Dear Shareholder,
Global stock markets produced strong returns during the first half of 2021, while rising yields weighed on returns in some bond sectors. Investor sentiment was buoyed by the reopening of developed market economies, unprecedented fiscal and monetary stimulus, and expectations that the economy would benefit from a release of pent-up demand.
All major global and regional equity benchmarks recorded positive results during the period. Developed market stocks generally outperformed emerging markets, while in the U.S., small-cap equities outpaced large-caps and value performed better than growth. The large-cap S&P 500 Index returned 15% and finished the period at a record high. The energy sector, which was the worst performer in 2020, was the leader for the six-month period amid a sharp increase in oil prices. Financial stocks also produced strong results as banks benefited from an increase in long-term interest rates, while the real estate sector was helped by a rollback in many pandemic-related restrictions. Utilities underperformed with slight gains.
Fiscal and monetary support remained a key factor in providing a positive backdrop for markets. President Joe Biden signed the $1.9 trillion American Rescue Plan Act into law in March, and the Federal Reserve kept its short-term lending rates near zero. However, as a result of strong economic growth, central bank policymakers revised their outlook in a somewhat less dovish direction near the end of the period and indicated that rate hikes could commence in 2023, which was earlier than previously expected.
The economic recovery was evident in a variety of indicators. According to the latest estimate, U.S. gross domestic product grew at an annualized rate of 6.4% in the first quarter of 2021 following 4.3% growth in the fourth quarter of 2020. Weekly jobless claims declined throughout the period to new pandemic-era lows, although the monthly nonfarm payroll report disappointed at times as employers struggled to fill positions. Meanwhile, overall profits for companies in the S&P 500 rose by nearly 53% year over year in the first quarter, according to FactSet—the best showing since late 2009.
However, less favorably, inflation concerns led to some volatility in the equity market and caused a sharp rise in longer-term Treasury yields in the first quarter. (Bond prices and yields move in opposite directions.) While inflation measures were above the Fed’s 2% long-term inflation target toward the end of our reporting period—core consumer prices, for example, recorded their largest annual increase (3.8%) since 1992 in May—investors seemed to accept the Fed’s determination that rising price pressures were due to transitory factors arising from the reopening of the global economy.
Longer-term Treasury yields trended lower as inflation expectations began to wane later in the period, but they still finished significantly higher than they were at the end of 2020. Rising yields were a headwind for many fixed income investors; however, high yield bonds, which are less sensitive to interest rate changes, produced solid results, and investment-grade corporate bonds also performed well amid solid corporate fundamentals.
As we look ahead, the central question for investors—assuming the economy’s recovery from the pandemic continues apace—is whether the returns on financial assets will be as robust. Valuations are elevated in nearly all asset classes, and, in some areas, there are clear signs of speculation. That said, a transformed global economic landscape is generating potential opportunities as well as risks. Post-pandemic trends have the potential to create both winners and losers, giving active portfolio managers greater scope to seek excess returns. It is not an easy environment to invest in, but our investment teams remain rooted in company fundamentals and focused on the long term, and they will continue to apply strong fundamental analysis as they seek out the best investments for your portfolio.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
Group Chief Investment Officer
FUND COMMENTARY
How did the fund perform in the past six months?
The Equity Income Fund returned 18.46% for the six-month period ended June 30, 2021. The fund outperformed its benchmark, the Russell 1000 Value Index, as well as its peer group, the Lipper Equity Income Funds Index. (Returns for the Advisor, R, I, and Z Class shares varied slightly, reflecting their different fee structures. Past performance cannot guarantee future results.)
What factors influenced the fund’s performance?
The Equity Income Fund generated strong performance, driven by stock selection, over the first half of 2021 as the portfolio benefited from our long-term focus and willingness to lean into market stress throughout 2020. Although the portfolio outperformed its benchmark for the first six-month period of 2021, it trailed the benchmark for the second quarter following the Federal Reserve meeting in June, when investors shifted rapidly into growth names as the Fed appeared to accelerate the timeline for reducing monetary stimulus. This was one of the most significant market reactions to a Fed meeting in the past 70 years.
Several financial names, including Wells Fargo (WFC, Financial), Fifth Third Bancorp (FITB, Financial), and Morgan Stanley (MS, Financial), were buoyed by the reflationary economy as consumer spending increased, fueled by monetary and fiscal stimulus. Amid the strengthening economy, Wells Fargo ended the period higher, benefiting from rising interest rates, consumer credit resilience, and the Federal Reserve clearing banks to resume returning capital to shareholders. Overall, the financials sector benefited from economic optimism, robust capital market activity, and the view that credit issues had peaked. We used the recent relative outperformance of Fifth Third Bancorp and Morgan Stanley and pared our positions to invest in other names within the investment universe we felt had more attractive risk/reward characteristics. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Certain names in the industrials and business services sector also delivered robust performance over the period. Multi-industrial GE (GE, Financial) ended the period higher as investors warmed to the company’s better-than-expected revenue growth in its renewable energy and health care segments, wider margins, and free cash flow generation. Additionally, later in the period, GE benefited when plane-maker Airbus confirmed an increase in the near-term production target for an aircraft that uses engines made by GE Aviation and Safran. UPS (UPS, Financial) also added to the portfolio’s results, propelled by continued shipment growth and evidence of strong execution, as well as estimates for continued growth in both global and U.S. small-package shipments.
