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After Talking the (Taper) Talk, the Fed Finally Walks the Walk

Fourth Quarter 2013

Much of the uncertainty that had lingered in the financial markets throughout 2013 faded during the fourth quarter. The federal budget standoff, which triggered an early-quarter partial government shutdown and led to the threat of a Treasury default, ended by mid-October. Then, late in the quarter, Washington policymakers crafted a two-year budget deal, removing the risk of another government shutdown in early 2014. But perhaps the greatest relief came at the hands of the Federal Reserve (the Fed), when it finally put its months of "taper talk" into action. Following its December policy meeting, the Fed announced it would begin reducing its monthly bond buying by $10 billion to $75 billion in January, with future tapering to remain data dependent. The Fed also indicated it would keep the federal funds rate target at its current range of 0-0.25% well beyond the point at which U.S. unemployment falls below 6.5%, providing more clarity regarding short-term interest rate policy.

Whereas the prospect of Fed tapering sent the financial markets into a frenzy earlier in the year, the Fed's decision to finally begin scaling back its monthly bond buying program had a less-dramatic effect on the markets during the fourth quarter. With economic data generally improving throughout the quarter, most investors assumed the taper would happen sooner rather than later. Also, the relatively modest amount of tapering, accompanied by forward guidance on interest rates, helped reassure investors the reduction in stimulus would be gradual.

All major U.S. stock benchmarks posted robust returns for the quarter, which helped generate the best yearly gains since the mid-1990s. Non-U.S. stocks also advanced during the quarter, but they generally lagged the U.S. market. Emerging markets advanced overall, but weaker growth, inflation concerns in certain markets, and the Fed's tapering announcement weighed on returns. Meanwhile, improving economic data, particularly in the U.S. and Europe, and the Fed's decision to taper generally pushed global bond yields higher.

U.S. Stocks: Fourth-Quarter Rally Capped Stellar Year
Optimism prevailed among equity investors during the fourth quarter, and strong returns during the three-month period helped the U.S. stock market (S&P 500 Index) finish 2013 with its best annual gain since 1997. In particular, a series of favorable economic releases helped lift stock market sentiment. The U.S. economy grew at an annualized rate of 4.1% in the third quarter, up from 2.5% in the second quarter, the manufacturing sector expanded, and the housing market continued to demonstrate strength. Furthermore, the government's employment report for November (released in December) showed relatively healthy payroll growth, and the unemployment rate fell to 7.0%-the lowest level since 2008. The improving economy provided an upbeat backdrop for corporate profits, which continued to grow at a relatively robust pace overall.

The improving economic data provided a catalyst for the Fed to finally announce tapering plans and interest rate guidance in December. This, too, helped boost stock investor sentiment, as the measured approach indicated by the Fed gave the market confidence that the removal of Fed stimulus would be a slow--and data-dependent--process. The announcement also suggested the Fed thinks the economy is improving--another positive sign for stocks. The stock market also received a late-quarter lift following the Congressional agreement on a two-year federal budget deal.

On the heels of a third-quarter return of more than 5%, the S&P 500 Index soared more than 10% during the fourth quarter, bringing the year-to-date gain for the broad measure of U.S. stock performance to 32%. All 10 of the index's industry sectors generated gains during the quarter, with the economically sensitive industrials, information technology, consumer discretionary, and materials sectors leading the way with benchmark-beating gains of 14%, 13%, 11%, and 11%, respectively. Once again, the more-defensive sectors, including utilities (up 3%) and telecommunication services (up 5%), were the weakest, weighed down in part by rising interest rates.

The quarter witnessed modest performance disparity among styles and market capitalization. In terms of capitalization, large-cap stocks were the fourth quarter's top performers, followed by small- and mid-cap stocks. The growth style outperformed the value style among large-cap equities, but the value style prevailed in the mid- and small-cap segments.

