Our Take on the First Quarter

A look at the Morningstar US Market Index's meager 0.6% return in the first quarter might make it seem like the market is simply taking a breather after 2013's breathless returns. But the first part of 2014 has been anything but tranquil. Concerns about emerging-markets growth and currencies, the Fed, stretched equity valuations, mixed economic data, and escalating tensions in Ukraine sent stocks on a bit of a wild ride.

Economic data released throughout the quarter were far from blockbuster. From the housing market to manufacturing to jobs, there were signs that the economic recovery may be slowing, putting a damper on hopes that were building at the end of last year that the recovery was truly on the verge of breaking out of its slow-growth rut. The real question was if the weak data coming in was merely an artifact of the abysmal weather or a sign of true underlying weakness. Morningstar director of economic analysis Bob Johnson thinks it is likely a combination of both with some sectors of the economy seeing a fundamental slowdown while others are only experiencing a temporary shift in demand. He still expects gross domestic product to grow between 2.0% and 2.5% for the full year and anticipates an improving housing market, less restrictive fiscal policies, and energy production to power the recovery for some time. 

The Fed remained a key focus, as well, for investors as Janet Yellen took the reins of the central bank from Ben Bernanke. The Federal Open Market Committee, following its most recent meetings, stayed the course on tapering its quantitative easing program despite the softer economic data. The FOMC under Yellen did make a few changes to how the Fed is communicating when it may actually begin to raise rates. Committee members dropped the explicit 6.5% unemployment-rate target, and instead the Fed is looking at a broad range of metrics and also said the rates could rise as soon as six months after the taper is complete. That timeline is a bit earlier than many in the market had expected, causing some brief volatility, but it is also a sign that monetary policy might be normalizing and that the economy is doing a good job absorbing the Fed's exit so far. Despite the taper, yields on Treasury bonds fell during the quarter. The 10-year Treasury started the year at a 3.0% yield but was at 2.7% during the last week of March. 

Congress stayed out of the limelight this quarter ahead of the midterm elections. The debt ceiling was quietly raised in February, avoiding the fireworks that had characterized recent fiscal negotiations. 

The Fed's removal of its extraordinary monetary policy doesn't just affect the United States, however. Emerging-markets currencies went on a wild ride through January with major swings in the currencies of many markets including Turkey, Brazil, and Venezuela as investors worried about the tighter monetary policy in the U.S. as well as growth and political stability in some cases. Aggressive moves by central banks stemmed the currency slide, but many of the underlying fears remain unresolved. China, in particular, is still a question mark on the growth front. Data indicated the country's manufacturing sector was slowing considerably and that growth would be well below levels achieved in the recent past. 

Of course, the ongoing geopolitical crisis in Ukraine also contributed to the volatility during the quarter. Stocks wavered as investors weighed the shifting possibility of a full-scale war between Russia and Ukraine over Crimea and what impact that would have on Europe and the rest of the world. 

Sector-by-Sector Performance
Most stock sectors turned in positive performances for the quarter. Utilities led the way with a nearly 9% return, followed by health care (up 8%) and basic materials (up 7%). Communications services (down 4%) and consumer cyclical (down 1%) were the worst performers during the past three months.

For most sectors, concerns over valuation were exacerbated during the period. We now believe that the broad market looks overvalued, and that some sectors like technology, industrials, health care, and consumer cyclical look particularly pricey. Morningstar's Lauren Adams suggests investors take a more defensive stance and perhaps consider taking some gains on firms that they aren't comfortable holding for the long run.

Equity precious metals (up 13%) continued its wild ride around the open-end sector equity fund performance leader board, going from the top performer in the third quarter of 2013, to the worst in the fourth quarter, to the top again this period. Real estate (up 7%) and utilities (up 6%) were the next two best performers. Communications (down 2%) was the only category to lose ground while financial and industrials rose less than 1%.

India equity (up 7%) was far and away the big winner among international-equity fund categories. China region (down 6%) was the big loser, with Japan stock (down 5%), diversified Pacific/Asia (down 4%), and Latin America stock (down 3%) the next worst performers.

After a rough 2013, many taxable bond-fund categories rebounded somewhat at the start of this year as rates came down. Long government (up 8%) led the charge with preferred stock (up 5%) and long-term bond (up 4%) following. No category lost ground in the quarter.