May came to a merciful end last week, as the Dow Jones Industrial Average had its biggest monthly decline in two years, retreating by 6 percent. While those returns are discomforting, the real pain was felt outside of our borders.

The MSCI EAFE, MSCI Emerging Markets and MSCI Europe indices were down (-12 percent), (-12 percent) and (-13 percent), respectively, for the month of May. As the dollar strengthened against most currencies, the currency headwind hindered U.S. dollar-based investors, and oil plummeted to less than $85/barrel.

And, in the fixed-income world, the 10-year Treasury bond yield plunged to record depths, clocking in at less than 1.50 percent. This places a high probability that investors who purchase those 10-year bonds today and hold them to maturity will lock in returns that will not keep pace with inflation.

What precipitated the pullback? The markets have a keen way of being forward-looking, sniffing out what is to come. In addition to the European unrest, what else might the markets have been sniffing?

In China, a recent Bloomberg survey estimated that GDP growth for the second quarter could register at 7.9 percent, with full-year 2012 growth forecast at 8.2 percent, representing the lowest annual economic growth rate for China since 1999. In the manufacturing arena, the data also soured as China’s May Purchasing Managers’ Index fell to 50.4. (any reading above 50 signals expansion).

Back at home, the U.S. government released revised first-quarter GDP figures, revealing that GDP expanded by an annualized pace of only 1.9 percent. The headline May employment report was very disappointing, as the unemployment rate inched up to 8.2 percent. Payrolls climbed by only 69,000, well short of expectations.

As the economic data has decelerated, the catcalls for governmental policy response continue to grow in volume. China has plenty of ammunition, and they have proven to be adept at stimulating both monetarily and fiscally in previous rough patches. Declining oil prices also remove one stimulus deterrent as inflation fears subside.

For the United States, the Federal Open Market Committee (FMOC) meets this month. With these recent data points being fresh, expect some strenuous debates about further monetary easing. On the fiscal front, all eyes continue to focus on November and the ramifications of the election results. Our policymakers must not (and we believe they will not) allow the current law to stand, resulting in massive tax increases across the board beginning in 2013. More on the looming tax issues in future writings.

For now, remember that “Investment Returns = Reality – Expectations.” If expectations rise, as they did in the first four months of the year, reality must rise higher in order to clear the hurdle to positive investment returns. As reality came in below those higher expectations, lower investment returns resulted.

Currently, the expectations are very low across the globe, moving the expectation hurdle back down. If reality (whether in the form of effective monetary/fiscal stimulus, Europe news, economic data, etc.) starts exceeding those expectations, aided by very compelling valuations as a tailwind, improved returns should follow.

Mark Sorgenfrei Jr. is vice president and investment analyst for Waddell & Associates Inc.