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Our Take on the Second Quarter

Stocks eked out gains amid Fed-watching, continued mergers and acquisitions, and the ongoing Greek debt crisis.

U.S. stocks eked out gains in the second quarter as investors shrugged off worries about rising rates. The broad-based Morningstar US Market Index was up 0.3% during the last 13 weeks.

Data received in the quarter confirmed that the U.S. economy slowed to a halt in the first quarter yet again, with GDP decreasing 0.2%. However, there were signs throughout the current quarter that the economy was bouncing back as the weather improved. The jobs market looked better, with May's employment report particularly strong. Housing also seemed to find its footing. Manufacturing continued to be a weak spot, and lower oil prices were still a headwind to growth. Overall, though, the economy looks back on track to grow about 2% for the year.

"Despite a lot of ups and downs over the last three months, our full-year economic forecast remains relatively unchanged since our last report. Our full-year GDP growth forecast remains steady at 2.0%-2.5%, as it has for the last three years. We see nothing that would cause the economy to break sharply out of that channel," said Morningstar director of economic analysis Bob Johnson in his quarterly economic outlook.

Although at one point it appeared that the Fed may raise short-term interest rates as early as June, the weak data in the first part of the year made that date unrealistic even as the central bank removed the language about being "patient" in when it would boost rates. At the June meeting, the Fed made clear that it was planning on the first rate increase sometime this year but also said that the pace of increases may be slower than many had initially expected.

Data in Europe also showed early signs that the European Central Bank's quantitative easing program was helping raise price levels and reboot growth in the eurozone. But once again, the big story out of Europe was the continuing Greek saga. Global stock markets continued to rally and sell off throughout the quarter as news vacillated between optimism and pessimism that Greece would be able to repay its debts. As the markets closed on June 30, the Greek government, in an effort to avoid defaulting on its expiring loan from the International Monetary Fund, had asked for a two-year bailout from the eurozone to cover its financing needs and restructure its debt.

China had a tumultuous quarter. The economy continued to slow, growing 7% in the first quarter, the slowest in six years. Other indicators of the country's economic health, such as the Markit HSBC China Manufacturing Purchasing Managers Index, point to a contraction in the manufacturing sector. The government has been pulling a number of levers to try to stimulate the economy. Despite this uncertain growth picture, Chinese stocks have been soaring as investors seem to be pouring money into stocks rather than investing in the slumping property market. Though the Shanghai SE Composite Index has fallen 7.3% in the last month, it has gained 14.1% in the last three months, 32.2% for the year to date, and 108.8% in past 12 months.

On the corporate front, mergers and acquisitions dominated the headlines. There were major deals across a number of sectors from semiconductors (

In his quarterly outlook for credit markets, Morningstar corporate bond strategist Dave Sekera posited that slow-but-steady economic growth will support the corporate credit market. Also, interest rates appear poised to rise further as they normalize relative to other financial metrics and an improving economy, Sekera said; in such an environment, he expects high-yield bonds to continue outperforming investment-grade.

Sector by Sector Stock-sector performance was generally higher during the second quarter. The top-performing sector was communication services (up 4.9%), followed by financial services (up 4.3%) and health care (up 3.2%). Real estate lost 9.4% during the quarter, while utilities companies were down 6.3%, and industrials were down 2.4%.

The energy sector lost around 2% during the quarter. Oil prices rebounded somewhat in the second quarter, trading in the high $50s/low $60s, but oil is still far from its highs; the sector has lost nearly 23% in the past 12 months.

The S&P 500 is approximately flat since last quarter, leaving stocks fully valued. "We encourage investors to consider their risk tolerance, pick their spots carefully, and prepare for subpar market returns over the next five years," said Morningstar StockInvestor editor Matt Coffina in his quarterly outlook.

The small-growth category was the best-performing U.S. open-end mutual fund category, gaining 1.8% for the three months ended June 30. The next-best performers were large-cap growth and mid-cap growth, rising around 0.5% and 0.4%. respectively. Mid-cap value funds lost the most, declining 0.9%, and mid-cap blend declined 0.7%. Small-value funds lost 0.5%. Among sector equity open-end funds, health-care funds were the best-performing category, rising 4.5%, followed by financial funds, which rose 3%. The two worst-performing categories were real estate and global real estate, which lost 9.6% and 4.9%, respectively.

The China-region category was the top performer in the international-equity funds category, adding more than 7.6% in the last three months. Japan stock was the next-best performer, up 3.9%, followed by foreign small/mid-growth (up 3.7%). India equity (down 2.9%) was the only international fund category to decline.

Yields on the 10-year Treasury rose in the quarter, starting at 1.9% and moving to as high as 2.5% in early June before backing off to end the quarter at 2.3%. The bank-loan category was the top-performing taxable-bond category during the quarter, gaining 0.6%. The biggest decliners were long-term government bond and long-term bond, which lost 6.4% and 5.7%, respectively.

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