Our Take on the Second Quarter

The runup in stocks showed no signs of stopping during the second quarter, despite headwinds of the Fed's tapering, a slowdown in China, and lingering effects of the harsh winter. The Morningstar US Market Index rose nearly 6% during the past 13 weeks, and the index is now up 6.8% year to date. On an annualized basis, stocks are up nearly 20% during the past five years. 

This continued upward movement in stock prices took place against an uncertain economic backdrop. The U.S. economy seems unable to thaw out from the deep freeze experienced across most of the country last winter. Data were decidedly mixed in the quarter, with housing continuing to be lethargic as a result of bad weather, declining house affordability and tighter lending standards. Inflation showed signs up picking up toward the end of the quarter, driven by higher food and energy prices, though Morningstar director of economic analysis Bob Johnson doesn't expect for price levels to get out of control. On the mostly positive side, the manufacturing sector showed improvement in the quarter, while job growth continued. Overall, the economy is likely to bounce back somewhat from the sharp 2.9% decline in gross domestic product seen in the first quarter, but hopes of a strong growth in 2014 are becoming a thing of the past.

The Federal Reserve stayed the course during the quarter, continuing tapering its bond purchases by $10 billion a month. The central bank did lower its economic-growth-rate forecast, but any concerns were not enough to knock to the Fed off its trajectory. The real monetary policy action in the quarter was in Europe. The European Central Bank rolled out a series of measures, including a negative interest rate on reserve deposits, intended to combat the threat of deflation in the eurozone. ECB head Mario Draghi also indicated that the bank is open to further action if price levels don't pick up. 

The ECB is headed toward a looser monetary policy at the same time that the Bank of Japan is aggressively expanding its own monetary base. This dynamic may be responsible for the decline in U.S. Treasury rates seen this year, even as the Fed is beginning to rein in policy. The 10-year Treasury stood at a 3.00% yield at the start of the year and is now trading at a 2.53% yield. 

Economic data out of China during the quarter did little to soothe worries that the country's economy was slowing down. Morningstar's Dan Rohr believes that "much of the slowdown originates in a deceleration in credit expansion that began in the second half of 2013" and that the real estate sector has been the hardest-hit so far. A slowing Chinese real estate market is having a large impact not only on Chinese GDP but also on commodities markets. 

Merger and acquisition activity was alive and well in the second quarter. Deals ran the gamut from large strategic tie-ups (like the combination of  AT&T (T) and  DirecTV ) to a number of deals in the health-care sector that were more focused on tax savings ( Medtronic (MDT) and  Covidien for example). Even though some major deals like  Pfizer (PFE) and  AstraZeneca (AZN) didn't get off the ground, there is clearly a fair amount of appetite for M&A. On the IPO front, the quarter saw the debut of, among others, Ally Financial (ALLY), GoPro (GPRO), JD.com (JD), and IMS Health . The notable S-1 filings in the quarter included Chinese e-commerce giant Alibaba and GoDaddy.

Sector-by-Sector Performance
All stock sectors recorded positive performance in the second quarter. Energy (up 17%) and utilities (up 12%) led the way with consumer defensive (up 10%) and real estate (up 10%) falling close behind. Consumer cyclical (up 3%) was the worst performer while health-care stocks rose 5%.

With stock prices rising at faster clip than earnings, it is no surprise that valuations became even further stretched during the quarter. Morningstar now sees U.S. equities at trading at a 6% premium to our estimate of their fair value. Our analysts see technology, industrials, health care, and consumer cyclical as looking particularly pricey right now. Morningstar director of European equity research Alex Morozov cautions that "aggregate analysis doesn't tell you the whole story" and that investors can still find some wonderful businesses trading at reasonable prices.

Equity energy (up 14%) was the best-performing open-end equity mutual fund category. Energy limited partnership (up 13%) and equity precious metals (up 12%) were close behind. Miscellaneous sector (up 2%), financial (up 2%), and consumer cyclical (up 3%) were the worst performers in the quarter.

Hope that newly elected Indian prime minister Narendra Modi would bring significant economic reforms sent the India equity open-end fund category up more than 18% in the quarter. Latin America stock (up 13%), Japan stock (up 10%), and diversified emerging markets (up 9%) were the next best performers. Europe stock (up 2%) and the foreign small/mid-cap growth, blend, and value categories were the relative laggards.

The unexpected rise in Treasury bond prices led to good performance across open-end taxable-bond categories. Emerging-markets bond (up 5%), long government (up 4%), and preferred stock (up 4%) were at the top of the heap. Given how low short-term rates remain, it should be too surprising to see ultrashort bond (up 0.4%), short government (up 0.7%), and short-term bond (up 1.3%) as the weakest performers.