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Commodity Real Return Strategy Fund —
Fourth quarter sees rise in oil prices and inflation expectations
4th Quarter, 2016
"Our baseline forecast for 2017 calls for real global growth to remain in the 2.5% to 3.0% range that has held for the past five years. "
– 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 Commodity Index Total Return SM posted a return of 2.66% for the quarter. The Bloomberg Commodity Index is an unmanaged index of futures contracts on a diversified group of physical commodities.
The Harbor Commodity Real Return Strategy Fund advanced for the quarter but underperformed its benchmark, returning 2.42%. The Fund invests in commodity-linked derivative instruments backed by a portfolio of inflation-indexed bonds, such as U.S. Treasury Inflation-Protected Securities and other fixed income securities. Underperformance relative to the benchmark was driven in part by a strategy of shorting soybeans versus corn, as recent adverse weather in South America has been supportive of soybean prices. The portfolio’s longstanding “platinum versus gold” strategy detracted from relative returns as well, as gold outperformed platinum as the principal flight-to-safety metal. A strategy based on European refinery margins rolling up to more normal levels aided relative results, as stronger propane demand and growth in ethane inventories have supported propane relative to ethane.
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

Investment Themes
In agriculture, we remained positioned long ethanol versus corn. This positioning is based on our belief that deferred ethanol margins are currently inexpensive, and that solid demand for gasoline combined with plentiful corn inventories should be supportive of stronger margins as they roll up to prompt months. We are short soybean versus corn, due to our view that the ratio of deferred soybean to corn prices is on the higher end of the historical range, which should incentivize more soybean planting next summer and reduce soybean prices relative to corn. In addition, we continued to maintain our long positioning on platinum relative to gold. Platinum generally trades at a premium to gold given that platinum has a smaller supply, higher production cost and dual uses. Platinum is at a rare discount largely due to emerging market weakness and gold’s safe-asset bid, which we expect will correct over time.
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 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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