Asset Management

2013 Third Quarter Equity Market Review


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Global equity markets produced broadly positive results in the third quarter, with both U.S. and foreign stocks rising despite economic and geopolitical uncertainty. In the U.S., the S&P 500 Index advanced 5.2% during the period, while foreign developed- and emerging-market indexes gained 11.6% and 5.8%, respectively, based on MSCI indexes.

Article Highlights

  • U.S. stocks moved higher during a volatile quarter highlighted by Fed announcements, Syrian tension and wrangling in Washington.
  • Foreign developed markets recorded their best quarterly gain since 2010, with Europe leading the way.
  • Glimmers of hope in economic data helped push Japanese stocks into positive territory for the quarter.
  • Aided by improving Chinese economic data and a delay in Fed tapering, emerging markets trimmed some of their first-half losses.
  • U.S. stocks are poised to move higher in 2013 and into 2014, while prospects for foreign developed and emerging markets are mixed.

A volatile period for the S&P 500 IndexU.S. equity investors endured a volatile summer, with a down August sandwiched between an upbeat July and a solid September. In July, the S&P 500 Index hit a record high as the outlook for corporate earnings improved and the Federal Reserve soothed fears of imminent tapering of its monthly bond purchases. August began with another record-high close, but U.S. shares retreated amid geopolitical concerns that included potential military involvement in Syria and renewed apprehension over Fed tapering. The index rose again in September, after the Fed surprised the markets by announcing that it would not begin to taper until signs of stronger, more sustainable economic growth emerge. September also brought into sharp focus the contentious debate in Washington, D.C. over government spending and a looming debt-ceiling confrontation.

Within the S&P 500, the Materials (+10.1%), Industrials (+8.7%) and Consumer Discretionary (+7.7%) sectors led the way; only Utilities (-0.1%) and Telecommunications (-4.7%) finished the quarter in negative territory. The broad-market Russell 3000 Index also enjoyed a strong quarter (+6.4%), with growth stocks (+8.5%) more than doubling their value counterparts (+4.2%) as measured by their respective Russell indexes. This performance reversed the finish of the first two quarters, in which value topped growth. Thinking small benefited investors: Small caps (+10.2%) outpaced both mid caps (+7.7%) and large caps (+6.0%).

As we head into 2014, a potentially powerful addition to U.S. growth is the reduced impact of fiscal drag (that is, the negative effects of curtailed government spending). In 2013, reduced government spending and tax increases lowered GDP growth by 1.7%, based on some estimates. That effect should ebb next year, which would meaningfully enhance growth and provide a supportive environment for equities.

Europe leads non-U.S. markets, while peripheral countries lead Europe

3Q total returns for equity benchmarksFor the period, foreign developed markets outperformed U.S. equities as the MSCI EAFE Index posted a robust 11.6% return in dollar terms—its best quarterly showing in three years. Despite some cautionary signs late in the quarter, particularly statements from European Central Bank President Mario Draghi that a decline in money supply and loan growth across Europe could jeopardize “green shoots” of growth, economic data showed the region was slowly emerging from recession. Manufacturing data readings were better than expected, consumer confidence edged up, and GDP growth turned positive for the first time in two years, albeit at a modest 0.3% rate.

This positive news helped European stocks rise 13.6% in the quarter, with equity returns in Europe’s three largest economies (Germany, +12.7%; France, +15.4%; and the U.K., +12.0%) outpacing the EAFE index. Some peripheral nations in economically weaker southern Europe notched even larger gains, including Greece (+33.6%), which reported rising exports and a rebound in tourism, and Spain (+25.7%), whose economy grew modestly following nine consecutive quarterly declines.

Japan ends the quarter on a high note

After concluding the first two months of the quarter in negative territory, Japanese shares rose 8.4% in dollar terms in September, supported by the announcement that Tokyo had been selected to host the 2020 Olympics and by some glimmers of hope in Japanese domestic data. For the quarter, stocks in the world’s third-largest economy rose 6.7% in U.S. dollar terms, based on the MSCI Japan Index.

China and emerging markets bounce back

Following a -9.6% return in the year’s first six months, the MSCI Emerging Markets Index rebounded with a 5.8% third-quarter gain. Currencies of developing nations had been hammered by the fear of rising U.S. interest rates, but this pressure came off once the Fed announced its non-tapering decision on September 18. Improving Chinese economic data provided a lift to the Shanghai Stock Exchange “A” Share Index and also helped emerging-market returns overall.

The outlook for equities

With this as a backdrop, U.S. equity markets appear poised to continue moving higher through year-end and, in fact, they have risen sharply to open the fourth quarter. We are now concerned that the market may be approaching extended (that is, overvalued) levels, despite a clear economic slowdown in the aftermath of the bickering in Washington and the summer’s rise in interest rates as anticipation of a September taper intensified. Because short-term investor sentiment is edging back to optimistic, equities may be vulnerable to a mid-quarter correction. If we do see a sharp market drop, however, in our view it will be a buying opportunity, as we remain confident about the economy overall and believe the Fed’s decision to delay tapering will help prop up stock prices.

European economic activity continues to improve, and the resolution of political uncertainty in Italy has eliminated a major threat to EU stability. However, real risks remain, particularly regarding fiscal and political challenges in Greece, Portugal and Cyprus. We remain optimistic about European equities near term, but we are concerned that too many others share that view, which could lead to investors overbuying the market.

China and Japan face very different economic scenarios, but a common theme in both countries is the need for meaningful government action. In China, markets expect the Communist Party Congress scheduled for November to deliver major economic reforms. If significant policy changes do not ensue, there are concerns that imbalance may outweigh the actual strengthening that is likely as the government seeks to stimulate growth by expanding credit and infrastructure investment.

In Japan, Prime Minister Shinzo Abe’s program to reinflate the economy remains suspect, in our view. A weaker yen is a centerpiece of “Abenomics” and a primary requirement to jumpstart export growth. While the yen may well decline further versus the dollar, supporting the equity prices of exporters in the near term, Japanese equities are still vulnerable over the longer term to the lack of real reform in the government’s approach.