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Real Return Fund —
Solid gains for inflation-linked bonds
2nd Quarter, 2016
"We expect that global economic and policy divergence will continue to provide a mix of risks, opportunities and volatility. "
– Pacific Investment Management Company LLC

Within the inflation-linked bond (ILB) markets, after seeing a meaningful recovery from February’s multi-year lows, U.S. breakeven inflation levels moved lower across the curve on the back of global growth fears and lower than expected inflation measures. Most global ILB markets posted strong gains for the second quarter of 2016, supported by the sharp rally in global rates, while inflation expectations ended lower across most regions. The Barclays U.S. TIPS Index posted a positive return of 1.71% for the quarter, trailing the Barclays U.S. Aggregate Bond Index, a diversified benchmark of investment grade bonds, which gained 2.21%. The Harbor Real Return Fund advanced 1.85% in the quarter, outpacing its TIPS benchmark.
The Fund invests primarily in inflation-linked bonds issued by the U.S. and other governments. During the quarter, tactical holdings of intermediate- to long-end Mexican ILBs contributed to relative performance, posting strong returns as Mexican real rates rallied across the curve. A modest allocation to non-agency mortgage-backed securities also added relative value, as that segment performed well despite macroeconomic uncertainty as spreads tightened and prices rose. The Fund’s U.S. interest rates strategy—maintaining a neutral duration overall with an underweight to nominal rates in favor of real rates—detracted as global yields rallied and U.S. breakeven inflation rates fell.
PIMCO’s comments were made in an 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.
Investment Themes
We are looking to maintain a neutral duration in the portfolio, as we expect global rates to remain broadly range-bound in the near-term, although markets may be mispricing future Fed tightening. We expect to maintain our overweight to U.S. breakeven inflation as embedded inflation expectations appear too low relative to both history and the Fed’s current target. As of quarter end, the Fund continued to hold select global ILBs, favoring countries with attractive breakeven pricing and higher real yields, such as Italy and Mexico. The Fund also remained overweight U.S. Dollar exposure, specifically through a long Dollar bias relative to both the Euro and the Renminbi.
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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