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Diversified International All Cap Fund —
Fourth Quarter Manager Commentary
4th Quarter, 2018
"In Europe, the significant decline in markets during the quarter left valuations looking more attractive than they have for some time. "

Economic Overview
The ongoing trade dispute between the U.S. and China; central bank efforts to normalize monetary policy, either through interest rate increases or balance sheet reductions; evidence of European economic weakness; and the latest twists in the Brexit saga remained the key macro-level events disturbing markets during the fourth quarter of 2018. In addition, a significant drop in oil prices during the quarter caused a number of oil price-sensitive stocks to fall. Energy was the worst performing sector during the quarter, followed by Information Technology. Despite significant declines earlier in the year, emerging markets overall performed better than other markets, and Brazil and Indonesia led returns.
Portfolio Review
During the fourth quarter of 2018, the Harbor Diversified International All Cap Fund returned -11.82%, underperforming its benchmark, the MSCI All Country World Ex U.S. (ND) Index, which returned -11.46%.
Much of the Fund’s underperformance came from Europe, where equity markets were pushed lower by a range of factors, including the heightened global trade dispute between the U.S. and China, the ongoing Brexit saga and general fears of a global growth slowdown combined with higher interest rates in the U.S. In particular, the U.K. and Italy detracted from relative results, due to stock selection. Conversely, stock selection in several emerging markets, including Brazil, contributed to relative performance. Elsewhere, security selection in Japan benefited relative results, as the Fund’s more defensive and domestic-oriented Japanese holdings held up better than many export-oriented Japanese companies, which suffered from the heightened trade tensions noted above. Stock selection in Canada also supported relative performance, as did the Fund’s residual cash position.
Top individual detractors for the quarter included Germany-based kidney dialysis company Fresenius Medical Care. The company’s shares declined during the quarter following two profit warnings related to unexpectedly high costs in the U.S. market, as well as much higher investment. Italian energy equipment and services company Saipem also hindered relative performance. Its shares fell due to the effect of sharply weakening oil prices and a set of third quarter results that missed consensus expectations.
In contrast, top contributors included Brazil-based personal products company Natura Cosmeticos. The company benefited from newly announced growth plans and a long-term margin target of 12%. Wind turbine manufacturer Vestas Wind Systems, based in Denmark, also aided performance. The company had double-digit revenue growth in the third quarter of 2018.
We added a couple of European positions to the Fund during the fourth quarter, including DS Smith, a U.K.-listed packaging manufacturer. The company is benefiting from industry consolidation and the significant growth in packaging required for the e-commerce world in particular. The position in U.K. transportation services company Stagecoach Group was sold. We believe that the company is unlikely to deliver much value going forward through its strategy, and political risks remain, given its exposure to the U.K.’s semi-regulated transportation infrastructure.
In Europe, the significant decline in markets during the quarter left valuations looking more attractive than they have for some time, with the forward price-to-earnings multiple for the U.K. market at its lowest level in five years, while Continental European markets were at a low double-digit multiple with an attractive yield. These valuations, of course, reflected a more uncertain outlook due to the ongoing Brexit-related risks, concerns over potential downturns in the U.S. and China, and the ongoing trade dispute between the U.S. and China.
In Japan, the equity market fell to near record-low valuation levels, and we believe the key issue is what investors will focus on as longer term return drivers, once current turbulence has died down. In our view, the global macro environment is likely to remain challenging in many areas although there are opportunities to focus on positive developments in domestic governance. Such developments are already visible in terms of the nature of the relationship between management and shareholders, and shifts in management objectives toward wealth creation (driven by the necessity of breaking the lifetime labor "pact" as Japan’s demographics structurally ratchet up the need to allocate labor effectively). We believe the changes could unlock value that lies in corporate Japan’s balance sheets, company structures and industry structures.
We believe slowing economic growth in emerging markets is an opportunity for the management of companies to reassess their capital allocation policies and, more broadly, the market structures in which they operate. Improvements in profitability and cash generation in those companies that comprehend this shift can more than make up for slowing economic growth. As always, emerging markets investors should continue to be disciplined with regard to valuation.
Developed Asian markets remain highly influenced by Australia and Hong Kong, particularly the banking, insurance, and real estate areas within these markets. Australian financials, dominated by the big four Australian banks, make up about 30% of the MSCI Australia Index. We do not currently own any of the Australian banks, primarily due to valuations, increasingly onerous capital commitments,thanks and heavy reliance on residential mortgages.
In Canada, five interest rate increases since the middle of 2017 are starting to exert their toll on consumers, who are more indebted than their U.S. counterparts. This effect has already shown in the housing market, where transactions and prices in Toronto fell during 2018. In Vancouver, transactions declined the most since 2000. Light vehicle sales in Canada showed their first annual drop in 2018 since the last recession. Although the country’s unemployment rate remained low and the economy was operating close to capacity, inflation was close to the central bank’s target, and it continued to walk a tightrope given the potential effects on consumers. We believe that the Fund’s defensive positioning was the correct strategy in 2018 and that it remained valid entering 2019, but lower equity prices create more long-term investment opportunities and potential to shift investment into other areas of the capital cycle.

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