Market Sector Update

• Government bonds were mixed over the second quarter, with German bunds and Canadian government bonds underperforming U.S. treasuries and European peripherals. The quarter began with strong treasuries due to the unwinding of the “Trump reflation” trades and talk around the potential Federal Reserve (Fed) balance sheet adjustment by the end of the year and ended with the expected U.S. Fed rate hike, the second in 2017. In Europe, the European Central Bank (ECB) left policy rates unchanged, indicating that any change would be reliant on sustained positive economic data.
• Over the quarter, improving economic data in Europe led to changes in the ECB’s policy guidance towards a more balanced growth assessment. Following the French elections which brought in a pro- European Union (EU) government, French and Spanish government bonds outperformed German bunds. Similarly, Italian government bonds strongly outperformed a rising bund market as the Italian elections were effectively pushed back to 2018, as the revamp of electoral legislation failed to pass and an agreement was reached to liquidate Banca Popolare Vincenza and Veneto Banca.
• At quarter end, government bonds in developed markets were under pressure following hawkish ECB, Bank of England and Bank of Canada comments, implying a round of coordinated central bank policy tightening. In the UK, Prime Minister Theresa May surprised the markets and her electorate by calling for early elections; however, this move backfired, resulting in the Conservative party losing its majority and needing to find a coalition partner in the Democratic Unionist Party from Northern Ireland. With UK inflation below target and Brexit jitters remaining, Bank of England kept rates steady.
• Developed market credit performed well in all major sectors. The sustained low yield environment, positive but moderate growth, solid earnings releases, expected business-friendly policies from the U.S. administration and continued injections of liquidity by the main Central Banks, were supportive of credit markets. European high beta sectors like subordinated financials and high yield outperformed other credit sectors supported by the French election results. Europe’s issuers also benefitted from Europe’s Single Resolution Board smooth execution of its first resolution with the acquisition of Spain’s Banco Popular by larger rival Santander and the liquidation of Banca Popolare Vincenza and Veneto Banca in Italy.
• The U.S. dollar was weak over the quarter on disappointment over the lack of real policy changes, despite the U.S. administration’s push to meet campaign promises within the first 100 days of the Trump presidency, and a second Fed rate hike. Focus ended up mainly on the euro, which was strong following the French debate early April and marketfriendly outcome of the Macron election. The euro also performed strongly among the majors as Eurozone economic data was stronger. This positive sentiment carried over to other European currencies. Similarly, oil currencies suffered over the quarter, with oil prices dropping due to historically high crude stockpiles levels, as well as increasing production out of Libya.

Portfolio Strategy

• The portfolio outperformed its cash benchmark. Our spread positions were the largest contributor to performance, with strong performance from emerging market hard currency, sub-financials and U.S. corporates. Rates positioning in the U.S. also contributed positively to performance. In currencies, performance was slightly negative, given our short EM FX exposure vs. U.S. dollar.
• We have reduced duration over the quarter, both in the U.S. and in Europe. With the new U.S. administration discussing ultra-long treasury issuance, we reduced U.S. long duration by shifting some long-dated U.S. treasuries to the front end, but still retained a long U.S. duration bias. We also reduced our short duration in Europe by reducing our underweight in Germany as yields rose. In credit, we continue to pare back risk in certain sectors, such as subordinate financials in France and corporate hybrids in Europe. In currencies, we reduced our short euro and Japanese yen, as well as our long U.S. dollar.

Outlook

• The outstanding feature of this first half of 2017 is that most financial markets performed well despite increasingly hawkish rhetoric from the main central banks in the developed world. With economic growth numbers fairly robust but rolling over and inflation continuing to fall, central bank focus has moved towards financial conditions. Similar to Alan Greenspan when he made his “irrational exuberance” remarks in 1996, Yanet Yellen recently described asset valuations as “somewhat rich.” Also similar to the end of the 1990’s, inflation is well below the Fed’s symmetric 2% target. It seems that the Fed is targeting asset prices—not inflation—now that the U.S. economy has reached full employment.
• Many market participants point to the divergence between the Fed’s rate forecasts and what is currently priced by the market and say that it is the market that is wrong. We believe there might be some room for further hikes but tend to agree with current market pricing. In the end, if the Fed hikes because of financial conditions, longer duration Treasuries should be well supported as riskier assets sell-off.
• We have reduced our duration given the strong performance of the rates market in the first part of the year and we have reduced our credit spread positions where valuations are starting to look stretched. But our main scenario for the remainder of 2017 remains one of moderate growth and subdued inflation which should be supportive of fixed income assets. The risk in our view is that economy rolls over and the Fed ends up not hiking rates at all.

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, 2017, 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.

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. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. 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, especially securities with longer maturities. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher rated bonds. The Fund may seek to manage exposure to various foreign currencies, which may involve additional risks. The value of securities, as measured in U.S. dollars, may be unfavorably affected by changes in foreign currency exchange rates or exchange control regulations. Investing in foreign securities involves a number of risks that may not be associated with the U.S. markets and that could affect the Fund's performance unfavorably, such as greater price volatility; comparatively weak supervision and regulation of securities exchanges, fluctuation in foreign currency exchange rates and related conversion costs, adverse foreign tax consequences, or different and/or less stringent financial reporting standards. Mortgage-backed and asset-backed securities in which the Fund may invest are subject to prepayment risk and extension risk. The Fund employs investment management techniques that differ from those often used by traditional bond funds, including a targeted return strategy, and may not always perform in line with the performance of the bond markets. The Fund is also non-diversified and may hold fewer securities than other funds and a decline in the value of these holdings would cause the Fund's overall value to decline to a greater degree than a more diversified fund. The Fund expects to use derivatives in pursuing its investment objective. The use of derivatives presents several risks including the risk that fluctuation in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative's value is derived. Moreover, some derivatives are more sensitive to interest rate changes and market fluctuations than others, and the risk of loss may be greater than if the derivative technique(s) had not been used. These and other risks are more fully described in the Fund's prospectus. Diversification does not guarantee a profit or protect against loss in a declining market. It is a method to manage risk.

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