11Mid-Cap Growth Portfolio 3.91 23.38 13.49 3.62 11.63 12/31/96 0.85 12/31/11New America Growth Portfolio 4.79 22.39 11.53 3.32 9.47 3/31/94 0.85 12/31/11Personal Strategy Balanced Portfolio 5.66 20.56 9.42 2.64 7.88 12/30/94 1.02 12/31/11Prime Reserve Portfolio8 -0.55% -0.14 -0.49 -0.49 0.31 1.16 12/31/96 0.55 12/31/11
An investment in the money market funds is not insured or guaranteed by the FDIC or any other government agency. Although the funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the funds. Money fund yields more closely reflect current earnings than do total returns.7 A prospectus is available to existing clients who are considering an exchange into a new portfolio. The prospectus includes investment objectives, risks, fees, expenses, and
other information that you should read and consider carefully before investing. The T. Rowe Price No-Load Variable Annuity (Variable Annuity) is issued by Security Benefit Life Insurance Company (Form V6021). In New York, it is issued by First Security Benefit Life Insurance and Annuity Company of New York, White Plains, New York (FSB201(11-96)). (Security Benefit Life is not licensed in New York and does not solicit business in New York.) The yields and performance figures are based on the accumulation unit value (AUM) of the Variable Annuity subaccounts. Variable Annuity subaccount performance reflects a hypothetical contract and includes the effects of a mortality and expense risk charge of 0.55% on an annualized basis. The inception date relates to the date the portfolios were available as investment options in the Variable Annuity. The Variable Annuity, which has been available since April 1995 and in New York since November 1995, has limitations; contact your representative. It is distributed by T. Rowe Price Investment Services, Inc.; T. Rowe Price Insurance Agency, Inc.; and T. Rowe Price Insurance Agency of Texas, Inc. The underlying portfolios are managed by T. Rowe Price Associates, Inc. The Security Benefit Group of companies and the T. Rowe Price companies are not affiliated. The Variable Annuity may not be available in all states.
8 The 7-day unsubsidized simple yield for the Prime Reserve Portfolio was -0.82% as of September 30, 2012. In an effort to maintain a zero or positive net yield for the underlying portfolio of the Variable Annuity subaccount, T. Rowe Price has voluntarily waived all or a portion of the management fee it is entitled to receive from the underlying portfolio. This voluntary waiver is in addition to any contractual expense ratio limitation in effect for the underlying portfolio and may be amended or terminated at any time without prior notice. A fee waiver has the effect of increasing the underlying portfolio’s and subaccount’s net yield; without it, the underlying portfolio’s and subaccount’s 7-day yield would have been lower.
Indexes included in this update track the following: S&P 500—500 large-company U.S. stocks; S&P MidCap 400—stocks of 400 mid-size U.S. companies; NASDAQ Composite (principal only)—U.S. stocks traded in the over-the-counter market; Russell 2000—stocks of 2,000 small U.S. companies; MSCI EAFE—stocks of about 1,000 companies in Europe, Australasia, and the Far East; MSCI Emerging Markets—more than 850 stocks traded in over 20 emerging markets; Barclays U.S. Aggregate Bond—investment-grade corporate and government bonds; Barclays Municipal Bond—tax-free investment-grade U.S. bonds; Credit Suisse High Yield—noninvestment-grade corporate U.S. bonds; Barclays Global Aggregate ex USD Bond investment-grade government, corporate, agency, and mortgage-related bonds in markets outside the U.S.; J. P. Morgan Emerging Markets Bond–Global—U.S. dollar-denominated Brady Bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities; Lipper averages—all funds in each investment objective category; and Lipper indexes—equally weighted indexes of typically the 30 largest mutual funds within their respective investment objective categories. It is not possible to invest directly in an index.
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