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Diversified International All Cap Fund —
Fourth Quarter Manager Commentary
1st Quarter, 2019
"We believe the recent uptick in market volatility and increased prospects for future equity market retrenchment would likely be a more favorable backdrop given the Fund's positioning and characteristics profile. "

Economic Overview
Following many central bank efforts to "normalize" monetary policy by raising rates in the latter part of 2018, the U.S. Federal Reserve (the Fed) became more dovish, and it more or less committed to no further interest rate hikes during the first quarter of 2019, as did the European Central Bank. Trade negotiations between the U.S. and China seemingly moved closer to culmination, given that enforcement issues appear to have largely been addressed and U.S. tariff hikes on China have been suspended; however, sticking points in the negotiations clearly still remain. Additionally, after an initial delay, the deadline for Britain’s exit from the European Union (Brexit) was deferred (again) to October 31, 2019, which has ruled out the imminent possibility of a hard, or "no deal," Brexit. Collectively, these developments seem to have eased market sentiment and resulted in global equity markets rallying sharply and reversing course from the tail end of last year. The MSCI All Country World Index achieved a 12.18% return (in U.S. Dollar terms) during the first quarter of 2019, versus a -13.33% return during the fourth quarter of 2018. Emerging markets also rallied off of the fourth-quarter 2018 retrenchment, though they generally lagged broader index returns. Certain markets (such as those of Turkey and Qatar) remained negative or fairly flat during the quarter amid continued macroeconomic and/or geopolitical concerns.
Portfolio Review
In the first quarter of 2019, the Harbor Diversified International All Cap Fund (Institutional Class) returned 10.54%, outperforming its benchmark, the MSCI All Country World ex U.S. Index, which returned 10.31%.
During the quarter, stock selection and currency exposure benefited relative performance and offset a negative allocation effect. The Fund’s currency allocation is a residual of the individual stock decisions, as we do not actively manage the Fund’s currency exposure. Security selection in the emerging markets region contributed to relative results, particularly within South Africa, Taiwan, and Greece. Within Europe, relative performance benefited from stock selection in Denmark and Sweden, as well as overweight exposure to the rising British Pound Sterling. Conversely, stock selection within Hong Kong detracted from relative performance during the quarter. Underweight exposure in China and security selection within Canada also hindered relative results, as did the Fund’s residual cash exposure. The Fund’s sector and country weightings are a residual outcome of the bottom-up stock selection process.
From a sector perspective, stock selection in Health Care and Information Technology contributed to relative performance. In contrast, security selection in Consumer Discretionary weighed on relative results.
Individual contributors to relative performance included Brazilian information technology firm TOTVS, which reported strong organic growth of its software revenue, as well as significant improvements to its financial position in 2018. Greek property developer Grivalia Properties was another notable contributor after it received a €780m purchase offer from Greece’s third-largest lender, Eurobank, during the period. The world’s largest platinum producer, Anglo American Platinum, also benefited relative results, as it saw its profits rise significantly amid elevated commodity prices.
One of the largest negative influences on relative performance came from not owning shares of Chinese technology giant Alibaba Group Holding. The company reported earnings for its fiscal third quarter that beat expectations, despite the negative effects from a slowing Chinese economy. A position in Hong Kong-based conglomerate Jardine Matheson weighed on relative returns, as it reported a drop in annual profits and warned about challenging conditions for 2019. Another significant detractor was tour operator group TUI, which issued a profit warning caused by a heatwave in Northern Europe, the grounding of the Boeing 737 MAX aircraft, and a difficult outlook. In addition, the company’s full-year earnings forecast was reduced by 25%.
In Japan, a position in JAFCO was initiated during the quarter. The company is Japan’s only listed venture capital firm. With a price-to-earnings ratio of 11, half its market capitalization in equity, and cash on the balance sheet, we believe it presents an inviting investment case. The company also has multiple investments within its own funds, aligning its interests with those of long-term shareholders. The position in investment holding company GL Limited, based in Singapore, was sold over the period for valuation reasons.
The largest sector overweights entering 2019 were Industrials and Consumer Discretionary. The largest underweights were Financials and Energy. The largest country overweights at the beginning of the quarter were the U.K. and Denmark, while the largest underweights were China and France. These relative weightings did not materially change during the quarter.
