Quarterly Market Review
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Fourth Quarter 2014
'Global Divergence' Put U.S. in Spotlight
The theme of “global divergence” became more prominent during the fourth quarter, as the U.S. continued to set itself apart from the rest of the world. While the U.S. economy gained ground, prompting the Federal Reserve (the Fed) to conclude its massive quantitative easing (QE) program and move closer to monetary policy tightening, other regions of the world experienced slowing or stalled economic growth and additional central bank stimulus.
In this environment, the U.S. stock market rallied, while non-U.S. stocks generally remained weak. In addition to sluggish global growth, a 42% plunge in oil prices (Brent crude) and ongoing geopolitical tensions clouded the backdrop for non-U.S. stocks. The relative strength of the U.S. dollar, which rallied significantly versus the euro, yen, and other major currencies and put additional pressure on commodity prices, further reduced non-U.S. stock returns for U.S.-based investors.
The U.S. bond market also remained a global bright spot, rallying despite improving U.S. economic growth and the end of QE. Returns among non-U.S. bonds also remained strong in local currency terms, driven by slow growth, falling interest rates, and central bank stimulus measures.
U.S. Stocks: Rally Capped Another Strong Year
Despite facing an uptick in market volatility and two steep, but short-lived, sell-offs, U.S. stocks advanced across the board. Against a backdrop of improving economic data and healthy corporate earnings, the benchmark S&P 500® Index continued to reach milestone levels during the quarter, bringing the total number of record-high closes to 53 for the year. Overall, the fourth-quarter return of 4.93% represented the large-cap benchmark’s eighth-consecutive quarterly gain, and the index recorded its third-straight double-digit annual return. Meanwhile, the gains were even stronger among mid-cap stocks, which advanced 5.94% in the quarter, as measured by the Russell Midcap® Index. But small-cap stocks (Russell 2000® Index) were the shining stars, rebounding from a 7.36% decline in the third quarter to generate a gain of 9.73% in the fourth quarter.
Solid U.S. economic growth, healthy corporate earnings, cash flow, and dividend growth, and low interest rates helped drive U.S. stocks higher. Data released during the quarter showed solid gains in the labor market, manufacturing sector, retail sales, housing prices, consumer spending, and consumer confidence. Although the quarter’s steep decline in oil prices battered energy stocks, it provided welcomed relief to consumers, who had more discretionary buying power thanks to tumbling fuel prices. Lower fuel costs also helped bolster the bottom line of many businesses. Late in the quarter, the government revised third-quarter gross domestic product (GDP—the measure of the total economic output in goods and services for an economy) upward to 5.0% (annualized), the fastest quarterly growth rate since 2003, and stocks rallied on the news. The Fed further boosted market spirits when in December it pledged to be “patient” in raising short-term interest rates from their near-zero level. This announcement helped alleviate fears that better-than-expected growth would trigger a sooner-than-expected rate hike.
Sector performance was largely positive during the quarter. Seven of the S&P 500 Index’s 10 industry sectors generated positive performance, and each of those sectors outperformed the index average. The defensive, dividend-heavy utilities sector was the top performer, gaining 13.19%. Other standout sectors included consumer discretionary, up 8.74%, consumer staples, up 8.15%, health care, up 7.48%, financials, up 7.25%, industrials, up 6.76%, and information technology, up 5.24. Meanwhile, tumbling oil prices, triggered by the relative strength of the U.S. dollar and mounting supply/demand imbalances in the market, hampered performance in the energy sector, which fell -10.68%. The telecommunication services and materials sectors also struggled, declining -4.16% and -1.80%, respectively.
Value stocks maintained an edge over growth stocks in the mid- and large-cap segments, while growth stocks outperformed in the small-cap universe. These style trends also were prevalent in the one-year returns. Overall, small-cap growth stocks were the fourth quarter’s top performers, up 10.06% (Russell 2000® Value Index), while large-cap growth stocks were the weakest, gaining 4.78% (Russell 1000® Growth Index).
Non-U.S. Stocks: Sluggish Growth Subdued Returns
Reflecting the effects of disparate global growth, non-U.S. stock returns were mostly muted in local currency terms. Weak growth in Europe and Japan, slowing growth in China, falling commodity prices, and ongoing geopolitical tensions generally dragged down developed and emerging market stock performance. The relative strength of the U.S. dollar further hampered non-U.S. stock returns for U.S.-based investors.
