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Real Return Fund —
Fourth Quarter Manager Commentary
4th Quarter, 2018
"We maintain a preference for U.S. real rate exposure versus other developed markets given what we believe are still attractive valuations in the U.S. and rich valuations in U.K. and European markets. "

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 Real Return Fund (Institutional Class) returned -1.04%, underperforming its benchmark, the Bloomberg Barclays U.S. TIPS Index, which returned -0.42%.
The Fund’s performance in the fourth quarter was negatively impacted by our overall underweight duration position in interest rates, which was primarily held in developed market countries with rich valuations, such as the U.K. and Japan. While the Fund benefited from its overweight to U.S. nominal rates – which rallied during the quarter – this was more than offset by short rate exposure in Japan and the U.K. as rates in both regions fell during the quarter.
Conversely, Fund performance benefited from our long position in U.S. real rates versus the U.K. and eurozone. We maintain a preference for U.S. real rate exposure versus other developed markets given what we believe are still attractive valuations in the U.S. and rich valuations in U.K. and European markets. This benefit was partially offset by our U.S. breakeven inflation positioning.
The Fund received a positive contribution from our position in U.S. agency and non-agency mortgage-backed securities. Relative performance also benefited from our exposure to select Latin American currencies, including the Argentine Peso. We remain tactical in foreign exchange, with an emphasis on select emerging markets currencies that offer attractive valuations and diversifying risk exposures.
As regards portfolio positioning, in the fourth quarter we increased our overall duration underweight position and increased our overweight position in real interest rates.
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 global inflation 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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