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Bond Fund —
In the fourth quarter, volatility fell and yields moved dramatically higher
4th Quarter, 2016
"In our baseline scenario, we anticipate that the economic expansion, now already in its eighth year, will become the third-longest in postwar history in March and stay alive during the remainder of 2017. "
– Pacific Investment Management Company LLC

Donald Trump stunned in winning the U.S. presidential election, but the market reaction was almost as surprising. Most markets focused on the pro-growth and inflationary potential of fiscal stimulus, as many risk assets rallied while inflation expectations and yields rose. During the fourth quarter of 2016, volatility fell, equities rallied, credit spreads tightened and the Dollar strengthened as investors anticipated expansionary fiscal policy, tax cuts, and deregulation. U.S. yields moved dramatically higher across the curve and sparked a broad sell-off in rates across most developed markets. Underpinning part of this move was an increase in inflation expectations. Inflation expectations also moved higher alongside rising oil prices, which were supported by news of an agreement to cut production by oil producers. Despite the generally positive risk sentiment, emerging markets weakened as protectionist rhetoric from the incoming Trump administration weighed on the asset class.
The Harbor Bond Fund returned -2.32% during the quarter, faring better than its benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, which returned -2.98%. Contributors to relative return included out-of-benchmark allocations to Treasury Inflation-Protected Securities (TIPS), high yield bonds and non-agency mortgage-backed securities. Detractors from relative performance included U.S. interest rate positioning and an underweight allocation to investment grade bonds.
PIMCO’s comments were made in a January, 2017 report. Highlights adapted from the report appear below. All comments relate to the quarter ended December 31, 2016, unless otherwise indicated. All references to the year-to-date are for the period January 1 through December 31, 2016.

Interview Highlights

Changes to Positioning
We have moderated our positioning at the front end of the U.S. yield curve given the move in front-end yields post-election and in the wake of the Fed’s more hawkish tilt. We remain overweight the intermediate part of the curve as we believe rates are likely to be range-bound in the near-term. We continue to maintain positions in TIPS as inflation expectations embedded in markets still remain low despite the recent move in breakevens. However, we harvested gains toward the end of the quarter, leading to a reduction in TIPS exposure.
We Anticipate Continued Economic Expansion
We anticipate that in 2017 real global growth will likely remain in the 2.5%–3.0% range that has held for the past five years. We believe headline inflation may pick up in developed market economies, while high inflation in emerging economies like Brazil and Russia is likely to ebb significantly. However, in light of significant political and policy uncertainty ahead, we recognize that both left- and right-tail risks have increased. In our baseline scenario, we believe that the economic expansion, now already in its eighth year, will become the third-longest in postwar history in March and stay alive during the remainder of 2017. We believe that three transitions will progress in a relatively orderly fashion: fiscal policy will become supportive, including a package in the U.S. that could take effect from October for fiscal year 2018; central banks will largely maintain their stimulus, thus limiting the rise in bond yields; and a full-blown trade war will be avoided. Consumer spending is likely to be supported by further declining unemployment, rising wages and expectations of personal income tax cuts. Headline CPI inflation should rise to converge with core inflation above 2%, and we believe the Federal Reserve could raise interest rates two or three times during 2017 (with risks to the upside).
International Outlook
For the eurozone, we believe growth could hover in a 1%– 1.5% range as political uncertainty remains elevated ahead of crucial elections in France, Germany, the Netherlands and, potentially, Italy. Headline inflation should rise above 1% in our view, but we believe that core inflation is unlikely to make much headway toward the European Central Bank’s objective of below but close to 2%. In the U.K., we believe growth could slow to 0.75%–1.5%, reflecting fairly robust momentum tempered by the ongoing uncertainty over Brexit. In Japan, we anticipate that fiscal stimulus and recent Yen weakening may propel GDP growth to 0.75%–1.25% in 2017 while inflation remains significantly below the 2% target.

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