Morningstar’s Take on the Third Quarter

Stocks rallied in a remarkably calm third quarter, but watch out for bumps ahead.

Jeremy Glaser 15.10.2012
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After the summer fireworks of the last few years, the third quarter of 2012 was remarkably calm. Global stocks rallied as fears that the world economy was stalling and that the eurozone was headed for a sudden breakup subsided as investors generally cheered policymakers' actions to turn things around. The Morningstar US Market Index jumped 9.1% during the last 13 weeks (as of September 28, 2012).

Once again, Europe was a primary area of focus during the quarter. But unlike in the past, the continent actually made real progress in fixing the euro crisis during the last three months. European Central Bank president Mario Draghi kicked off the wave of optimism by saying in July that he was willing to do whatever it takes to keep the eurozone together. The ECB followed up on that pledge in September with a new Outright Monetary Transaction program that will allow the bank to buy an unlimited amount of sovereign debt from countries that have accepted a bailout and are in compliance with the bailout's terms. The German high court's approval of the permanent European Stability Mechanism, the return of a pro-euro government in the Netherlands, and some progress in creating a pan-European fiscal union also helped soothe fears. Despite these developments, Europe is hardly clear from danger. Yields on sovereign debt from peripheral countries like Spain remain unsustainably high, data show the eurozone is firmly in a recession, and it will still be years until the necessary institutions are in place to end the crisis once and for all.

All eyes were on the Federal Reserve in the United States. After hinting that it was ready to act to jump-start the recovery again, a series of weak employment reports pushed the Fed to announce its third major round of bond buying. The Fed now plans to buy $40 billion of mortgage-backed securities a month until the employment situation looks much better. The hope is that the purchases will help lower mortgage rates even further and help boost the housing sector. The central bank also extended its commitment to keeping interest rates at very low levels until the middle of 2015.

Sector-by-Sector Performance
The rising tide lifted all sectors in the third quarter. Energy had the highest return, gaining more than 16% with communication services not far behind with a 15% increase. Basic materials (up 11%) and financial services (up 10%) also had double-digit returns. Utilities (up 2%) turned in the worst performance followed by real estate (up 5%) and consumer defensive (up 6%).

The uptick in prices left stocks looking almost entirely fairly valued at the end of the quarter. The market-cap weighted price/fair value ratio stands at 0.91. Morningstar vice president of global equity and credit research Heather Brilliant says given the full valuations investors should focus "on stock-specific investments, rather than following along with the overall market or macroeconomic picture" and that the best values are in the most cyclical sectors.

Equity precious metals (up 20%) was the best performing domestic-equity open-end fund sector during the last three months. Natural resources (up 14%) and equity energy (up 14%) also posted impressive gains. Real estate (up 4%) and utilities (up 6%) brought up the rear.

International-equity funds had a good quarter. India equity (up 17%), Europe stock(up 13%), and foreign large value (up 12%) were the top performers. China region(up 4%), Japan stock (up 5%), and diversified Pacific/Asia (up 8%) were at the bottom.

Emerging-markets bond led the way for fixed-income funds in the quarter, gaining nearly 7% during the last three months. High-yield bond, world bond, long-term bond, and multisector bond all returned more than 4%. Long government (down 0.2%) was the only category to see a loss, while short government and ultrashort bond were each up by less than 1%.

Look Beyond Quarterly Gains
Although stocks cheered the economic developments in the quarter, the economy is far from out of the woods. In the U.S., the economy continues to grow below trend, the job market is far from healed, and the fiscal cliff looms in the distance. Europe is in a recession and will need to avoid any number of potential hiccups to make its rescue plans a reality. The future of Chinese growth remains an open question as the country enters its once-a-decade leadership change. Given that equities look fully valued, as well as the potential for speed bumps in the coming months, investors should be prepared for the possibility of a rough road ahead.


Jeremy Glaser is the Markets Editor for Morningstar.com.

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

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