Non-U.S. Stocks: Europe's Gains Drove Developed Market Performance
Continued strong stock gains in Europe, fueled primarily by an economy that continued to recover from an extended recession, largely drove performance of the broad non-U.S. developed market. Improving economic growth rates throughout Europe, combined with favorable corporate earnings results among many European companies, drove stocks higher. In addition, interest rate policy continued to support market gains. Early in November, the European Central Bank (ECB) cut its key lending rate to 0.25% in a surprise move made in response to shrinking inflation numbers on the Continent. Worries about declining inflation prompted ECB President Mario Draghi to assert the institution would be "ready and able to act" if the inflation rate remains low for an extended period. Meanwhile, the Bank of England upgraded its economic and employment projections, thereby raising the possibility it would increase its key lending rate sooner than previously expected.

Japan's economic growth rate slowed slightly during the quarter but remained positive. Corporate earnings were slightly better than expected, with many export- and industrial-based companies continuing to benefit from a weaker yen and the Bank of Japan's program to buy back bonds and pump inflation into the economy. Optimism grew late in the quarter as the government reported prices remained firm and the core consumer price index posted its largest gain in five years. Elsewhere in the developed Asia-Pacific region, Australia and New Zealand stocks generally declined, while the Hong Kong and Singapore markets advanced.

Emerging markets generally posted positive performance, but they continued to lag their developed market counterparts. The larger emerging market nations, including China, experienced slowing but stabilizing growth rates, which put pressure on corporate profits. Tighter credit and monetary policies in China suggested the government may tolerate slower near-term growth as it attempts to balance the nation's economic growth drivers. Inflation remained a concern in certain larger markets, including Brazil and India. Volatility spiked late in the quarter as political unrest (particularly in Turkey and Thailand) and the Fed's decision to begin tapering weighed on many emerging markets.

Global Bonds: Fed's Taper Decision, Economic Gains Drove Yields Higher
Fixed income investors continued to gauge when and by how much the Fed would taper QE in light of modest economic gains and muted inflation. Investors increasingly expected the Fed's temporary "taper delay" (announced in September) would expire sooner rather than later, and this sentiment gathered strength as the quarter unfolded and economic growth data improved. Market expectations turned to reality in December, when the Fed announced it would begin tapering in January. The modest nature of the initial tapering was likely due in part to the low inflation rate, which remained well below the Fed's target of 2% and enabled the central bank to also commit to a continuation of its near-zero short-term interest rate policy for the foreseeable future.

Against this stronger economy/QE tapering backdrop, U.S. Treasury yields generally increased. The yield on the two-year Treasury note rose 6 basis points from the end of the third quarter to 0.38%, while the yield on the 10-year Treasury note advanced 42 basis points to 3.03%, according to Bloomberg. With longer-maturity yields increasing to a greater degree than shorter-maturity yields, the Treasury yield curve steepened.

The broad investment-grade taxable bond market average (Barclays U.S. Aggregate Bond Index) declined fractionally during the quarter, weighed down by losses among Treasuries, mortgage securities, and agencies. But investment-grade corporate securities were notable exceptions, continuing to benefit from investor demand for yield and modest tightening of spreads (yield differences compared with comparable-maturity Treasuries) as Treasury yields rose. Similarly, high-yield corporate bonds advanced and were the top performers in the U.S fixed income market, according to Barclays.

Municipal bond (muni) investors faced similar interest rate challenges as their taxable bond counterparts--and more. The fallout from Detroit's second-quarter bankruptcy filing, the struggling fiscal health of Puerto Rico (one of the largest muni bond issuers), and continued muni fund outflows weighed on the market. Nevertheless, most muni indices advanced fractionally, with the highest-quality, most-liquid, and shorter-duration (less price sensitive to interest rate changes) munis generally faring best.

Non-U.S. bond returns were mixed but generally moved lower due to improving economic conditions in the U.S. and Europe. The main exceptions were the peripheral European markets, particularly Spain and Italy, where returns increased during the quarter. Asian markets, including Japan and South Korea, posted relatively flat returns, while bond markets in commodity-driven economies, such as Australia and Canada, declined slightly. Overall, non-government bonds continued to outperform government securities.

Currency fluctuations had a negative overall effect on on-U.S. bond returns for U.S. investors. The U.S. dollar strengthened against most major currencies, including 3.5% against the Canadian dollar, 4.5% versus the Australian dollar, and 7% against the Japanese yen. But in Europe, the dollar weakened versus the euro (-1.5%) and the British pound (-2%).

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Source: Barclays Indices