The inherently contrarian nature of our investment approach has made it challenging (but not impossible!) to keep pace during what has been a fairly broad-based (and indiscriminate) ongoing rally across equity markets for several years. However, we believe the recent uptick in market volatility and increased prospects for future equity market retrenchment may be a more favorable backdrop given the Fund’s positioning and characteristics profile.
Bearing in mind that our skill set and focus are on bottom-up, fundamental analysis and stock selection (and anchored on a time horizon that looks beyond shorter term macroeconomic and geopolitical headlines of the day), the market environment during the quarter did not alter our outlook. Market participants (broadly speaking) may have somehow convinced themselves that all is well (and central banks may have, in fact, bowed to political pressures); however, at current levels, these markets are still subject to downside risks and uncertainties in the short-term relating to the aforementioned Brexit and U.S. trade tensions with both China and now the European Union. Further, monetary policy normalization must have its day at some point. Debt levels have ballooned. Thus, while we are taking advantage of price dislocations and establishing new, often more cyclical, positions where we believe relative valuations present an opportunity to do so, the Fund’s portfolio in aggregate remains focused on downside protection with a quality tilt from a characteristics standpoint.
In Europe, despite the broad-based recovery in the markets in the first quarter, we believe there are still pockets of good value to be found. There remain, however, significant uncertainties relating to Brexit and U.S. trade tensions. The earnings season produced better-than-expected results, and a significant number of our meetings with managements after results were overall cautiously positive.
Japan is widely seen as only able to join the macroeconomic party once policy elsewhere has worked, kicking off a round of growing external demand as domestic demand has remained demographically constrained. Despite unemployment of 2.3% amid record participation rates, and with chronic shortages of labor beginning to materially impact corporate behavior, this perception is deep-rooted and underlines how entrenched the belief is that Japan can never work. Against this macroeconomic backdrop, foreigners remained heavy net sellers, while the market was still heavily influenced by passive buying from the Bank of Japan. (The passive share of new flows is now over 60%, versus 40% in the U.S. and 30% in European markets). Given the current macroeconomic trends, governance has increasingly come to the fore, and we believe wide-ranging (and in some cases, we hope, quite dramatic) initiatives could be announced at upcoming annual general meetings, with a clear focus on shareholder returns, corporate structures, and balance sheet efficiency. We believe the likelihood of the current policy stance (i.e., of tight fiscal policy and excessively loose monetary policy that is totally contrary to the route we believe the rest of the world is starting to take) continuing indefinitely is low. Indeed, discussions are building over the desirability of raising the sales tax, while the Bank of Japan is under growing pressure to explain its rationale for sticking to a policy that we believe clearly is not working.
We believe emerging markets present an attractive opportunity set over the medium-term, as investors continue to recalibrate growth expectations, pull capital from those markets as a result, and, in turn, force managers operating businesses in those markets to allocate capital more efficiently. Despite a combination of factors weighing heavily on emerging markets last year, we believe underlying company financials remain attractive. However, slowing economic growth continues to be a risk to investors, particularly in China. The developed Asian markets are highly influenced and reliant on China for growth. With a slowdown in the Chinese economy, higher oil prices, and sustained trade tensions between the U.S. and China, the outlook for the region has deteriorated, in our view. However, we believe the drops in valuations seen in 2018 have also led to promising investment opportunities among select Asian exporters, as well as more domestically focused companies.
Canada’s economy is closely allied to the U.S. and is exhibiting a slowdown currently, which the country’s central bank hopes will be temporary. We believe the more commodity-related areas of the economy could receive a boost from an improvement in oil prices. In addition, the price discount between Western Canadian Select crude oil and West Texas Intermediate crude oil, which had widened significantly last year, has now narrowed once again. We believe the construction of new pipelines over the next couple of years will be important to sustain this trend, however, as mandated production cuts from Alberta caused the discount to narrow. The main long-term problem for Canada, in our view, is household debt, which is the highest among the Group of Seven countries relative to Gross Domestic Product. This situation has led to household credit exhibiting the slowest growth since 1983, a factor we believe is unlikely to help economic growth. The best we can hope for is probably a gradual deleveraging by households and adjustment of housing prices to more affordable levels over time. Our investments are focused in global businesses that happen to be located in Canada, rather than businesses that are dependent on domestic credit growth.

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