Europe continued to struggle with stalled growth, rising unemployment, and possible deflation. In December consumer prices in the eurozone fell 0.2%, the weakest reading since September 2009. Furthermore, as a major trading partner with Russia, Europe suffered amid the economic, political, and currency turmoil in Russia. These events put pressure on the European Central Bank (ECB) to take additional steps to revive economic growth beyond low-rate bank loans and record-low interest rates. By year-end, expectations mounted for the ECB to launch a full-scale, Fed-like QE. Meanwhile, Greece returned to the forefront late in the quarter, as escalating political tensions led to concerns the financially troubled nation would exit the eurozone.
Japan’s economy slipped into another recession, the country’s fourth recession since 2008. The contraction in economic output was primarily due to the effects of a large national sales tax increase enacted earlier in the year, which stifled consumer spending. In response, the Bank of Japan expanded its already massive stimulus programs, which encouraged investors and provided some support for Japanese stocks. The central bank’s action also drove the yen’s value lower, which aided stock prices among Japan’s exporters and industrial companies. But the additional easing also triggered concerns about deflation, a condition the world’s third-largest economy has been battling since the early 1990s.
Ongoing concerns about the uneven global economic recovery, combined with slowing growth in China, plunging commodity prices, a soaring U.S. dollar, and geopolitical tensions in Russia/Ukraine and throughout the Middle East, put considerable pressure on emerging markets. Oil-exporting nations, such as Russia, Mexico, Iran, and Venezuela, were particularly hard hit by the quarter’s steep drop in oil prices. On the other hand, oil-importing nations, such as Turkey, Indonesia, and China, benefited from plunging oil prices. In China, the People’s Bank of China responded to the nation’s slowing growth and inflation data with its first rate cut in more than two years, which pushed China stocks higher in local currency terms.
Global Bonds: Falling Rates Fueled Gains
The U.S. bond market ended 2014 the same way it began the year—by defying most investors’ expectations. Despite persistent economic gains during the fourth quarter, U.S. bonds generally rallied. Additionally, bonds advanced despite the October conclusion of the Fed’s QE program, an event many feared would drag down bond performance. The main factors driving the rally included weak inflation and strong demand for U.S. fixed income securities. Plummeting oil prices kept a lid on inflation, which helped drive down yields on longer-maturity bonds. Additionally, demand from investors seeking perceived “safe haven” protection from global unrest, along with demand from those taking advantage of the yield differential between U.S. bonds and sovereign securities of other developed nations, further supported U.S. fixed income gains.
In this environment, the U.S. Treasury yield curve flattened. Short-maturity yields rose on expectations the Fed will respond to improving U.S. economic data (particularly in the labor market) by hiking short-term interest rates in 2015, while longer-maturity yields declined due to the factors mentioned above. U.S. investment-grade sector performance was mostly positive, except for Treasury inflation-protected securities (TIPS). Overall, traditional nominal Treasuries outperformed the broad investment-grade market average, mortgage-backed securities (MBS) matched the average, and agencies and investment-grade corporate bonds underperformed. Continuing the trend that emerged in the third quarter, high-yield corporate bonds struggled, generating negative returns as spreads (yield differences compared with comparable-maturity Treasuries) widened and volatility mounted. Meanwhile, TIPS underperformed as inflation expectations fell to 2008 levels.
Performance in the broad municipal bond (muni) market continued to follow the Treasury market higher, with fourth-quarter returns capping off a stellar year. The still-low interest rate environment, higher federal tax rates, and continued easing of credit concerns fueled investor demand for munis. Meanwhile, global bond yields fell, reflecting continued economic weakness in many regions of the world. With the exception of the Fed, most major central banks maintained aggressive stimulus programs. In addition, the sharp decline in energy prices kept global inflation low. The combination of decelerating global growth, increased stimulus, and subdued inflation provided a favorable backdrop for global bonds. European bond markets delivered the best returns, led by a strong rally in U.K. bonds. Bond markets in the Asia/Pacific region also advanced, but to a lesser extent. Overall, government securities outperformed non-government bonds.
The U.S. dollar continued to advance against most major foreign currencies, reducing non-U.S. bond returns for U.S. investors. In particular, the U.S. dollar appreciated nearly 10% against the yen, 7% versus the Australian dollar, and 3%-4% against the euro, British pound, Canadian dollar, and South Korean won.
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Source: Barclays Indices