Our Take on the Third Quarter

Volatility returned in the third quarter thanks to geopolitical worries, but stocks ultimately proved resilient.

Jeremy Glaser 17 October, 2014 | 15:16
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Geopolitical wobbles introduced some volatility but couldn't derail the equity rally in the third quarter. The broad-based Morningstar US Market Index rose less than 1% over the last 13 weeks. The index is now up 8% so far in 2014 and has returned an annualized 16% over the last five years.

Concerns over conflicts across the globe were a major driver of U.S.-equity markets during the quarter. Tensions between the Ukraine and Russia were under particular focus as investors worried about the reverberations that an armed conflict would have on the European and global economy. The ongoing conflict in the Middle East, culminating with the U.S. and allies launching air strikes against targets in Iraq and Syria in September, was also eyed. The vote for Scottish independence, although ultimately unsuccessful, created some turbulence as the market fretted over both short-term issues and longer-term concerns about other European regions considering independence. South American economic issues also came to the forefront. Argentina entered selective default after U.S. courts ruled that the country couldn't treat creditors who had agreed to a bond swap differently from the creditors who had not.

The U.S. economy showed signs that the weak economic data seen in the first half of the year was likely an artifact of the bad weather and not a sign of a major slowdown. Still, the economy was hardly growing at a robust rate with housing, in particular, looking weak. Morningstar's Bob Johnson expects full-year GDP growth of 2.0% to 2.5% with around 200,000 jobs added per month.

World economic growth has been a "big disappointment," according to Johnson. Europe remained stuck in very-slow-growth mode as previous drivers of economic growth, such as Germany, began to slow down. Inflation in the eurozone is also extremely low, raising the prospect of a deflationary environment. Growth in China remained a concern as the economy struggled to meet its GDP-growth target and signs of soft Chinese demand emerged.

Against this backdrop, it shouldn't be too surprising to see global central banks moving in somewhat opposing directions. The U.S. Federal Reserve announced it would, as expected, end its quantitative easing program in October. The central bank didn't, however, budge from its language that rates would stay low for a "considerable time" after the end of quantitative easing. Short-term rates are expected to be hiked sometime next year, though there is considerable debate (both inside and outside of the Fed) over the exact timing of the move. The Fed's moves to begin normalizing monetary policy haven't led to big changes in interest rates. The 10-year Treasury yield of around 2.52% is only down slightly from the 2.58% yield seen at the start of the quarter. The Bank of England also signaled that it is prepared to raise rates reasonably soon. The European Central Bank, on the other hand, is moving to a more accommodative policy. They lowered key rates further and paved the way for other measures, including asset purchases, in the future in an effort to keep price levels in the eurozone from falling further. The Bank of Japan also remains firmly in expansionary mode.

Despite the uncertain global backdrop, the IPO market remained wide open. By far, the biggest story of the quarter was the September debut of Alibaba (BABA). The Chinese e-commerce giant raised over $21 billion in the largest U.S. offering in history. High-profile S-1 filings in the quarter included Virgin America, Lending Club, and Dave & Buster's Entertainment.

Sector-by-Sector Performance 

All but one of the stock sectors gained in the quarter. Technology led the way with a more-than-10% increase followed by real estate (up 7%) and communication services (up 5%). Consumer defensive lost a slight amount of ground whileindustrials (up 1%) and utilities (up 2%) rounded out the three worst-performing sectors.

The continued upward trajectory of the stock market has kept valuation levels stretched. The median price/fair value ratio in our coverage universe came down slightly in the quarter (it now stands at 1.00 versus 1.06 at the start of the quarter), but it is still high compared with historical levels. Other valuation measures, including the Shiller P/E, also indicate that the U.S. stock market is pricey. Morningstar StockInvestor editor Matt Coffina thinks that there are a few values left in the market but that, from these levels, investors need to have modest expectations for future returns.

Health (up 6%) was the best-performing open-end sector fund category in the quarter. Technology (up 1%) and energy limited partnerships (up 1%) were the only other gainers. Equity precious-metals funds (down 16%) were, by far, the worst performer with equity energy (down 9%) and natural resources (down 8%) following behind.

India equity funds (up 7%) continued their winning streak on the hopes of more economic reforms. The category is up more than 50% over the last year. Foreign small/mid-value funds (down 7%), Europe stock (down 7%) and Latin America stock (down 6%) were the worst-performing categories in the quarter.

The interest-rate environment helped long-duration fixed-income funds in the quarter. Long-government funds rose 3.4% while long-term bond was up 1%.Emerging-markets bond (down 3%) was the worst performer followed by high-yield bond (down 2%) and inflation-protected bond (down 2%).

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Jeremy Glaser  Jeremy Glaser is the Markets Editor for Morningstar.com.

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