Volatility returned this quarter in both stocks and bonds as fears about the central-bank actions across the globe made investors nervous about the future. Large Cap U.S. stocks, represented by the S&P 500 Index, returned 2.9% in the second quarter, bringing the year-to-date return up to a lofty 14.0%. By contrast, the EAFE Index, a measure of developed international markets, lost 1.0% in the quarter, bringing the year-to-date return down to 4.0%. In fact, as shown in the graph at right, no other asset class comes even close to the return on U.S. stocks so far this year.
The Barclays U.S. Government/Credit Index had a negative return of 2.5% for the quarter. Bond returns move in the opposite direction of interest rates. The yield on the 10-year Treasury moved from 1.6% at the beginning of May all the way to 2.6% in June, before pulling back slightly to end the quarter around 2.5%. The increase in interest rates was the cause of the negative bond returns for the quarter.
Bond markets were hammered after Fed Chairman Ben Bernanke announced last month that the bank may start winding down its bond-buying programs. The Fed policy of buying bonds to keep interest rates artificially low was intended to spur the economy and reduce unemployment. Many economists came out against the policy fearing a dramatic increase in inflation. However, inflation has been quite modest and the market expectation for future inflation is quite low. While the Fed policy continues to be controversial, the unemployment rate has fallen to 7.6% as of the end of May 2013.
We still expect challenges ahead for the bond market as interest rates rise. However, we cannot predict when and by how much rates will rise in the future. Therefore, we continue to advocate holding high quality bonds in a portfolio. Bonds dampen volatility of a diversified portfolio while also providing income over a long investment time horizon.
Other Asset Classes
Emerging Market stocks continued their year-long decline, reporting a negative return of 8.0% for the quarter. Global uncertainty in these young volatile markets likely fueled the sell-off in emerging market stocks. The Dow Jones REIT Index, a measure of the U.S. real estate market, also reported a negative return of 1.3% for the quarter but was positive year-to-date with a return over the last 6 months of 5.7%. Emerging Market stocks and REITs continue to offer investors diversification benefits in global portfolio construction.