Q2 Recap: Stocks and Bonds Both Rise as Low Volatility Reigns

There were plenty of potential triggers that could have sent financial markets into a panic in the second quarter of the year: it was revealed that the economy contracted in the first quarter at an annualized rate of almost 3%, the Federal Reserve continued to scale back its monetary stimulus, and oil prices rose as Iraq was overrun by insurgents. But financial markets shrugged off these developments, and the quarter was characterized by low volatility (few large ups and downs in the markets).

Both stocks and bonds did well, with emerging markets in particular rebounding strongly after lagging last year and in the first quarter of this year. Cash, with its return of essentially 0% in the current low interest rate environment, was the worst-performing asset class.

Q22014 Asset Classes

Every sector of the stock market made gains in the second quarter. Energy stocks led the way, partly driven by increases in the price of energy commodities such as oil. For many sectors 2014 has so far been a reversal of the trends of the previous year. For the second straight quarter, utilities (the worst-performing sector in 2013) were near the top while consumer discretionary (the best-performing sector in 2013) was near the bottom.

Q22014 Stock Sectors

The top-performing countries in the second quarter were a potpourri of emerging markets, largely as a result of political developments. Turkish stock leapt following local elections at the end of March, although they lost some ground toward the end of the quarter as conditions in neighboring Iraq deteriorated. Indian stocks surged as Narendra Modi was elected in the country’s May elections.

The worst-performing countries in the second quarter were Greece and Ireland, countries on the European periphery that had been central figures in the continent’s sovereign debt struggles. Not all such countries did poorly, however: Spanish stocks returned more than 6%.

Q22014 Countries

The outlook going forward depends on a few factors. Most economists expect the US economy to rebound strongly in the rest of the year after its negative growth rate in the first quarter (which has generally been blamed on rough winter weather), but any continued economic slowdown could cause stocks to give up their recent gains.

A second factor is inflation, which has ticked up recently. A continued rise in the inflation rate could lead to losses for bonds, which have benefited from an inflation rate below the Federal Reserve’s 2% target in recent years.

Lastly, the outlook for China continues to be a major influence on the global economy. So far the Chinese government has been able to manage a slowdown in the country’s growth rate without triggering a broader economic collapse, and the second quarter saw some encouraging data about the state of the Chinese economy. Continued success in avoiding a broad financial crisis would support stocks globally and in particular could boost Chinese stocks, which gained almost 5% in the second quarter.