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Real Return Fund —
Fourth Quarter Manager Commentary
1st Quarter, 2019
"Fund performance benefited from our long U.S. position versus U.K. and eurozone breakeven inflation (BEI) expectations, given what we believe are still attractive valuations in the U.S. and richness in U.K. and European markets. "

Economic Overview
Following the steep sell-off in December 2018, risk assets bounced back in the first quarter of 2019 as dovish pivots from global central banks helped ease financial conditions and optimism over U.S.-China trade negotiations bolstered investor sentiment. Robust appetites reverberated across most risk assets – global equities surged higher, developed market yields fell, credit spreads tightened, and oil prices climbed – although not all retracted to the previous quarter’s declines.
Even as risk sentiment improved, fundamental data continued to indicate a slowdown in global growth. The eurozone saw downside surprises in growth metrics as external demand weakened, driven in part by the persistent slowdown in China, which in turn spurred stimulus measures from Chinese policymakers. Economic data in the U.S. was mixed, particularly due to the temporary government shutdown, but labor and housing markets remained broadly robust.
Global central banks signaled more accommodative stances as evidence grew of a deceleration in global economies. The U.S. Federal Reserve established a “patient” approach to monetary policy, lowering both growth expectations and its rate hike outlook for 2019. Other central banks likewise struck more cautionary tones, further contributing to the broad-based rally in both risk assets and sovereign yields.
Geopolitical developments were mixed: headlines highlighted continued political uncertainty surrounding Brexit, but also progress on a potential U.S.-China trade deal, although a full agreement remained elusive.
Portfolio Review
In the first quarter of 2019, the Harbor Real Return Fund (Institutional Class) returned 3.52%, outperforming its benchmark, the Bloomberg Barclays U.S. TIPS Index, which returned 3.19%.
Fund performance benefited from our long U.S. position versus U.K. and eurozone breakeven inflation (BEI) expectations, given what we believe are still attractive valuations in the U.S. and richness in U.K. and European markets. U.S. inflation expectations rebounded sharply from fourth quarter 2018 weakness in concert with the rally in oil prices and improved risk sentiment.
The Fund also benefited from allocations in U.S. agency and non-agency mortgage-backed securities and emerging markets foreign exchange. Select holdings in residential mortgage-backed securities contributed to performance. We remain tactical in foreign exchange with an emphasis on select emerging markets currencies that offer attractive valuations and diversifying risk exposures.
The Fund’s overall underweight duration position detracted from performance due to a synchronized move lower in global interest rates. We maintain an underweight position overall, primarily sourced in developed market countries with rich valuations such as the U.K., Japan, and select European countries.
We decreased our overall duration underweight position in the first quarter. We adopted a “butterfly” strategy on the U.K. yield curve in which we are underweight 15-to-20-year real yields versus five- and 30-year yields due to rich valuations caused by persistent U.K. pension fund demand.
We believe world Gross Domestic Product (GDP) growth will slow to 2.5% to 3% this year from 3.3% in 2018. However, with China increasing stimulus and a trade deal between the U.S. and China in the making, we believe there is a good chance that global growth will stabilize or even pick up moderately later this year. Inflation globally is likely to fall to 1.5% to 2% from 2.2% in 2018 due to continued below-target inflation in the U.S., Europe and Japan.
In the U.S., we continue to anticipate growth slowing to 2% to 2.5% in 2019 from nearly 3% last year. Factors contributing to the deceleration are likely to include fading fiscal stimulus, the lagging effect of tighter monetary policy over the past few years, and headwinds from the China-global slowdown. In our view, China’s easing is not likely to filter through to U.S. growth until late 2019 or early 2020. Headline inflation looks set to drop to 1.5% to 2% this year, we believe, while core inflation holds steady. With growth slowing and inflation remaining below target, the Fed is likely to keep rates unchanged in 2019, we believe.
For the eurozone, growth is likely to slow to a trend-like pace of 0.75% to 1.25% in 2019 from close to 2% in 2018, as weak global trade exerts significant downward pressure on the economy. An improvement in global trade conditions through this year may contribute to a gradual reacceleration, we believe. Reflecting firmer wage growth, we anticipate a moderate pickup in core inflation, which has been stuck at 1% for some time. In line with the European Central Bank’s (ECB) forward guidance, we believe policy rates are likely to remain unchanged this year.
In the U.K., we anticipate real growth in the range of 1% to 1.5% in 2019, modestly below trend. In our view, a chaotic no-deal Brexit is a low-probability event. In the event of a soft Brexit by midyear, a rate hike by the Bank of England in the second half of the year would appear likely.
Japan’s GDP growth is likely to be modest at 0.5% to 1% in 2019, broadly unchanged from 0.7% in 2018. With core inflation likely to dip into negative territory (due to temporary factors) around the middle of the year, the Bank of Japan is likely to keep its targets for short rates and the 10-year yield unchanged this year, in our view.
In China, growth is likely to slow in 2019 to the middle of a 5.5% to 6.5% range from 6.6% in 2018, we believe, stabilizing in the second half of the year as fiscal and monetary stimulus find some traction and a likely trade deal between the U.S. and China supports confidence.

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