Download the PIMCO 1Q07 Market Outlook in PDF format.

The most likely outcome for the global economy in 2007 is slower growth with modest disinflation. Growth in Europe and Asia will be less reliant on U.S. demand than in the recent past. Each of these major economic regions is likely to grow at an annual rate of about 2 percent. The slowdown in the U.S. will be triggered by weakness in the property market that will spill over into consumption. The predominant risk to PIMCO's forecast is that the downturn in the U.S. economy will be worse than we anticipate because of a more severe contraction in housing.

Housing Recession to Hit Employment, Consumption

While job destruction in the housing sector has been muted, changes in construction employment tend to lag more forward looking indicators such as housing starts and permits. Thus, job losses and pressure on consumer spending can be expected to kick in only after existing pipelines of housing starts have been completed. PIMCO believes that the magnitude and pace of these job losses will build throughout 2007, dampening consumption and resulting in slower economic growth overall.

• Fed Easing Cycle Will Likely Begin-The decline in the U.S. housing and auto sectors will generate weakness on a broader level in 2007, causing the Federal Reserve to begin easing in the first half of the year. Once the Fed starts easing, it will be more difficult for the European Central Bank and the Bank of Japan to raise their own rates.

• European Growth Now Self-Sustaining-Drivers of growth in Europe will be sturdy business confidence and robust capital spending, especially in Germany, where companies continue to make productivity-enhancing investments. The potential for increases in European consumption remain limited, however. Labor has little pricing power in Europe in the face of East European immigration and the threat of outsourcing. Germany's imposition of a Value Added Tax in early 2007 could further crimp consumption.

• China to Lead Asian Growth-China's investment boom continues and will act as a growth multiplier throughout the region. This is especially true for Japan, a huge and growing exporter of capital goods to China. As long as China sustains its growth, the rest of the region will absorb the impact of a slower U.S. economy with little hardship.

• Emerging Markets Resilient as Global Growth Cools-Emerging economies should feel the impact of decelerating U.S. growth but these effects will be far less severe than in the past. Improvement in their economic fundamentals, including more flexible exchange rates and abundant currency reserves, will likely cushion the slowdown.

• Inflation Contained Worldwide-Inflation is likely to remain well contained globally and could even subside a bit. Slower growth, combined with competition from lower cost labor in developing economies, should help contain wage pressures. The decline in commodity prices that began in mid-2006 should also have a positive effect.

Focus on Select Strategies That Can Offer Highest Potential Reward Relative to Risk
In an environment where risk is masked by low volatility and risk premiums are near historical lows, PIMCO plans to focus on select strategies that offer the highest potential reward relative to the potential risks incurred. These strategies include:

• Duration-We plan to target duration above the index in an effort to capture gains from falling rates as the U.S. economy weakens. In addition to the U.S., PIMCO likely will take exposure to European interest rates, which reflect more and faster central bank tightening than we believe is likely to occur once the Fed begins easing.

• Yield Curve-PIMCO believes that global yield curves will steepen as slower growth unfolds and markets begin to anticipate future central bank easing. We will emphasize short maturity positions in the U.S. and the U.K. in an effort to benefit from these trends.

• Credit-Compression of risk premiums is especially apparent in corporate bonds as investors have crowded into this asset class in recent years in search of higher yields. PIMCO plans to retain its underweight to corporates as a slowing economy raises the risk that credit spreads will widen from historically low levels.

• Currency-PIMCO expects the U.S. dollar to continue to weaken. Over a cyclical time frame, interest rate differentials that now favor the U.S. should narrow as the Fed begins easing. Over a longer time frame, a weaker dollar will be needed to help reverse the massive U.S. trade deficit. PIMCO plans to take positions in the yen, the euro, the Chinese renminbi and other emerging market currencies to take advantage of dollar weakness.

• Mortgage Overweight-Mortgages remain attractive as a potential source of high quality yield for portfolios, especially when compared with corporate bonds and other riskier assets. There is modest potential for price gains in mortgages because of lower supply and demand from central banks looking to diversify their fixed income holdings. PIMCO will also seek gains from mortgage security selection.

Additional Strategies
PIMCO sees additional pockets of value beyond the major strategies noted above. While TIPS valuations are not especially compelling, we plan to maintain relatively small positions of longer maturity TIPS. These issues may benefit from demand from corporations looking to redress the asset/liability mismatch in their pension plans. Municipal bonds are also less attractive from a valuation standpoint now that their yields have moved closer to historical levels when compared to Treasury yields. Nevertheless, since the long end of the municipal yield curve is relatively steep, there is still some advantage in holding munis in an effort to enhance the income of the portfolio.

High yield and emerging market credits are relatively unattractive overall as their credit premiums have been driven to near-historic lows amid a flood of global liquidity. PIMCO plans to hold modest levels of these bonds when we can gain from security selection. Select shorter maturity high yield bonds are one example, as are holdings of Brazil, Russia and Mexico.