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International Small Cap Fund —
Fourth Quarter Manager Commentary
4th Quarter, 2018
"Our outlook has been adjusted to increase our caution with regard to profit growth and profit margin developments in 2019. "

Economic Overview
During the fourth quarter of 2018, international equity market performance reflected a widespread deterioration in business confidence survey indicators, which resulted in clear downgrades to economic growth forecasts and challenged previous assumptions that 2018 would be a year of continued acceleration in global growth. Various concerns that had afflicted equity markets earlier in the year—including fears of a slowdown in Chinese economic growth and consumer spending, concerns that the U.S. Federal Reserve’s interest rate policy had become too aggressive, uncertainty about the impact and extent of the U.S.-China tariff disputes, and dissatisfaction with developments in European and Australian politics—began to have an impact on short-term economic indicators across a wide range of countries and had a more pronounced effect on confidence in future economic conditions.
These influences combined to negatively affect a wide range of asset classes, with perceived "safe haven" assets tending to perform better than those assets seen as sensitive to economic growth and more risky. Accordingly, U.S. bond yields fell, while the U.S. Dollar remained strong relative to the Euro and British Pound Sterling during the quarter. Despite declining inflation forecasts, the price of gold rose, while prices for other commodities, particularly oil, fell. The Japanese Yen experienced a strong rebound relative to the U.S. Dollar at the end of the quarter. During the quarter, equity markets worldwide performed poorly, with notable weakness in countries and sectors seen as more sensitive to global trade growth. Companies and sectors with "growth" characteristics, however, also fell back, on both profit-taking and more cautious views of their long-term growth potential.
Portfolio Review
In the fourth quarter of 2018, the Harbor International Small Cap Fund (Institutional Class) returned -17.57%, underperforming its benchmark, the MSCI EAFE Small Cap (ND) Index, which returned -16.05%.
By region, the U.K. and Japan detracted from relative performance, due to stock selection. Among the Fund’s holdings in the U.K., there were some sharp price declines for some Industrials and Energy holdings, despite the export-oriented characteristics of the companies. By sector, underweight exposure to Real Estate detracted from relative results, as did stock selection in the sector. The Fund’s sector weights are derived from the individual company investment decisions made for the Fund, not from top-down asset allocation decisions. Real Estate proved resilient during the quarter, supported by declines in government bond yields, despite apparently full valuations relative to net asset values.
Individual detractors from the Fund’s performance during the quarter included TGS-NOPEC Geophysical Company, a Norwegian provider of seismic data to the oil and gas industry. TGS published a financial update for the third quarter of 2018 that revealed a revenue figure that was slightly below market expectations, with further detail provided with the publication of financial results in November. The combination of disappointing financial results and weakness in the price of oil, which is considered a predictor of future customer demand, led to share price weakness during the quarter. Despite weaker-than-anticipated financial performance in the third quarter, TGS could deliver strong profit growth over 2018 as a whole, in our view.
Senior plc, a U.K.-listed manufacturer of aerospace components, also hindered relative results. Weakness in Senior’s share price in October was largely related to the significant declines experienced in global stock markets during the month; however, toward the end of November, the shares were further pressured following the release of a trading update. The update stated that trading had been in line with market expectations, but that there would be higher-than-expected investment required to expand production facilities following recently awarded new contracts. The increase in costs, ahead of revenue generation from the new contracts, led to a downgrade in profit forecasts and a corresponding negative share price reaction.
Conversely, contributors to performance included Marshalls plc, a U.K. supplier of stone and landscaping products to the construction industry. We established the Fund’s investment in Marshalls in October, following the completion of our analysis into the company’s business model. In December, the company announced that recent trading had been strong and that management expected profit to exceed existing expectations. This positive update highlighted the benefit of the company’s investment in research and development, which has expanded the company’s product range and addressed customers’ requirements from changes in legislation.
Costa Group Holding Ltd., an Australia-based horticulture company that grows a variety of fruits and vegetables, was also a top contributor. The company’s shares were supported during the quarter by two announcements by the company in November. The first contained details of a complementary acquisition, which was forecast to be accretive to future profits, while the second disclosed that profit growth was expected to be around 26% in 2018.
We have continued to follow our investment approach: quality growth at a reasonable price. During the quarter, the most noteworthy changes to the Fund’s sector exposures included reduced exposure to Industrials, counterbalanced by increased exposures to Materials and Financials. These changes were driven by stock selection decisions.
Outlook
Our outlook for international smaller companies is dependent on our confidence in the sustainability of our profit growth forecasts for the companies in the asset class. Given the continued uncertainty surrounding many of the macro-level drivers of the world economy, we believe equity market volatility is likely to remain at the more elevated levels that prevailed last year, rather than at subdued levels, as was the case in 2017. As a result of the share price declines of the fourth quarter of 2018, however, in a context of limited downward revisions to profit growth forecasts, the valuations of many of the companies held in the Fund have become more attractive to us. Furthermore, while business confidence fell back during the fourth quarter, survey readings have remained consistent with environments of continued economic growth, not recession.
Our outlook, therefore, has been adjusted to increase our caution with regard to profit growth and profit margin developments in 2019. While raw materials price pressures have declined somewhat, end demand across several sectors has moderated, and labor cost pressures have continued to present challenges. In addition, corporate investment plans appear to have moderated. Should profit growth remain relatively resilient, however, we believe valuation levels present opportunities.

Performance data shown represents past performance, which is no guarantee of future results. Current performance may be higher or lower than the past performance data shown. Investment returns and the value of an investment will fluctuate, and an investor's shares, when sold, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end (available within seven business days after the most recent month-end) by calling 800-422-1050 or visiting harborfunds.com.

Performance figures discussed reflect that of the institutional class shares.

The views expressed herein are those of the portfolio manager at the time of the interview and may not be reflective of their current opinions or future actions.  These views are not necessarily those of the fund company and should not be construed as such.

This information should not be considered as a recommendation to purchase or sell a particular security and the holdings or sectors mentioned may change at any time and may not represent current or future investments.