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Bond Fund —
Fourth Quarter Manager Commentary
4th Quarter, 2018
"We maintain a preference for U.S. duration against rate exposure in other developed regions, including the U.K. and Japan. "

Economic Overview
The coordinated efforts of global central banks to normalize monetary policy continued to be a focus for fixed income markets in 2018. Overall, markets were more challenged in light of continued reduction in global central bank accommodation and myriad geopolitical events, with volatility rising well above recent averages. In the U.S., expectations for higher inflation, increased Treasury debt supply and more Federal Reserve (Fed) interest rate hikes all contributed to higher interest rates.
In the fourth quarter of 2018, most risk assets experienced challenging performance as volatility rose. Concerns about slowing economic growth, along with several other sources of uncertainty, contributed to a sell-off in global equity markets while credit spreads widened and developed market yields fell. Meanwhile, central banks remained on course for diminished monetary support as the fundamental backdrop remained positive. The Fed raised interest rates again, although it lowered its expectations for further rate increases in 2019, while the European Central Bank (ECB) reiterated its intention to end its quantitative easing program.
Portfolio Review
In the fourth quarter of 2018, the Harbor Bond Fund (Institutional Class) returned 1.16%, underperforming the Fund’s benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, which returned 1.64%.
The Fund’s short rate position in select non-U.S. developed markets, including Japan, the U.K. and several European markets, detracted from the Fund’s performance relative to the benchmark. We believe interest rates in those markets are likely to face increased upward pressure as their central banks shifted towards reducing accommodation. We also believe our positioning may serve as an efficient hedge against global rates drifting higher, particularly in Japan. However, rates in Italy, the U.K. and Japan fell during the fourth quarter.
The Fund’s modest allocation to U.S. high yield credit also detracted from relative performance as the sector underperformed U.S. Treasury securities of similar duration. Likewise, the Fund’s position in U.S. mortgage-backed securities detracted from performance as both agency and non-agency MBS underperformed similar-duration Treasuries.
Conversely, the Fund benefited from its overweight position to U.S. duration, with a focus on intermediate rates and an underweight to the long end of the curve. We maintain a preference for U.S. duration against rate exposure in other developed regions, including the U.K. and Japan. An overweight position to intermediate maturities contributed to Fund performance as rates fell across the yield curve, offsetting detractions from an underweight position in longer term maturities. We believe the intermediate portion of the yield curve continues to offer attractive characteristics, while longer term rates may rise as the Fed continues to reduce accommodation and term premiums return.
The Fund also received a positive contribution from its modest allocation in local emerging markets, particularly in Latin America. We believe in holding local duration in select countries, such as Brazil, that offer attractive valuations while providing additional yield and diversification.
The Fund also benefited from its underweight position in U.S. investment grade corporate bonds as spreads widened during the quarter. We remain underweight this sector in favor of more diversified credit exposures elsewhere. However, we would look to add opportunistically again amid market dislocations as we do not anticipate any imminent downturn in the business cycle.
In our view, world Gross Domestic Product (GDP) growth is likely to slow somewhat but remain above trend at 2.75% to 3.25% in 2019. With tighter global financial conditions, increased political and economic uncertainties, and U.S. fiscal stimulus starting to fade in 2019, we think the economic divergence of 2018 – the U.S. accelerating and other regions slowing – could give way to a more synchronized deceleration, with the U.S., the eurozone and China all seeing lower growth. We believe inflation globally could fall to a range of 1.75% to 2.25%, from about 2.3% in 2018, due to the recent plunge in oil prices and continued below-target inflation in the U.S., Europe and Japan.
In the U.S., after an expansion of close to 3% in 2018, we look for growth to slow to a below-consensus 2.0% to 2.5% range in 2019. Our opinion reflects the recent tightening of financial conditions, fading fiscal stimulus and slower growth in China and elsewhere. Growth momentum, we believe, is likely to moderate during the year, converging to trend growth of just below 2% in the second half. We anticipate that headline inflation could drop sharply over the next several months, reflecting base effects and the recent plunge in oil prices, with core inflation to hold steady at about 2%. In our view, one or two more increases in the federal funds rate by year end 2019 seems possible, with a high chance of the Fed pausing or even ending the rate-rising cycle in the first half of the year.
For the eurozone, we believe growth could slow to a below-consensus 1.0% to 1.5% in 2019 from close to 2% in 2018. With the ECB announcing the end of net asset purchases, we anticipate one rate increase in the second half of 2019. However, if the Fed pauses and the Euro appreciates versus the U.S. Dollar, we believe the ECB may leave rates unchanged until 2020.
In China, our view is that growth might slow in 2019 to the middle of a 5.5% to 6.5% range that reflects large uncertainties caused by trade tensions with the U.S., domestic pressure to deleverage, and an economic policy with partially conflicting targets (i.e., growth and unemployment versus financial stability).

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