Market Sector Update

• The second quarter saw a continuation in the risk-on environment from the first quarter, however the period was marked by a moderate sell-off in risk assets in May as trade tensions resurfaced.
• Despite the risk-on environment, U.S. Treasuries continued to rally. This was due to the anticipation of the Federal Reserve (Fed) cutting its benchmark interest rate, as well as falling interest rates across the globe. The market was pricing in a greater than 60% chance of one or more 25 basis points (bps) rate cuts by year end at the end of the first quarter. That has shifted to the market pricing in a nearly 60% chance of three or more cuts of 25 bps by year end.
• The macroeconomic data, as well as the expectations for Fed easing, caused the 2-year yield to decline 51 bps to 1.75% and the 10-year yield to decline 40 bps to 2%. The spread between the 10-year U.S. Treasury note and the 3- month U.S. Treasury bill, which last quarter turned negative for the first time since 2007, remains negative or inverted. Historically, an inverted yield curve has implied a forthcoming recession, but the time lag can be significant. Another yield curve measure, the spread between the 10-year U.S. Treasury Note and the 2-year U.S. Treasury Note steepened from 14 bps to 25 bps in the quarter, a small indicator that the Fed will rekindle growth expectations with rate cuts.
• After a significant rise of over 7% in the first quarter, high yield returned a more modest 2.5% as Treasury rates fell and the spread on the index fell from 391 bps to 377 bps. Leveraged loans returned 1.58%, continuing to lag behind high yield as loans don’t benefit from falling Treasury yields, and the asset class saw outflows in the quarter.
• Overall fundamentals for the investment grade universe continue to weaken, especially as the expansion is in its 11th year. The growth in revenues and earnings before interest, tax, depreciation and amortization (EBITDA) (excluding commodity sectors) were up 3.2% and 2.6% in the first quarter of 2019, a deceleration versus 4.5% and 4.3% in the fourth quarter of 2018, respectively.
• Investment grade issuance was $291 billion in the quarter, down 14% year over year. Issuance, net of maturities, was up 14% year over year, however net supply growth for the first half of the year remained down 9% versus the first half of 2018. Merger and acquisition (M&A) related funding has declined this year to $106 billion in the first half of 2019 versus $143 billion in first half 2018. BBB issuance is 40% of year-to-date supply, down slightly from 43% of full-year supply in 2018.

Portfolio Strategy

• The Fund had a positive return, but underperformed its benchmark, the Bloomberg Barclays U.S. Credit Index. The benchmark returned approximately 4%, which was driven primarily by falling rates as well as the benchmark’s spread tightening from 113 bps to 109 bps.
• The Fund further reduced its duration relative to the benchmark, but the difference remains modest. Benchmark duration rose 0.2 year to 7.4 years at quarter-end. Higher duration means higher price volatility for a given change in spreads.
• Overall risk positioning in the Fundremained relatively constant in the quarter with no material changes to exposures to the various ratings categories.
• The largest changes in sector positioning were increases in the communications and technology sectors and decreases in the financial and consumer cyclical sectors.

Outlook

• The second half of the year has two large factors that likely drive asset performance – Fed policy and trade policy. While the end of the second quarter saw a commitment by the U.S. to hold off on additional tariffs with China while talks resume, we did see an increase in tariff rates to 25% from 10% on $200 billion of imports into the U.S. from China as well as other trade frictions, most notably being restrictions on Huawei. This has already begun to and will continue to weigh on global growth. More importantly, the uncertainty over the trade relationship between the U.S. and China may dampen confidence and investment going forward.
• The Fed has indicated they are likely to ease, but the pace of easing will have a material impact on asset prices. The market is pricing in a nearly 60% chance of three or more cuts by year end, a pace which we believe to be slightly too aggressive although we do anticipate the Fed easing. We believe macroeconomic data will continue to show a softening trend and will likely fall short of expectations in the second half due to trade policy uncertainty, Brexit and geopolitical concerns.
• We believe credit spreads should widen for the second half of 2019 due to a few factors. First, macroeconomic data points are likely to underwhelm relative to consensus. Secondly, fundamentals in investment grade remain stretched with corporate balance sheets at their most levered levels post-crisis. Lastly, duration in investment grade marketplace continues to rise.
• The technical backdrop for spreads remains relatively positive. We believe net supply should be materially lower than last year due to smaller M&A volume and tax changes reducing the incentive to issue debt. However, we expect a higher amount of total fixed income issuance principally from U.S. deficit funding. On the demand side, we see the trends modestly supportive of spreads. Mutual fund flows remain robust and are likely to continue in the near future, but overall yields in the market have compressed, which may reduce demand.
• Given our expectation for modest widening of spreads in 2019, we believe our conservative positioning relative to the benchmark is appropriate. We will be opportunistic in our credit selection and overall positioning to take advantage of the opportunities and dislocations as they present themselves.

The opinions expressed are those of the Fund's managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 30, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The Bloomberg Barclays U.S. Credit Index measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related bond markets, including a non-corporate component of non- U.S. agencies, sovereigns, supranationals and local authorities. It is not possible to invest directly in an index.

Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. These and other risks are more fully described in the Portfolio's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.