Economic and earnings growth disappointed during the second quarter and geopolitical tension escalated in a key oil-producing region, yet risk assets resumed their upward assent. Reassuringly dovish comments by developed markets central bankers boosted risk appetite, as did a certain indifference to bad news after several years of false starts for a coordinated global economic recovery. Volatility across asset classes (both equity and debt) dropped during the quarter to levels last seen during 2005–06, reflecting a perceived central banker “put,” but also highlighting the risks if unexpected developments during the second half of 2014 challenge the complacent consensus.

US equities returned 5.2% for the quarter, slightly outpacing developed markets peers (4.4%). Investors cheered comments from the Federal Reserve that inflation was contained and that asset prices looked in line with historical norms, curiously overlooking May’s 2.1% CPI figure (above Fed targets) and a host of metrics that suggest equity valuations are stretched. Of course, June’s news that the US economy shrank at an annualized pace of nearly 3% in the first quarter hardly suggests that price pressures are rising; the Fed, the International Monetary Fund, and others have now trimmed GDP growth forecasts for 2014. Consensus estimates for S&P 500 earnings growth fell slightly in turn and stand at 7.6%. Given lackluster sales growth, record buyback volumes and margin expansion help explain earnings per share growth. US companies have purchased a record $535 billion of stock over the past 12 months, equivalent to 3.3% of outstanding shares.US fixed income also enjoyed a robust quarter, with the Barclays Aggregate index returning 2.0% (3.9% year-to-date). Technicals in US fixed income markets are very favorable; net supply of US Treasuries is near cyclical lows as the deficit narrows and QE continues, while foreign buying is rising given relative value (yield differentials) and as some countries try to weaken their currencies to restore competitive advantage.

European markets also enjoyed healthy gains, though Eurozone economic data were somewhat downbeat (first quarter GDP growth was barely positive) and disinflation remains a threat (June CPI at just 0.5% was near five-year lows). Last month, the European Central Bank (ECB) delivered on earlier promises to do more to tackle these problems by announcing a package that included rate cuts and funding (LTROs) for banks intended to facilitate SME lending (lending to small and medium enterprises). If credit demand rather than supply is the problem, these measures may do little. Eurozone sovereign bonds returned 2.9% as yields fell further, taking their 2014 gain to 6.6%. Returns on European equities (3.0%) trailed world peers during the quarter given growth data and declining earnings forecasts. As was the case in the United States, energy (12.1%) was the best-performing sector as instability in Iraq combined with ongoing OPEC supply problems to push crude oil prices higher and as relative valuations remain favorable. Health care stocks (4.5% in the second quarter; 10.6% year-to-date) have also fared well across regions, in part because the rising level of mergers & acquisitions in the sector (which hit a record $317 billion during the first half of 2014) is lifting target prices.

Emerging markets assets benefited from Fed and ECB guidance, as well as local political and economic developments. EM equities returned 5.2%, outperforming developed peers for the first time since fourth quarter 2012. India (13.5%) was a star performer, as the election of Narendra Modi as prime minister sparked hope that long-awaited corporate reforms would be enacted. In addition, India’s currency has stabilized at levels deemed to give a boost to local exporters. Taiwanese stocks (8.2%) also lifted the index as earnings expectations rose for the heavily weighted technology sector. As fears over Fed tapering fade, EM valuations are coming back into focus. The MSCI Emerging Markets Index currently trades at less than 11 times forward earnings, roughly a 30% discount to US equivalents, with normalized valuations suggesting an even larger discount. EM bonds also enjoyed a robust quarter, with US$-denominated sovereigns returning 4.8% and local currency sovereigns up 3.5%. Fragile 5 concerns have not totally disappeared—though rising commodity prices help exporters like Brazil, they have the potential to spark inflation (or increase government deficits if price increases are absorbed) for importers.

Perhaps unsurprisingly, it was a strong quarter for real assets. Leadership rotated as commodities posted flat returns, but property and natural resources securities were up strongly. Within the commodity space, gains on precious metals (3.8%) and energy (4.4%) were offset by plunging agricultural prices (-10.0%) as supply concerns eased. Gold benefited from safe-haven demand given rising tensions in Iraq, while corn and soybeans plunged on news that supplies would be larger than expected. US REITs returned 7.1%, lifting their year-to-date return to 16.2%, while Europe ex UK property securities returned a whopping 11.5%. The dividend yield of 3.52% on US REITs may not appear compelling on an absolute basis, but clearly has appeal relative to ten-year US Treasuries, which yield 2.53%, and US stocks, which yield around 2%.

Exhibit Notes

Performance Exhibits
Total returns for MSCI developed markets indexes are net of dividend taxes. Total returns for MSCI emerging
markets indexes are gross of dividend taxes.

US dollar index performance chart includes performance for the Barclays Corporate Investment Grade, Barclays
High Yield Bond, Barclays Municipal Bond, Barclays US TIPS, Barclays US Treasuries, BofA Merrill Lynch 91-Day
Treasury Bills, FTSE® NAREIT All Equity REITs, J.P. Morgan ELMI+, J.P. Morgan GBI-EM Global Diversifi ed,
MSCI Emerging Markets, MSCI World, and S&P GSCI™ indexes.

Euro index performance chart includes performance for the Barclays Euro-Aggregate: Corporate, Barclays Pan-
Euro High Yield, Citigroup EMU Govt Bonds, FTSE® EPRA/NAREIT Europe ex UK RE, J.P. Morgan ELMI+, J.P.
Morgan GBI-EM Global Diversifi ed, MSCI Emerging Markets, MSCI Europe, MSCI Europe ex UK, MSCI World ex
EMU, MSCI World, and S&P GSCI™ indexes.

UK sterling index performance chart includes performance for the Barclays Sterling Agg Corps, BofA Merrill Lynch
Sterling High Yield, FTSE® British Government All Stocks, FTSE® British Government Index-Linked All Stocks,
FTSE® EPRA/NAREIT UK RE, J.P. Morgan ELMI+, J.P. Morgan GBI-EM Global Diversifi ed, MSCI Emerging
Markets, MSCI Europe ex UK, MSCI World, MSCI World ex UK, and S&P GSCI™ indexes.

Valuation Exhibits
The composite normalized P/E ratio is calculated by dividing the infl ation-adjusted index price by the simple
average of three normalized earnings metrics: ten-year average real earnings (i.e., Shiller earnings), trend-line
earnings, and return on equity–adjusted earnings. We have removed the bubble years 1998–2000 from our mean
and standard deviation calculations. All data are monthly.