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Bond Fund —
Brexit pushes yields lower
2nd Quarter, 2016
"We expect the 'delicate handoff' from slowing job growth to higher wages to succeed as the main driver of income creation, supporting further gains in consumer spending. "
– Pacific Investment Management Company LLC

A relatively calm beginning to the second quarter of 2016 was disrupted by the unexpected Brexit result in the U.K.’s historic referendum, in which the British public voted to end the nation’s more than 40-year relationship with the E.U. The vote precipitated a sharp risk sell-off, as markets scrambled to price in the unanticipated outcome. While moves on the day were significant, many were not as outsized when put in the context of levels earlier in the year, and even earlier in June. Sovereign yields fell to new record lows, but many markets outside of those that are U.K.-linked recovered at least some of their initial declines.
The Harbor Bond Fund returned 2.16% during the quarter, slightly lower than its benchmark, the Barclays U.S. Aggregate Bond Index, which returned 2.21%. Detractors from relative performance in the quarter included a short position at the front of the U.K. yield curve, exposure to local rates in Mexico, security selection within investment grade bonds, and an allocation to Treasury Inflation-Protected Securities (TIPS), which were affected negatively by a fall in breakeven inflation rates. Contributors to relative return included a modest out-of-benchmark allocation to high yield bonds and out-of-benchmark holdings in non-agency mortgage-backed securities. U.S. interest rate strategies produced mixed results, with an underweight to the front end of the yield curve detracting as rates fell, but an overweight to longer maturities that performed well in the quarter more than offset that negative impact.
PIMCO’s comments were made in a July, 2016 report. Highlights adapted from the report appear below. All comments relate to the quarter ended June 30, 2016, unless otherwise indicated. All references to the year-to-date are for the period January 1 through June 30, 2016.

Interview Highlights

Economic Backdrop
Major central banks seemed to be in wait-and-see mode ahead of the Brexit referendum as the Fed, European Central Bank (ECB) and Bank of Japan (BOJ) all kept monetary policy steady. In the U.S., market expectations for the next Fed rate hike rose and fell dramatically through the quarter, as investors struggled to assess exactly which data points affected the Fed’s decision to raise rates. Expectations fell after the surprisingly weak employment report in June and again after the unexpected Brexit outcome; markets then priced out the next rate hike to 2018. In the eurozone, first quarter gross domestic product (GDP) growth was revised higher to the fastest rate in 12 months; however, inflation continued to remain far below its 2% target. In Japan, Prime Minister Shinzo Abe declared a second delay to his planned sales tax hike and expectations rose for additional fiscal and monetary support as the Yen strengthened 9.1% in the quarter and is now over 16% stronger for the year.
Changes to Positioning
In June we added Italian rate exposure. The Italian economy is undergoing a fragile recovery on the back of a weaker Euro, looser financial conditions and weaker oil prices. Recent political stability has aided structural reforms, which in our view should continue to raise the country’s competitiveness and productivity. We also reduced emerging market local rate exposure in Mexico during the quarter. We expect the Mexican central bank to hike rates parallel with the U.S. in response to normalization of the U.S. monetary policy. Lastly, given recent market moves, we have moderated the extent of our currency positioning. We continue to expect divergence between the Fed and other central banks, including the BOJ and ECB. While we believe this policy divergence will nudge the Dollar higher, we recognize the impact may be more limited given the extent of Dollar appreciation over the past 18 months.
Outlook: Risks and Opportunities
We expect that global economic and policy divergence will continue to provide a mix of risks, opportunities and volatility. Our 2016 forecasts for global growth and inflation remain low in light of weaker economic momentum as well as the tightening in financial conditions that occurred at the beginning of the year. Importantly, we do not expect a global or U.S. recession over the cyclical horizon. In the U.S., our expectation is for above-trend economic growth in a 1.75%–2.25% range in 2016. We expect the “delicate handoff” from slowing job growth to higher wages to succeed as the main driver of income creation, supporting further gains in consumer spending. Assuming steadier crude oil prices, headline inflation is likely to hover in the 1.0%–1.5% range before potentially rising to 2% by year end.

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