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Real Return Fund —
Risk assets perform well despite geopolitical tensions and increased volatility
3rd Quarter, 2018
"We anticipate that three more increases in the federal funds rate could happen by the end of 2019. "
– Pacific Investment Management Company LLC

Geopolitical developments – including escalating U.S.–China trade tensions, NAFTA negotiations, Brexit developments, Italian budget concerns, and turmoil in certain emerging market countries such as Turkey and Argentina – dominated news headlines and contributed to bouts of volatility in the third quarter of 2018. At the same time, several developed market central banks shifted toward reduced monetary accommodation. Nevertheless, risk assets performed well in the quarter. In particular, U.S. equities experienced gains as strong growth momentum helped to fuel positive investor sentiment.
The Harbor Real Return Fund posted a return of -0.78% in the third quarter, outperforming the -0.82% return of its benchmark, the Bloomberg Barclays U.S. TIPS Index. The TIPS index underperformed the Bloomberg Barclays U.S. Aggregate Bond Index, a diversified benchmark of investment-grade bonds, which had a return of 0.02%. The Fund invests primarily in inflation-linked bonds issued by the U.S. and other governments. The Fund’s overall underweight duration position, primarily focused on developed market countries with rich valuations, such as the U.K. and Japan, contributed to relative performance as interest rates in developed markets generally moved higher in the third quarter, fueled by a continued move towards policy normalization by major central banks. The Fund’s long position in the U.S. versus the U.K. and the eurozone detracted from performance as U.S. breakeven inflation remained restrained amid oil price volatility and mixed inflation data, while U.K. inflation came in higher than expected.
PIMCO’s comments were made in an October, 2018 report. Highlights adapted from the report appear below. All comments relate to the quarter ended September 30, 2018, unless otherwise indicated. All references to the year-to-date are for the period January 1 through September 30, 2018.

Interview Highlights

Higher Interest Rates Shape Our Strategy
We moved to a modestly overweight position in U.S. nominal rates, reflecting our view that the Federal Reserve (Fed) may be further along in unwinding its stimulative monetary policy compared to central banks in other developed markets, particularly Japan, the eurozone and the U.K. We also increased the portfolio’s position in short U.K. real yields.
We Anticipate a Synchronized Deceleration of Growth
We believe world economic growth could slow somewhat in 2019 but remain above-trend at 2.75% to 3.25%. With tighter global financial conditions, increased political and economic uncertainties, and U.S. fiscal stimulus starting to fade in 2019, we believe the economic divergence of 2018 – with the U.S. accelerating and other regions slowing – could give way to a more synchronized deceleration, with the U.S., eurozone and China all seeing lower growth next year compared to 2018. In the U.S., following an expansion of about 3% in 2018, we believe growth could slow to a below-consensus 2.0% to 2.5% range in 2019. This anticipated drop reflects our view that we will likely see less support from fiscal stimulus, the ongoing removal of monetary accommodation, a stronger U.S. Dollar and a less favorable trade and external environment. With economic growth still above potential, however, we believe the U.S. unemployment rate could decline further. We believe inflation could peak at around 2.5% in response to tariff increases before moderating somewhat. We anticipate that three more increases in the federal funds rate could happen by the end of 2019.
International Outlook
For the eurozone, we believe growth could decline to a range of 1.5% to 2.0% over the next year, down significantly from 2.5% in 2017 but still above potential. In our view, the European Central Bank could end its net asset purchases by the end of 2018, with a first interest rate increase more likely to happen than not in the second half of 2019. In the U.K., we believe real growth could accelerate to an above-consensus range of 1.5% to 2.0% in the next year based on our belief that Brexit negotiations could progress, avoiding a hard Brexit. This could help domestic demand in 2019. In our view, Japan’s Gross Domestic Product is likely to remain steady at 1.0% to 1.5% in 2019, supported by a tight labor market and accommodative fiscal stance. While we don’t believe the Bank of Japan will raise interest rates, we anticipate further tapering of bond purchases and further steepening of the yield curve. In China, we believe 2019 growth will land roughly in the middle of a 5.5% to 6.5% range, reflecting large uncertainties caused by trade tensions with the U.S. and an economic policy with partially conflicting targets.

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