HIGHLIGHTS
| â– | U.S. stocks rose in the first half of 2018 as the bull market entered its tenth year, but volatility increased in the spring as U.S.-China trade tensions heated up. Large-cap value stocks declined. |
| â– | The Equity Income Fund returned -0.50% in the first half of its fiscal year but outpaced the Russell 1000 Value Index and its Lipper peer group index. |
| â– | Stock selection in the consumer discretionary and industrials and business services sectors contributed to performance. Detractors were concentrated in the financials sector, where a few large holdings struggled due to company-specific reasons. |
| â– | We expect more volatility in the near term as the trade rift deepens and potentially leads to a cycle of retaliation between the U.S. and China, which could harm global economic growth. |
CIO Market Commentary
Dear Shareholder
U.S. stocks recorded decent gains in the first half of 2018, but unlike last year, investors had to absorb some bumps along the way. In February, volatility spiked and the S&P 500 Index briefly tumbled over 10% from its highs, putting it in correction territory. The major U.S. benchmarks recovered their losses in the spring, eventually bringing the technology-focused Nasdaq Composite Index and the smaller-cap indexes to new highs. Volatility stayed somewhat elevated, however, and many investors clearly remained anxious as the first half of your fund’s fiscal year ended.
Solid corporate and economic fundamentals initially seemed to promise that 2017’s strong stock market momentum might carry forward into 2018. Continued global synchronized growth led to strong profits for many multinationals. In the U.S., earnings for the S&P 500 rose by nearly 25% in the first quarter versus a year before, according to FactSet—the best performance since the recovery from the financial crisis. Profit growth also picked up in Europe, Japan, and emerging markets, even as growth in many international economies cooled a bit.
Inflation fears presented the first obstacle to the markets in February, however. Stocks tumbled on news that hourly wages had jumped in January, sparking fears that the Federal Reserve would pick up its pace of interest rate increases in order to head off inflation. Wage growth moderated in the following months, but a series of strong economic reports raised growth expectations and sent long-term interest rates to multiyear peaks by May. Investors also worried that the massive U.S. fiscal stimulus from December’s tax cuts and March’s spending bill might overheat the economy, though interest rates fell back in late May and June as Fed officials stressed their intention to move slowly in tightening monetary policy.
Trade tensions soon emerged as a second impediment for the markets. The Trump administration began implementing a more populist trade stance in March, announcing tariffs on steel and aluminum imports, threatening to withdraw from the North American Free Trade Agreement (NAFTA), and later raising the possibility of taxing auto imports. The administration also announced a steady escalation in possible tariffs on Chinese goods, eventually targeting a list of $200 billion in Chinese imports. China and other U.S. trading partners vowed to retaliate proportionately.
Investors initially seemed willing to dismiss the tit-for-tat threats as negotiating tactics, but evidence eventually emerged that even the prospect of tariffs was impacting corporate strategies and profit outlooks. Stocks slumped on June 21, after German automaker Daimler lowered its earnings guidance due to possible tariff increases on SUVs it manufactures in the U.S. and sells in China. A few days later, Harley-Davidson revealed that it was planning to move some of its motorcycle production to Europe to avoid retaliatory tariffs recently announced by the European Union.
Boeing, Caterpillar, and other leading exporters suffered declines as trade tensions worsened, but small-caps, which typically have far less international exposure, fared much better than large-caps in the first half of the year. Growth shares continued to outperform value shares despite the strong performance of energy stocks, which benefited from a rise in oil prices to multiyear highs. Stocks in overseas markets reacted particularly poorly to growing trade fears and fell for the period. A decline in many currencies relative to the dollar also weighed on international bond and stock returns for U.S. investors.
Meanwhile, technology shares continued to dominate, with much of the market’s overall gain to date in 2018 concentrated in a handful of mega-cap companies able to leverage dominant Internet platforms. Data breaches and concerns about the growing power of these firms resulted in calls for government intervention in early 2018. For now, however, the threat of increased regulation seems a longer-term one that appears minor in comparison to the powerful fundamental strength of these companies.
T. Rowe Price’s global team of industry experts is monitoring the possible impact of tariffs and other challenges on a wide range of companies—from the global tech titans to small, domestic firms that get little analyst coverage on Wall Street. While the rest of 2018 may bring further surprises, you can rest assured that your portfolio manager is drawing on a wide range of insights in seeking to provide shareholders with superior returns while minimizing the impact of unforeseen political events or other pitfalls.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
Group Chief Investment Officer
Management’s Discussion of Fund Performance
INVESTMENT OBJECTIVE
The fund seeks a high level of dividend income and long-term capital growth primarily through investments in stocks.
FUND COMMENTARY
How did the fund perform in the past six months?
The Equity Income Fund returned -0.50% in the six months ended June 30, 2018. The fund outperformed the Russell 1000 Value Index and its peer group, the Lipper Equity Income Funds Index. Returns for the Advisor, R, and I Class shares reflect different fee structures. (Past performance cannot guarantee future results.)
What factors influenced the fund’s performance?
