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Real Return Fund —
Yields moved higher, sparking a sell-off
4th Quarter, 2016
"The fundamental backdrop appeared healthy as many economies rebounded from a sluggish first half of 2016. "
– 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 Bloomberg Barclays U.S. TIPS Index posted a negative return of -2.41% for the fourth quarter of 2016, faring better than the Bloomberg Barclays U.S. Aggregate Bond Index, a diversified benchmark of investment-grade bonds, which had a return of -2.98%. The Harbor Real Return Fund posted a return of -2.17% for the quarter, holding up better than its TIPS benchmark.
The Fund invests primarily in inflation-linked bonds issued by the U.S. and other governments. During the quarter, the Fund’s interest rates strategy, with an underweight to nominal rates in favor of real rates, contributed to relative return as U.S. rates drifted higher. An out-of-index allocation to non-agency mortgage-backed securities also boosted relative return. The Fund’s global relative value strategies detracted from relative return due to continued weakness in the Pound.
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

Central Bank Moves
Central banks appeared to decelerate the extent of policy accommodation. The Fed raised rates for just the second time in a decade—a move that was widely anticipated—but with a hawkish tilt, as indications of further rate hikes in 2017 increased. Meanwhile, the ECB announced an extension to its quantitative easing program, but at a tapered rate. The Bank of Japan held to its new framework of yield curve targeting. The fundamental backdrop appeared healthy as many economies rebounded from a sluggish first half of 2016. This noted improvement supported a positive risk sentiment apparent through much of the fourth quarter, despite rising geopolitical tensions.
We remained overweight to U.S. breakevens, given that inflation expectations remain below levels that we feel are justified based on what we see as strong core inflation dynamics. Within TIPS, we remain tactical in terms of curve positioning based on relative value and roll-down opportunities. We also look to seek out relative value opportunities across countries and curve structures as well as between real and nominal rates.
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, could become the third-longest in postwar history in March and stay alive during the remainder of 2017. We believe that three transitions could 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. We believe that headline CPI inflation could rise to converge with core inflation above 2%, and that the Federal Reserve could raise interest rates two or three times during 2017 (with risks to the upside).

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