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Real Return Fund —
Inflation-linked bonds lagged the overall fixed income market
2nd Quarter, 2017
"In the U.S., we believe GDP growth could reach 2%?2.5% in 2017 should business investment recover, particularly in the Energy sector. "
– Pacific Investment Management Company LLC

From key elections in France to political controversy in both the United States and Brazil, geopolitics dominated headlines during the second quarter of 2017 and contributed to brief periods of market volatility. Still, robust risk appetite continued, largely underpinned by a solid fundamental backdrop. Despite geopolitical uncertainty, volatility remained relatively low for the most part, equities rallied and credit spreads tightened. Emerging market assets broadly continued to strengthen despite falling oil prices (stemming from supply dynamics) and another U.S. Federal Reserve (Fed) rate hike.
The Harbor Real Return Fund posted a return of -0.32% in the second quarter, faring better than its benchmark, the Bloomberg Barclays U.S. TIPS Index benchmark, which returned -0.40%. The TIPS index underperformed the Bloomberg Barclays U.S. Aggregate Bond Index, a diversified benchmark of investment-grade bonds, which had a return of 1.45% for the quarter.
The Fund invests primarily in inflation-linked bonds issued by the U.S. and other governments. During the second quarter, an underweight to U.K. nominal duration contributed to relative returns, as expectations fell on weaker oil and the Bank of England’s downward revision of its inflation forecast in May. Also positive was the Fund’s modest out-of-benchmark allocation to non-agency mortgage-backed securities, which have been underpinned by a strong housing market. Conversely, the Fund’s U.S. interest rate strategies – notably, an underweight duration position maintained for most of the quarter – detracted from relative results as intermediate rates rallied.
PIMCO’s comments were made in a July, 2017 report. Highlights adapted from the report appear below. All comments relate to the quarter ended June 30, 2017, unless otherwise indicated. All references to the year-to-date are for the period January 1 through June 30, 2017.

Interview Highlights

Economic Backdrop
Financial conditions in the U.S. eased even as the Fed raised rates and unveiled details of its plan to gradually reduce its balance sheet. The Fed’s actions contributed to a flattening in the U.S. yield curve. On the back of falling oil prices, soft inflation data and waning prospects for fiscal stimulus, inflation expectations dropped to pre-U.S. election levels. Longer term U.S. yields also fell on the quarter. Global central bankers struck a less accommodative tone: rhetoric from the European Central Bank, the Bank of England and the Bank of Canada highlighted positive economic outlooks and suggested the potential for a reduction in easy monetary policy. In turn, most developed market yields rose higher even as those in the U.S. (outside the front end) fell.
Change in Duration Positioning
Our investment process and outlook focuses on longer term (three to five year) trends and secular considerations as political factors and structural changes in the domestic and international economy exert powerful, sustained influences on interest rates. Thus, a secular outlook updated annually determines a general maturity/duration range for the portfolio in relation to the market. Short-term, cyclical economic considerations determine shifts within this range. We moved to a modestly overweight duration position overall at quarter end.
We Believe the Economic Expansion Could Continue
We believe the eight-year-old global economic expansion could strengthen and broaden for the remainder of 2017. We maintain our view from last quarter that global Gross Domestic Product (GDP) growth could reach the 2.75%–3.25% range this year, up from 2.6% in 2016, while consumer price index (CPI) inflation could reach 2.0%–2.5%. Our outlook reflects several factors that we consider encouraging, including generally supportive fiscal policies (or expectations of them) in most developed market economies and improved consumer and business confidence data. In the U.S., we believe GDP growth could reach 2%–2.5% in 2017 should business investment recover, particularly in the Energy sector. Our forecast anticipates that core inflation could hover sideways this year at 1.75%–2.25%, owing to some softer trends of late. With policy normalization underway, we expect the Fed to embark on reducing its balance sheet by gradually tapering its reinvestments in a predictable and transparent manner.

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