"We continue to focus on sector/security selection within investment grade credit and look to add opportunistically amid market dislocations."- Pacific Investment Management Company LLC
Market in Review
Against an increasingly mixed geopolitical landscape and a backdrop of continued softening in global growth momentum, risk assets generally withstood bouts of market volatility while sovereign yields declined. Geopolitical developments garnered headlines and drove market volatility. Chief among these was the U.S.-China trade war, as tensions peaked during the quarter with more tit-for-tat tariff action and the U.S. Treasury formally labeling China as a “currency manipulator.” Outside of trade, political instability rose around the world: protests escalated in Hong Kong, unexpected electoral outcomes occurred in Argentina, and a formal impeachment inquiry following a whistleblower’s complaint against President Trump materialized in the U.S. Tensions in the Middle East also flared following attacks on Saudi oil facilities.
Financial markets moved in tandem with geopolitical uncertainty throughout the third quarter of 2019, particularly in August when escalating trade tensions precipitated a steep sell-off in risk assets and a surge in demand for sovereign bonds. However, investor fears subsided towards the end of the quarter, which led to some reprieve in markets: global equities ended the quarter higher, credit spreads were about flat, and sovereign yields ended lower. Central banks maintained more accommodative policy stances as growth and geopolitical concerns lingered. In the U.S., the Federal Reserve (Fed) lowered its policy rate twice as expected – ending a three-year hiking cycle that began in 2015 – though language from Fed Chair Jerome Powell and an updated “dot-plot” revealed a divided stance on the future path for rates. In Europe, the European Central Bank delivered a modest rate cut and announced that a quantitative easing program would restart later this year.
Global economic data was mixed, although the overall trend was weaker. The slowdown in global trade, which drove continued manufacturing weakness, was also reflected in broader economic measures, including corporate profitability and labor market momentum.
In the third quarter of 2019, the Harbor Bond Fund (Institutional Class) returned 2.30%, outperforming its benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, which returned 2.27%.
The Fund benefited from exposure to Italian duration and an overweight to U.S. duration, as U.S. and Italian yields fell during the quarter. Security selection within the investment grade credit sector, including a focus on Financials, also contributed. Short exposure to Japanese, U.K., and Australian rates detracted from performance as yields in these countries fell during the quarter. Out of benchmark exposure to U.S. Treasury Inflation-Protected Securities (TIPS) also detracted from performance as these securities underperformed their nominal counterparts during the quarter.
The Fund was roughly neutral headline duration but has favored U.S. duration against rate exposure in other developed regions, including in the U.K. and Japan. Although U.S. yields have fallen, we believe U.S. duration is still attractive. Meanwhile, positioning in Japan serves as a cheap hedge. To the extent rates rise, we would expect international rates to move at least as much, if not more, than those in the U.S. Overall, our duration positioning was negative for performance.
We have more diversified credit exposures in sectors beyond investment grade corporates and are more focused on sector/security selection over generic beta exposure. We believe valuations warrant a more defensive stance (i.e., higher quality, shorter maturity). We continue to favor Financials as well as mortgage credit. Overall credit sector positioning was positive for performance.
Out of benchmark allocations, particularly an allocation to U.S. TIPS, were a net negative for the quarter. An increase to our U.S. TIPS allocation given low breakeven rates detracted from performance. Although it was a detractor, we continue to allocate to the U.S. TIPS sector as we believe it is compelling as a source of potential outperformance, as well as a hedge against upside surprises in inflation, which we believe could occur given the Fed’s bias toward allowing inflation to overshoot its target.
Contributors and Detractors
During the third quarter, our duration positioning and credit strategies were the largest contributors to performance. While rates have fallen, U.S. duration is still attractive, we believe, given the material downside risks (e.g., growth slowdown, trade tensions, etc.), and the potential for capital appreciation (i.e., U.S. rates have more room to fall) in adverse market environments. We continue to focus on sector/security selection within investment grade credit and look to add opportunistically amid market dislocations.
Although it was the largest detractor in the account, we remain allocated to U.S. TIPS as we believe they are compelling as a potential source of outperformance, as well as a hedge against upside surprises in inflation, which could occur given the Fed’s bias toward allowing inflation to overshoot its target.
Buys and Sells
The Fund increased overall duration, as we believe U.S. duration is still attractive given material downside risks (e.g., growth slowdown, trade tensions, etc.), and the potential for capital appreciation (i.e., U.S. rates have more room to fall) in adverse market environments.
In the U.S., we continue to believe growth could slow to 1.25% to 1.75% in 2020 from a peak of 3.2% in the second quarter of 2018. We anticipate that slower global growth and elevated trade tensions could depress investment and export growth, while slower business output and lower profit growth could slow labor markets, weighing on consumption. In our view, core inflation is likely to firm somewhat to the 2.25% to 2.75% range due to the recent tariffs on Chinese goods, although it is likely to moderate in latter 2020. We believe the Fed may support growth by cutting rates further over the next few quarters. On the global front, we believe the eurozone could see the continuation of a 1% growth, 1% inflation economy. In the U.K., we think it’s possible that real growth could be in the range of 0.75% to 1.25% in 2020, modestly below trend. We anticipate an orderly Brexit, either through an amended withdrawal agreement or a relatively orderly no-deal exit. However, we anticipate headwinds from weak global trade, Brexit-related uncertainty, and possible disturbances in the event of a no-deal exit weighing on growth. Japan’s Gross Domestic Product (GDP) growth is likely, in our view, to slow to a 0.25% to 0.75% range in 2020 from an estimated 1.1% this year. In China, we anticipate growth slowing in 2020 to a 5.0% to 6.0% range from an estimated 6.1% in 2019 due to the trade conflict, rising unemployment, weakening consumption, and sluggish business investment. In our view, fiscal stimulus of around 1% of GDP may be possible, likely front-loaded in the first quarter of 2020.
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.