Elsewhere in the portfolio, shares of semiconductor capital equipment provider Applied Materials (AMAT, Financial) ended the period higher on the back of several impressive earnings reports as the company continued to benefit from cyclical strength. While we continue to appreciate Applied Materials’ market position, we moderated our position size over the period as we expect fundamentals will likely peak in 2021. Global insurance provider MetLife (MET, Financial) also advanced, peaking in May on a strong first-quarter earnings report that beat both topline and bottom-line estimates. Adjusted earnings on revenue also outpaced the year-ago quarter.
Some of the portfolio’s greatest absolute detractors came from the information technology sector. Although it was a top contributor for the second quarter, chipset-maker Qualcomm (QCOM, Financial) registered negative total returns for the semiannual period, as investors turned from technology stocks early in the period to invest in those with potentially more direct exposure to the post-pandemic reopening economy. A global chip supply shortage also hampered performance initially. However, as we progressed through 2021, reported financials showed supply constraints clearing, which was encouraging. Additionally, multinational software company Citrix Systems (CTXS, Financial) fell sharply toward the end of the period after the company reported a revenue miss driven by headwinds such as networking system supply constraints. Another notable detractor was Las Vegas Sands (LVS, Financial), which suffered due to coronavirus-driven uncertainty about a return to leisure travel, particularly as reported earnings later in the period continued to show uncertainty around when Macau and Singapore, from which Las Vegas Sands derives a majority of its revenue, would resume more normal operations as the vaccine rollout accelerated globally.
Compared with the benchmark, stock selection in materials contributed the most value to relative performance. Conversely, an overweight allocation in utilities detracted the most from relative results.
How is the fund positioned?
The Equity Income Fund seeks to buy well-established, large-cap companies that have a strong record of paying dividends and appear to be undervalued by the market. The fund’s holdings tend to be solid, higher-quality companies going through a period of controversy or stress, reflecting our dual focus on valuation and dividend yield. Each position is the product of careful stock picking based on the fundamental research generated by T. Rowe Price’s team of equity analysts, as opposed to selection based on broader market or macroeconomic trends.
Our top purchases over the six-month period hailed from a wide variety of sectors. In financials, we established a position in regional bank Huntington Bancshares (HBAN, Financial) mid-period. The bank continues to invest aggressively to grow market share, creating a temporary headwind to expenses for the business and temporarily depressing margins. While this investment has weighed on the company’s valuation, we believe the company is taking advantage of peers that have moderated spending and that these investments will set Huntington Bancshares up as a leader among regional banks this cycle. We also believe the potential for surprising economic strength and corresponding loan growth are underappreciated by the market. Additionally, we initiated a position in managed health care and insurance company Cigna (CI, Financial) following relative weakness in the name. We believe Cigna is a well-managed company that will be able to drive higher margins versus peers, particularly in its specialty and retail networks.
Notable sales were also spread out among several areas of the market. Our largest equity sale was specialty chemical conglomerate DuPont de Nemours (DD, Financial), which we reduced significantly over the period. We continue to appreciate the attractive end markets DuPont de Nemours serves, but a combination of selling into relative strength and the split-out and merger of its nutrition and biosciences business into International Flavors and Fragrances moderated our position size. In financials, we trimmed our position in global investment bank Morgan Stanley on continued relative outperformance. We remain appreciative of Morgan Stanley’s combination of lower capital requirements and amassing capital levels, as well as its progress on transforming into a less capital-intensive wealth and asset management business model.
The portfolio’s largest sector allocation is in financials. We remain overweight relative to the benchmark, and we increased our absolute exposure during the period. The portfolio’s second-largest sector allocation was to health care, where our absolute exposure increased. Our underweight to the benchmark also increased due in part to the reconstitution of the benchmark index that took place in June. Industrials and business services, our third-largest sector allocation, is underweight the benchmark and decreased in both absolute and relative terms during the period.
What is portfolio management’s outlook?
Equity market leadership changed in June after the Federal Reserve seemed to suggest a potential shift in monetary policy that could impact the duration of the economic recovery. Given the sizable stimulus and continued efficacy of the coronavirus vaccines against new variants to date, we believe economic activity will be robust in the second half of the year and that much of this is priced into the market at current levels. We therefore expect the market to continue to react meaningfully to headlines, which should make stock selection and valuation a more important factor in equity returns for the remainder of the year.
Despite the headline market valuations, we continue to find opportunities within health care and financials, as well as idiosyncratic ideas for the portfolio. We seek to create a balanced portfolio that is well positioned for a variety of market environments, but we feel comfortable maintaining a slight tilt toward economic normalization and consumer strength. We will continue to let valuation be our guide and look for situations where there is a favorable mix of attractive valuations, strong fundamental appeal, and a high dividend yield.
The views expressed reflect the opinions of T. Rowe Price as of the date of this report and are subject to change based on changes in market, economic, or other conditions. These views are not intended to be a forecast of future events and are no guarantee of future results.
