By Matt L. Peden, CFA, Vice President, Investment Officer

Over the short-term, markets can and are often influenced by swings in emotion, especially during times of uncertainty and lack of clarity, and in the second quarter, the capital markets experienced a noticeable shift in market sentiment. The first quarter encountered several exogenous shocks, including natural disasters, elevated unrest in the Middle East and higher oil prices. Despite these events, an overall optimistic outlook was in place. The capital markets remained resilient and riskier assets such as equities and higher yielding bonds generally outperformed. Moving into the second quarter, investors’ concentration transitioned and appeared to focus on and respond to elevating concerns over the sustainability and trajectory of economic recovery, and the rapid deterioration of the weaker peripheral bond markets of Europe (Greece, Ireland, Portugal and Spain). There is no doubt the absence of improving economic news domestically weighed heavily on investors, especially knowing that the Federal Reserve’s (“Fed’s”) quantitative easing (“QE2”) program was expiring at quarter- end without any further quantitative easing on the horizon. Gross Domestic Product (“GDP”), a domestic measure of economic output, came in below expectations at 1.9% and was largely driven by higher business inventories (not consumer consumption). Other primary concerns included: high unemployment; rising level of U.S. debt and debate on increasing the ceiling; poor consumer balance sheets; falling consumer confidence; uncertain regulatory environments and prospects for higher taxes; a lethargic housing market; and some signs of inflation. The quarter ended with investors’ asking a very big question - is the current economic slowdown a “soft patch” in the economic recovery (due to supply chain interruptions related to natural disasters and higher commodity prices) or will the aforementioned concerns, in aggregate, drag the economy into a “double dip recession”? The actual outcome of this question has huge implications. Many leading market pundits lean toward the “soft patch” argument, but there is a level of uncertainty. This uncertainty led to a “flight-to-quality” type behavior by investors resulting in bonds outpacing their riskier equity counterparts during the quarter. The broad domestic bond market, as measured by the Barclay’s Capital Aggregate Bond Index (“Aggregate Bond Index”), posted a quarterly return of 2.29%, compared to the U.S. stock market which generated a return of 0.10%, as measured by the S&P 500® Index. In a well diversified portfolio, bonds provided investors both return and risk benefits during the period.

The Fed met on several occasions during the period, and not surprisingly, left the target Fed Funds rate unchanged at 0 – 0.25%. Despite concerns over the U.S.’s economic condition, U.S. Treasuries served as a safe haven for investors looking for high quality securities. High demand for the securities caused U.S. Treasury yields to decline across the yield curve which proved bullish for the U.S. Treasury sector. The broad U.S. Treasury sector was the top performing sector within the Aggregate Bond Index, posting a quarterly return of 2.39%, with long-maturity U.S. Treasuries being the best performers at 3.36%. The quarter ended with the 10-year and 30-year U.S. Treasury yielding 3.16% and 4.37%, respectively.

Over recent periods, investors have sought riskier assets that trade at a spread (or “risk premium”) relative to U.S. Treasuries in an effort to gain incremental yield in the low rate environment. This trend reversed course during the second quarter. Spread sectors (such as mortgages and investment grade corporate bonds) within the Aggregate Bond Index posted positive quarterly returns, but marginally underperformed U.S. Treasuries despite their yield advantage, reflecting investors’ desire for safety over risk. The corporate bond sector produced a quarterly return of 2.28%, led generally by bonds within the utility and industrial industries. Mortgages, representing another large sector within the Aggregate Bond Index, posted a quarterly return of 2.28%. In general, spread sectors maintained their return advantage over U.S. Treasuries on a year-to-date basis.

Several bond sectors outside of the Aggregate Bond Index should be mentioned. U.S. TIPs posted a strong, positive return of 3.66% during the period. High yield bonds (defined as below investment grade corporate bonds) posted a quarterly return of 1.05%. The high yield bond sector underperformed investment grade corporate bonds, struggling comparatively due to investors’ risk aversion, pressure on the equity markets and too much new issuance supply. In the risk-averse environment, it is not surprising that credit quality mattered in high yield space as upper tier BB rated bonds outpaced lower rated, more speculative CCC rated bonds. Fundamentals within high yield generally were strong and default rates remained fairly benign. While lagging their investment grade counterparts, it should be noted that high yield bonds did outpace U.S. stocks during the period. Emerging market debt posted a quarterly return of 4.26%. The sector was positively influenced by stronger fundamentals and economic growth prospects relative to developed countries.

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All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.

GuideStone Funds shares are distributed by BNY Mellon Distributors Inc., a registered broker-dealer and underwriter of the funds, 760 Moore Road, King of Prussia, PA 19406. GuideStone Capital Management, a controlled affiliate of GuideStone Financial Resources, serves as the investment adviser to GuideStone Funds.