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

Fear and greed are the emotions often used to describe the behavior of investors and the capital markets. The third quarter was driven by investors’ fear over ambiguity and lack of clarity in macroeconomic issues, both domestically and abroad, that elevated concerns over future economic growth and the increasing prospects for a double-dip recession. Domestically, investors’ confidence in policymakers was shaken by their inability to work together and extend the debt ceiling until the very last minute. Shortly afterwards, Standard & Poor’s, a nationally recognized debt rating agency, removed its triple-A rating from U.S. Treasuries, citing the U.S. government had not taken sufficient steps to improve its long-term fiscal position. Lastly, there was some realization that more long-term, permanent solutions related to the fiscal problems may not be addressed or implemented until after the November 2012 presidential elections. These public policy issues were coupled with the release of lackluster economic reports. Abroad, the concerns were even greater and have overshadowed the global economic landscape. No doubt the largest concern is Europe where there are major worries over a sovereign debt and financial crisis, including the potential default of Greek debt and the need to recapitalize major financial institutions. A well-defined, long-term plan to remedy the European issues would go a long way in calming the global capital markets. Any one of these macroeconomic factors, in isolation, would cause concern, but in aggregate, these factors proved to be somewhat overwhelming, leading investors to implement “risk off” trades (example: selling perceived riskier assets such as stocks or high yield bonds and purchasing less risky assets such as U.S. Treasuries). As a result, the performance dispersion among asset classes and even within the bond market was quite diverse during the third quarter. As evidence, bonds outpaced stocks by almost 18 percentage points 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 3.82%, compared to the U.S. stock market which generated a return of -13.87%, as measured by the S&P 500® Index. As one can see, bonds provided investors’ diversified portfolios both return and risk benefits during the period.

The Federal Reserve has used many “levers” to stimulate the domestic economy over recent years including accommodative monetary policies (historically low rates) and quantitative easing (“QE1” and “QE2”). With fewer and fewer options remaining, the Fed announced that it would maintain the Fed Funds target rate at 0% - 0.25% through mid-2013. Also, it introduced a new strategy termed “Operation Twist”, a plan to sell roughly $400 billion in short-term U.S. Treasuries and to purchase long-term U.S. Treasuries. The Fed’s objective is to keep longer-term rates low in an effort to stimulate the housing market and bank lending activity. The capital market’s initial reaction to Operation Twist appeared rather benign, but time will tell whether or not this program will have a positive impact.

Despite the Standard & Poor’s downgrade, investors sought U.S. Treasuries as a safe haven during the quarter. Fed action coupled with high demand by investors led to U.S. Treasury yields declining across the yield curve, which proved very bullish for the U.S. Treasury sector. This sector was by far the best performing sector within the Aggregate Bond Index, posting a quarterly return of 6.48%. More specifically, longer dated maturity government bonds, which are more sensitive to interest rate movements, performed much higher, as evidenced by the 30-year U.S. Treasury bond’s quarterly performance of 31.07%. The quarter ended at remarkably low levels with the 10-year and the 30-year U.S. Treasury yielding 1.92% and 2.91%, respectively.

Non-U.S. Treasury sectors such as corporate bonds, mortgages and asset-backed securities trade at a risk premium (or “spread”) over perceived “risk-free” U.S. Treasuries to compensate investors for the “additional” risk taken. During the third quarter, the risk premium (or spreads) generally widened, causing these sectors to underperform U.S. Treasuries. Investment grade corporate bonds (defined as a credit quality of triple BBB- or higher) posted a quarterly return of 2.85%, led by bonds within the utilities and industrials sectors. Not too surprisingly, the financial sector was the worst performing segment of the corporate bond market, generating negative returns for the period. Mortgage-backed securities posted a quarterly return of 2.36% while asset-backed securities generated a return of 2.42% for the same period. While the returns of these sectors were below U.S. Treasuries, they provided investors positive returns in a difficult market environment.

Most of the return dispersion within the bond market occurred in sectors outside of the Aggregate Bond Index. High yield corporate bonds (defined as below investment grade corporate bonds) generated a quarterly return of -6.06%. Given the flight-to-quality and “risk off” trade, spreads on high yield bonds widened dramatically leading to their worst performance period since the latter part of 2008. Although the performance period was difficult, many believe the fundamentals of many high yield issuers remain rather strong. Emerging market debt was another sector that experienced a difficult period, posting a quarterly return of -1.82%. This sector, like high yield, was hurt due to risk aversion, as well as concerns over moderating economic growth.

In conclusion, Warren Buffett has been quoted saying “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” In other words, fear can lead to market overreaction and produce attractive investment opportunities for the future. On a positive note, the balance sheets of both consumers and businesses have improved and there is evidence of moderate economic growth. Many market pundits are in the camp of “no recessions,” believing that the most likely scenario is that the economic recovery will be long and slow. If certain public policy and macroeconomic issues can become clear or come to favorable conclusions, there is a foundation for brighter days ahead.

You should carefully consider the investment objectives, risks, charges and expenses of GuideStone Funds before investing. For a copy of the prospectus with this and other information about the funds, please call 1-888-98-GUIDE (1-888-984-8433) or download a prospectus. You should read the prospectus carefully before investing.

S&P 500® is a trademark of The McGraw-Hill Companies and has been licensed for use by GuideStone Funds. The Equity Index Fund is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard & Poor’s makes no representation regarding the advisability of purchasing the Equity Index Fund.

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.