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Quarter-End Insights

Our Take on the Third Quarter

All eyes were on the Fed during the quarter as stocks continued to rally.

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Despite continued uncertainty about the health of the global economy and the future of monetary policy, U.S. stocks retook all-time highs in the third quarter before pulling back slightly in September. The broad-based Morningstar US Market Index rose by nearly 7.5% during the last 13 weeks. The market is now 22% higher year to date and up 10% annualized during the past five years. 

The market's focus was squarely on the Federal Reserve again this quarter. At its September meeting, the Fed chose to keep in place its current program of purchasing mortgage-backed securities. This was seen as a major surprise given that the central bank had spent the last several months hinting that a taper was imminent. Fed chairman Ben Bernanke cited mixed economic data and the uncertain path of fiscal policy as the primary reasons for not yet taking the foot off the accelerator. The Fed is still broadly expected to begin tapering in the coming months, but the lack of a clear timetable has likely been causing some stock and bond market volatility.  

Complicating matters more is the expected change in Fed leadership. Bernanke's term ends in January and President Obama had looked poised to replace him with former Clinton-era Treasury Secretary Larry Summers. However this plan was derailed when several liberal senators objected to, among other things, Summers' ties to the financial-services industry. With Summers removing his name from consideration for the chairmanship, Obama now is likely to nominate Fed vice chair Janet Yellen, who is not expected to make any radical changes to current policy. Still, the uncertainty has created more question marks over the future path of monetary policy. 

The focus on the Fed contributed to some fairly large moves in the Treasury market. The yield on the 10-year bond started the quarter off at 2.5%, rose to nearly 3.0% as the market anticipated the tapering announcement, and then fell back down to 2.6% after the central bank's surprise move.

The U.S. economy continued its slow but reasonably stable growth in the third quarter. Morningstar's director of economic analysis Bob Johnson says the economy, despite some initial fears, hasn't been derailed by higher interest rates. Manufacturing is strengthening on the back of better auto sales, and consumer spending has held up. There have been some signs, however, that housing is weakening somewhat as mortgage rates rise and supply remains tight. Johnson expects the U.S. economy to grow between 2.00% and 2.25% in 2013. As the quarter ended, Congress was gridlocked in trying to passing bills to fund the government and to raise the debt ceiling. A shutdown or a breach of the debt ceiling could have an impact on economic growth in the fourth quarter.

The eurozone crisis remained on the back burner during the last three months. Economic growth looked better on the continent, with the eurozone finally appearing to be pulling out of the recession it has been in since 2011. German chancellor Angela Merkel's re-election eliminated some political risk as the German people endorsed her strategy of avoiding jointly guaranteed eurobonds and keeping inflation low while still providing funding to struggling eurozone countries to hold the common currency together. Despite the progress being made, the underlying competitiveness and sovereign debt issues that precipitated the crisis remain largely unsolved. 

Emerging markets had a mixed quarter. China's manufacturing sector showed signs of life, and the country's economy appeared to be rebounding. Still, growth in China remains well below the pace seen just a few years ago as the country negotiates the move from an export- and investment-driven economy to a consumption model. Other emerging markets, notably India, had tougher times as higher rates in the U.S. led to capital outflows that depressed currencies and stoked inflation

The largest IPOs (as measures by market cap) in the quarter included Sprouts Farmers Market (SFM), Frank's International (FI), Envision Healthcare Holdings (EVHC) and FireEye (FEYE). Notable S-1 fillings include RE/MAX Holdings, Potbelly, AMC Entertainment, ARAMARK Holdings, Hilton Worldwide, Chrysler. Twitter also indicated it filed a private S-1. 

Sector-by-Sector Performance
All stock sectors turned in positive performance for the quarter, with nine out of 11 sectors posting double-digit returns. Technology (up 33%) was by far the best performer. Excitement over social-media companies' results and continued interest in mobile platforms and devices drove shares higher. Consumer cyclical stocks were up 16% while basic materials shares rebounded 15% during the past three months after lagging for some time. Real estate (up 6%) and consumer defensive (up 7%) were the worst performers.

Equity precious metals (up 19%) topped the performance list of open-end sector stock mutual funds. Technology and health were the next strongest in the quarter, each rising 14%. The real estate fund sector was essentially unchanged in the quarter, putting the category at the bottom of the performance rankings. 

International stocks turned around in the third quarter after a majority of categories lost ground in the second quarter. Foreign small/mid value, growth and blend were among the top-performing international-equity open-end fund categories, each rising more than 13%. China region (up 13%) and Europe stock (up 13%) also did well. India equity (down 1%) was the only category to lose ground.

Fixed-income open-end mutual fund returns were muted after spectacular losses in the previous quarter. Long government (down 1%) was the only category that was down in the quarter and is now off 10% year to date. High yield (up 3%) was the best performer, and world bond (up 2%) was in the number-two spot.

All data as of Sept. 27. 

Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.