July 25, 2013
Stocks were mixed globally during the second quarter, as volatility increased when the yield on the bellwether 10-year Treasury bond spiked nearly 50% from May to June. Positive news on the U.S. economy actually contributed to global volatility, as improvements in U.S. housing and employment growth prompted Federal Reserve Board Chairman Ben Bernanke to suggest that the central bank may begin to “taper” or scale back its open-market bond purchases in 2013. Bernanke’s comments fueled a broad global sell-off, as investors shunned risk assets such as high-yield bonds and emerging-market equities. The continued recession in Europe and slower growth in China also took their toll on global equity returns.
U.S. stocks finished higher for the quarter, however, despite some of these nagging macro concerns and other global issues, such as large-scale protests in Brazil and Turkey. Overall, the S&P 500 Index posted its best first-half gain since 1998, and was up about 13% for the year as of June 30. The index advanced 2.9% for the quarter, led by strong gains in the Financial (+7.1%) and Consumer Discretionary (+6.7%) sectors. The index established a new record high on May 21, closing at 1,669.16, though it dropped to 1,606.28 to close the quarter. Utilities (-3.0%) fared the worst, as dividend-paying stocks lost favor due to rising interest rates. Based on specific Russell market-cap and style indexes, small cap (+3.1%) and large cap (+2.8%) finished slightly ahead of mid cap stocks (+2.2%), while value (+3.1%) modestly outpaced growth (+2.2%).
Japanese stocks were volatile but still positive
Among foreign developed markets, Japanese stocks (+10%) increased, though they suffered a sharp correction during the quarter after a huge run-up in Q1. Investors continue to wait and see whether Japanese Prime Minister Shinzo Abe’s “three arrow” program can jolt the country’s economy out of two decades of deflationary headwinds and deliver inflation and economic growth. Markets cheered when Abe fired the first two arrows — fiscal stimulus and aggressive monetary policies — earlier this year, but the May swoon may have signaled that investors are waiting on the critical third arrow, a program of broad-based economic reform. In our view, the Abe government has to deliver on reformist policy to maintain the market’s faith and to support the current elevated level of stock prices we have seen year-to-date.
Europe remained in recession
In Europe, stocks were down (-0.1%), as markets there encountered some negative political and economic headwinds, including an ongoing recession. Europe has contended with many issues including a debt crisis in Cyprus and political disarray in Italy, Greece and Portugal. European economic activity improved during the quarter, however, creating a case for optimism amid all the troubles. Business activity, while far from strong, increased, most notably in the peripheral countries (those with economies smaller than France and Germany), and recent indicators were surprisingly positive. Another positive development came from the European Central Bank (ECB) which became more accommodative in its language about interest rate easing, which may bode favorably for stocks. If European governments can refrain from taking overly restrictive measures to close fiscal deficits and voters do not install anti-EU parties, then we may see better equity results through the end of the year, though many challenges remain there.
Emerging markets hit hard by slower Chinese growth
Emerging markets stocks were dragged down by China and fell by over 8% during the quarter. Chinese stocks, as measured by the Shanghai A Shares market, fell 11.5% during the quarter. The nation’s economic growth slowed to 7.5% in Q2 from 7.7% in Q1. While still significant compared to recent G-7 economic growth rates, China’s growth has edged down from the peaks established over the last decade. Reform is taking shape within China, as the government seeks to transition the nation from an export and industrial-driven economy to a consumer-led one. As a result of slower growth, materials prices, which drive about 40% of emerging market economies, have plunged, creating some market weakness. The consensus forecast for economic growth in China continues to inch lower. The more important, long-term development is the slowdown in credit growth in the country and the deterioration of export and import growth. It increasingly appears that China is entering a new, slower phase of growth as are emerging-market countries dependent on commodities exports, such as Brazil, Russia and South Africa.
The second quarter started strong for stocks, though prices became volatile and declined in late May through early June. A recovery in stock prices took hold near the end of Q2 as fears of rising rates ebbed and economic news continued to improve. Despite a downward revision in first-quarter GDP growth (from 2.4% to 1.8%), much of the economic data released during the quarter was favorable. Employment gains, the ongoing housing recovery, and improving measures of consumer activity were among the major positive themes.
We are optimistic that equities will continue to rally into the third quarter and reach new highs for the year. Ironically, the economic strengthening that has fueled speculation about Fed tapering and sent markets tumbling in June is the same economic strengthening that provides a favorable market backdrop heading into the second half of 2013. We don’t see the pace of expansion as likely to push interest rates up to levels that would stifle growth. We also expect that the current “good but not great” economic expansion will continue and keep interest rates from spiking, which should continue to make equities more attractive versus bonds over the next few quarters. These are all good signs that we are gradually approaching a more normalized investing environment in which fundamental data, rather than Fed expectations, will take on greater importance.
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TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). Past performance is no guarantee of future results.