A Robust First Quarter

It was an extraordinary quarter for U.S. equity markets, one characterized by record highs, participation by all major sector categories, and a shift to positive flows among mutual funds. The S&P 500 delivered a 10 percent return, with six of its ten sectors delivering double digit returns, led by healthcare with a gain of 15.2 percent.

The fact that the fiscal cliff was averted, the economy appeared to gain some momentum, and the Fed renewed its commitment to policy accommodation all contributed to the gains. And, I would argue, the fact that the sequester was triggered, rather than in spite of it, also made a positive contribution.

The quarter was less rewarding in overseas markets. The MSCI EAFE index did produce a positive return, but at 4.4 percent it was less than half that of U.S. markets. Stocks in Europe rose just 2.1 percent for dollar-based investors, held back by sluggish economic activity and the financial crisis in Cyprus, but in Japan they rose by 10.7 percent, propelled by the expectation of rising export activity in response to the falling yen. Most disappointingly, emerging market equities fell 1.9 percent. Stocks in Asia fell 1.6 percent, led by a 4.5 percent decline in China, and a 2.7 percent decline in India. In Latin America, stocks eked out a small gain of 0.5 percent, but Brazil disappointed with a loss of 1.3 percent. Collectively, the BRIC countries fell 3.2 percent.

So, with the exception of Japan, it was a quarter that rewarded investors for staying close to home. Dollar strength was part of the story. After rising from 1.32 to the dollar at the start of the year to 1.36 at the end of January, the euro began a steady fall in the wake of the Cyprus crisis, to end the quarter at 1.28. The pound fell from 1.63 to 1.52. The dollar began the year at 86.8 to the Japanese yen, but finished the quarter at 94.2. However, had one perfectly hedged their overseas currency exposure, the results in local equity markets would have been decidedly more rewarding, at least within developed markets. Rather than rising just 4.4 percent, the MSCI EAFE index return would have been double that. In Japan, the return would have been 21.5 percent. Within emerging markets, however, the collective return would have improved only marginally, to -0.8 percent.

Partly explaining the weakness in emerging markets was weakness in commodity prices. The UBS Bloomberg CMCI index fell 1.5 percent during the quarter. Industrial metals were particularly soft, falling 6.3 percent. Copper fell 4.9 percent, but was surpassed by the 8.1 percent decline in aluminum, and the 8.9 and 9.4 percent declines in zinc and lead. Agricultural products also fell, losing 3.9 percent.

Corn was down 9.9 percent, wheat was down 11.8, and soybeans were down 3.7 percent. Offsetting some of this weakness was strength in energy prices, which rose 4.7 percent. Crude oil rose 5.1 percent, but it was natural gas, with a gain of 20.5 percent, that really drove this sub index higher. Among precious metals, gold fell 4.9 percent and silver fell 6.1 percent.

Neither was it much of a quarter for bond investors. Year-to-date, the Barclays U.S. Aggregate Index, comprised exclusively of investment grade and government securities, delivered a total return of -0.1 percent.

The weakness was attributable to longer maturities, seven years and beyond, where interest rates rose modestly. For example, the yield-to-maturity on the thirty-year Treasury bond rose from 2.93 percent at the start of the year to 3.12 percent to end the quarter. The ten-year note rose from 1.74 to 1.86 percent.

Conversely, the two-year note was unchanged at 0.25, anchored by Fed policy. Municipal bond indices fared similarly. The Barclays index total return for the first quarter was 0.3 percent, with some of the longer maturities suffering fractional losses. The Barclays High Yield index, on the other hand, produced a total return of 2.9 percent. And just has been the case with equities so far this year, it was the lower quality segments of the high yield universe that delivered the strongest returns. The Ba segment returned 1.97 percent, while the Caa segment returned 5.8 percent, and the long end of the Caa range returned an impressive 17 percent. Dollar based emerging market bonds fell 1.5 percent.

So, what can we conclude from a quarter characterized by the return data above? The first, and most obvious observation, is that investors were drawn to the relatively better economic growth of the U.S. economy, nsupported by an aggressive Federal Reserve. They were also drawn to the monetary policy initiatives unfolding in Japan, believing that this time it's for real. In Europe, cheaper valuations and the promise of a monetary backstop was enough to keep investors in place, but weak economic activity and another reminder of the fragility in the periphery kept a lid on price gains. These stories are relatively straightforward. And any change in the variables could change the equation. But the other outcomes are somewhat harder to square.

Weakness in emerging markets suggests global economic activity is perhaps weaker than U.S. equity market performance would seem to indicate. Muted increases in domestic bond yields would seem to suggest the same. So, too, with commodity prices. These are the worries that comprise the wall the market continues to climb. The next test will arrive shortly with start of first quarter earnings season. If it is strong enough, stocks can continue their ascent, albeit not at the same pace of the past three months. Valuations won't permit it, at least not in the U.S. If it is not, these doubts will reassert themselves.

Important Disclosures:

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

Morgan Stanley Capital International EAFE Index (MSCI EAFE), an unmanaged index, is compiled from a composite of securities markets of Europe, Australasia and the Far East.

The UBS Bloomberg Constant Maturity Commodity Index (CMCI) is a diversified commodity index family made up of components from specific sectors including energy, industrial metals, precious metals, agriculture and livestock as well as individual components.

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