PIMCO’s base case for the global economy is a soft landing with modest inflation. This forecast implies continued slow growth in the U.S. with only mild contagion effects from a slower U.S. on Europe, Asia and emerging markets. Risks to the forecast remain asymmetrically tilted toward the downside, given the potential for weakness in the U.S. housing sector to have a more drastic impact on consumption than anticipated.

• Subprime Mortgage Collapse to Dampen Risk Appetites—Tighter lending standards for the least creditworthy borrowers in a weakening property market have the potential to heighten risk aversion throughout the economy at a time when investors in riskier asset classes are already uneasy. Besides prompting a wideningof risk premiums in financial markets, such anxiety is likely to hurt consumer confidence and job creation, which is why PIMCO is most concerned about downside risks to the economy.  The graph on page 2 suggests that the ability of subprime borrowers to obtain financing has been substantially diminished as the percentage of banks tightening mortgage lending standards jumped in the first quarter.
• Fed Likely to Ease Later in 2007—The Federal Reserve is likely to hold back on easing until unemployment moves higher and until its preferred inflation indicator, the core PCE deflator, approaches the top end of its desired 1-2 percent range. PIMCO believes that over the next several months consumers should begin to feel the pinch of weakness in the housing market, providing the Fed with justification for beginning an easing cycle in the second half of 2007.  
• Investment Spending Sustains Europe, Japan —A robust corporate sector in Europe and Japan should help offset tepid consumer demand. Low-wage competition from the east has given European corporations a bargaining edge over labor, generating cash flow for productivity-enhancing investments. In Japan, a lull in investment activity during the long bout with deflation has set the stage for increased capital spending.   

• Modest Deceleration in China’s Growth—China’s leadership understands that rapid growth, while critical for job creation, has created a maldistribution of investment spending and rising income inequality. The latest Five-Year Plan for China’s command economy calls for a better balance between consumption and investment and will likely be achieved with a mix of restrictive administrative tools.
• Emerging Economies Cushioned From U.S. Downturn—While the picture in emerging economies is not uniformly positive, in general their improved economic fundamentals will cushion any adverse impact from a weaker U.S. These include: stronger financial institutions, more flexible exchange rates, and huge stocks of selfinsurance supplied by abundant currency reserves. 

Take Advantage of Risk Aversion, Yield Curve Steepening 

PIMCO will position portfolios to take advantage of long anticipated trends in financial markets that now appear to be coming to fruition. Two such trends are an expected widening of risk premiums and likely Fed easing later in the year. The following is a summary of PIMCO’s key strategies: 

• Duration—PIMCO plans to maintain duration above the benchmark as we expect interest rates, especially on the shorter end of the yield curve, to fall in the face of relatively weak economic growth.
• Yield Curve—PIMCO’s curve position will likely continue to emphasize shorter maturities that should gain as the market begins to anticipate sustained Fed easing. We will look to diversify this position with exposure to the U.K., Europe and Japan as well, where yields on short maturities are not likely to rise as much as markets expect.
• Tactically Position Mortgages, Underweight Corporates—It will be critical to protect capital in case historically low levels of volatility spike upward and/or risk premiums widen. While mortgages will likely remain an important source of high quality yield in portfolios, we will target more neutral allocations versus the index, relying on tactical positioning and security selection to attempt to add value.  PIMCO’s corporate underweight will likely be retained in light of the potential for price pressure on these assets as corporate profit growth cools and investor demand softens.
• Selective Emerging Market Exposure— PIMCO plans to hold only modest levels of high quality emerging market bonds as valuations in this asset class overall are now at historically tight levels. Favorable security selection in emerging markets has the potential to add value.
• Out-of-Index Allocations—Relatively low volatility assets such as TIPS and municipal bonds could lag Treasury bonds if interest rates fall in a flight to quality. While PIMCO will likely de-emphasize TIPS given our expectation of relatively benign inflation, we will likely hold modest levels of munis to help mitigate the impact of an unexpected jump in interest rates.
• Currency Exposure—Exposures to the yen and select emerging market currencies remain effective vehicles for potentially adding value in light of anticipated downward pressure on the U.S. dollar. Fed easing should reduce the short-term interest rate differential that now favors the U.S. against many developed country currencies. Moreover, a weaker dollar will be needed over a secular time frame to help the U.S. work down its huge current account deficit.