The consumer discretionary sector produced several top contributors. Media company Twenty-First Century Fox (FOXA, Financial), which is currently the subject of a bidding war between Comcast and Walt Disney Co., led contributors. Fox’s shares have been on a tear since November, when reports first surfaced that the company was in talks with Disney and hit a record high at the end of June. We have long held Fox as we recognized the value of its unique entertainment assets and think the shares have more upside as Comcast and Disney continue to battle for control of the company. Kohl’s (KSS, Financial) was another contributor as the retailer stepped up efforts to fend off competition from online sellers, including launching a pilot program with Amazon.com in some of its stores. We trimmed our position but maintained exposure to Kohl’s, whose standalone stores distinguish it from mall-based department stores that are struggling with declining traffic. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
The industrials and business services sector helped performance. Aerospace company Boeing (BA, Financial), whose shares repeatedly hit record highs for much of this year on surging aircraft demand, led advancers. Real estate stocks added value, particularly as a result of our position in Rayonier (RYN, Financial), a Florida timberland real estate investment trust that owns forests in the U.S. and New Zealand. Rayonier shares gained amid soaring lumber prices, which hit a record high this spring amid a stronger U.S. housing market, wildfires in timber-producing areas, and a trade dispute with Canada. We reduced our position in Rayonier as its stock price approached fully valued levels.
Detractors were concentrated in the financials sector, which weighed on returns as several holdings stumbled due to company-specific reasons. Brighthouse Financial, an insurance and annuities company, performed poorly due to disappointing underwriting activity and selling pressure from MetLife, which spun off the company in 2017. Other hefty detractors included Wells Fargo (WFC, Financial), which is trying to move past numerous regulatory investigations related to a fake customer accounts scandal in 2016, and MetLife, whose shares fell this year after the insurer revealed two significant accounting errors. We leaned into the declines and added to our positions in all three names, which remain fundamentally sound companies despite the negative headlines.
Information technology stocks detracted slightly from performance, driven by losses in Qualcomm (QCOM, Financial). The chipmaker’s slumping share price reflected numerous challenges, including ongoing royalty disputes with two key customers, slumping profits, and uncertainty regarding its proposed acquisition of NXP Semiconductors, a deal now pending regulatory approval in China.
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 that are going through a period of underperformance, 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.
Financials accounted for the fund’s largest sector allocation on an absolute basis and represented roughly one-quarter of its assets at the end of June. Our exposure to financials rose after we increased our position in Franklin Resources. Shares of the asset management company have fallen amid concerns about persistent client outflows, but the company holds a significant amount of cash that it could return to shareholders through special dividends or stock buybacks. We sought to take down risk by trimming economically sensitive names, such as JPMorgan Chase and Fifth Third Bank, and adding to more defensive companies, including PNC Financial Services and U.S. Bancorp, both strong underwriters with broadly diversified revenue streams that have lagged the broad market. In the insurance industry, we eliminated Bermuda-based insurer XL Group on strength after it agreed to be acquired by France’s AXA for a hefty premium in March, and added to Metlife and Chubb.
Our biggest sector overweight at period-end was industrials and business services, an area that features many highly cash-generative companies with durable businesses and diversified end markets. We initiated Alaska Air Group, a high-quality, well-run airline that is rapidly expanding beyond its Pacific Northwest base following its 2017 acquisition of Virgin America. As for sales, we trimmed our positions in industrial equipment maker Illinois Tool Works and in Boeing. We still have confidence in Boeing but pared our position size to reflect a slightly less attractive risk/reward profile after the recent months’ rally.
Real estate represented the smallest sector allocation and largest underweight versus the benchmark. However, our exposure rose after we bought SL Green Realty (SLG, Financial), a real estate investment trust (REIT) focused on commercial properties in New York City. REIT shares—which typically decline as interest rates rise—have struggled this year as faster U.S. economic growth and policy tightening by the Federal Reserve diminished their appeal relative to Treasuries. However, SL Green owns a portfolio of well-located, high-quality office buildings in Manhattan, and its management team has been taking advantage of the city’s strong real estate market by selling assets at a premium and buying back its own shares at discounted prices.
What is portfolio management’s outlook?
The U.S. economy continued to strengthen in the first half of 2018, as last year’s tax overhaul and financial industry deregulation efforts benefited U.S. consumers and companies. We believe that the broadening economic recovery, strong corporate earnings, and a moderate pace of future Fed rate hikes provide a generally favorable environment for the U.S. economy and stock market for the rest of the year.
On the policy front, however, the risks for investors have grown after this year’s rapid escalation in the U.S.-China trade dispute. Contrary to the claims of U.S. President Trump, trade wars are not good for the economy, and a trade war between the U.S. and China could inflict substantial harm on global growth. Uncertainty surrounding the Trump administration’s trade policies was a chief contributor to financial markets’ volatility in recent months; unfortunately, we expect more turbulence ahead as neither side appears willing to back down. Though the immediate economic impact of tariffs levied by the U.S. and China is relatively insignificant so far, the tit-for-tat cycle could spiral into a broader conflict and unleash protectionist measures in other economies.
Volatility can be unsettling for shareholders, but it also yields better stock-picking opportunities for active managers since it allows us to buy and sell companies at more attractive prices. Many large-cap U.S. companies have lagged the broader market advance for idiosyncratic reasons, making their valuations more appealing for long-term investors. Thanks to T. Rowe Price’s longstanding strength in fundamental research and the collective insights of our equity analysts, we are well equipped to navigate what will likely be a more unpredictable environment as we continue to identify and invest in high-quality, undervalued companies in our ongoing effort to generate solid returns over the long run.
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.
