The most likely outcome for the global economy in 2008 continues to be a soft landing with some decoupling of growth across regions, and generally stable inflation. However, PIMCO believes that the risks to this benign forecast are being skewed increasingly to the downside as we continue to witness the importance of global financial market linkages to the U.S. and other economies. Self-feeding global risk aversion in the wake of the subprime predicament has resulted in less decoupling of growth from the U.S. than would otherwise have been the case.

On the positive side, it is now apparent that the Federal Reserve and other central banks, as well as fiscal policymakers in the U.S, understand the gravity of these risks and will respond to them. Even so, heightened risk aversion and the subprime-induced squeeze on credit have increased the probability of a U.S. recession. PIMCO anticipates a long and arduous unwinding of twin bubbles in property markets and assorted non-bank and off-balance sheet vehicles associated with subprime lending. The graph below, which depicts the recent acceleration in housing price declines in the U.S., is a reminder that the unwinding of the property bubble is well under way: 

The following are the key themes in PIMCO’s outlook:       

• U.S. Slowdown – The U.S. economy should likely slow down over the coming year as weakness in the property market spills over into the broader economy, especially employment at bank-dependent small businesses and larger companies with mainly domestic operations. Consumer spending, which has held up so far, is unlikely to retain its vigor. Over the next year the Federal Reserve could lower the Fed funds rate to 3 percent or lower. Some kind of fiscal relief for subprime borrowers is likely as well.
• Less Decoupling of Growth – Financial market linkages have been just as strong in Europe and the U.K., which have their own problems with an over-leveraged “shadow” banking system of off-balance sheet structures and conduits. Credit tightening in these regions is likely to make decoupling of their growth from the U.S. a less robust proposition. In Europe, retrenchment in hiring and investment by cash-strapped small companies, along with the bursting of the property bubble in southern Euroland, should be drags on growth. A housing downturn would crimp growth in the U.K., creating downside risks there similar to the U.S. We expect the Bank of England and the European Central Bank to respond to these circumstances by easing.
• Japan to Decelerate – The immediate reason is tighter zoning laws that are hurting construction but another burden will be weak consumer spending, which has not revived along with business investment. Conservative lending by Japanese banks is likely to cool growth in capital spending, at least among small businesses. This outlook means that the Bank of Japan is unlikely to raise Japan’s low interest rates for some time.
• Decoupling Still Valid in China – Chinese growth should remain strong with signs of a shift in investment toward the domestic economy and away from export-oriented sectors. China’s biggest challenge will be maintaining the undervalued Yuan, which fuels asset price bubbles that are difficult to control with monetary policy. PIMCO expects a steady revaluation of the Yuan over the next year.
• Other Emerging Markets – Emerging market financial conditions remain generally strong thanks to improving domestic fundamentals, large stores of currency reserves and positive terms of trade amid soaring commodity prices. To date, however, most emerging economies have not used their wealth to stimulate their domestic economies in any significant way. The result is that emerging countries are contributing less to global growth than they could be.

Protect Against Downside Risk With High Quality Focus
PIMCO plans to employ strategies that look to truncate downside investment risk. At the same time, we will seek to take advantage of opportunities created by the subprime-induced credit squeeze, especially among higher quality assets. The following is a summary
of these strategies:

• Interest Rate Strategies – With the U.S. economy slowing, it is unlikely that interest rates will move higher, so we will target above-index duration. Much of this overweight will come from exposure to the front end of the U.S. and U.K. yield curves, as we believe these central banks will have to cut short-term rates by more than the market now expects. PIMCO’s yield curve strategy will also seek to include exposure to short maturity interest rate swaps, which currently offer attractive yield premiums amid concerns about liquidity and credit quality in the banking system.
• Mortgages – High quality mortgage-backed bonds arranged by the major mortgage agencies represent some of the most compelling values in the fixed-income markets. PIMCO plans to overweight this sector to capture yield premiums well above historical averages.
• Credit – PIMCO will remain cautious in credit but look to opportunistically reduce our underweight in select issues. We plan to focus on higher-grade bonds, especially in the banking and finance sector where the credit crisis has helped produce attractive valuations.
• Currency – A slowing U.S. economy, relatively low U.S. short-term rates and the longer-term problem of a large trade deficit should continue to pressure the U.S. dollar. PIMCO plans to focus on a basket of Asian and emerging market currencies in an attempt to benefit from the softer dollar.
• Emerging Market Bonds – We plan to maintain holdings of emerging market bonds near current levels. The EM asset class has the potential to add significant value to portfolios over the long run. High quality credits such as Mexico, Russia and Brazil could see upgrades given large and growing currency reserves and strong fiscal positions.
• TIPS and Municipals – With real yields lower after the 2007 rally and break-even inflation levels relatively high, TIPS are not attractive from a tactical standpoint at present. Municipal bonds are a different story, as their yields are at historically high levels versus comparable Treasuries. We will look to add municipals to reap gains as these yield relationships revert back to more typical levels.

About PIMCO
PIMCO is one of the country’s leading investment management firms. Founded in 1971, PIMCO has grown under the direction of its founder and Chief Investment Officer, Bill Gross. Today PIMCO manages more than $746 billion in assets for clients ranging from central banks to multinational corporations to individual investors. The firm attributes its success to a philosophy, process and track record that have transcended more than three decades of economic change.
 
PIMCO assets under management are as of December 31, 2007.