Real global growth will continue to advance at an annual rate of around 5% over the next several years, led by rapid expansion in developing economies such as China and India. More mature developed economies will grow at rates closer to 2% amid demographic and other challenges. The U.S. economy will remain weak in 2007 and 2008.

The downturn in the residential property market has not found a bottom and the corresponding influence on homeowners and consumers has yet to be fully realized.

Key implications of our outlook include:

• Global Inflation to Move Slightly Higher – A gradual shift in the internal growth dynamics of developing countries, especially China, will tilt global inflation upwards. While China will remain a production-driven economy with high savings, a more internal orientation is developing that will absorb savings, boost  consumer demand and push prices higher. Additional inflationary pressure will come from the voracious
  Chinese/Asian demand for commodities, which should continue unabated.
• Interest Rates Trend Higher Over 3-5 Years – Strong growth and higher inflation will push rates higher during the later part of PIMCO’s secular time frame. Global consumption and rates are likely to be boosted as emerging economies adjust to greateraffluence by spending more and saving less at the margin. PIMCO forecasts that the yieldon the 10-year Treasury should range from 4.0% to 6.5% over the next five years.
• Capital Flows Will Help Push Rates Upward – A critical component of PIMCO’s forecast for higher rates over a secular time frame will be the direction of global capital flows. The bond “subsidy” provided by capital flows into U.S. Treasuries from savingsrich developing economies will give way to diversification in favor of riskier assets. This shift toward a more profit seeking investment strategy has begun in China, as evidenced by the recent Chinese investment in a leading U.S. private equity firm.
• Interest Rates to Stay Low in 2007-2008 – A weak cyclical environment in the U.S. points to interest rates closer to the lower end of PIMCO’s forecast range in 2007-2008. The soft domestic housing market will feed into a broader economic slowdown, exacerbated by the sharp increase in gasoline prices that will act as a tax on consumer demand. Rising unemployment and tame inflation will prompt Fed easing.
• Fed Will Likely Ease to Bolster Homeowners, Consumers – With households under pressure, the Fed will likely ease even if lower rates over stimulate the robust U.S. corporate sector. The recent backup in mortgage rates will strain consumers’ ability to service mortgages and other debt and prompt further reductions in mortgage equity withdrawals that have helped sustain consumption. (Note the sharp drop in mortgage equity withdrawals that has already occurred depicted in the graph below.) Several hundred billion dollars of adjustable rate mortgages that are poised to reset in 2007-2008 will add to the burden.

Pursue Opportunities Arising From Global Prosperity

PIMCO’s 3- to 5-year forecast for robust global growth with a modest up-tick in inflation could present compelling opportunities for investors. Our forecast suggests that owners of global growth could fare especially well. Non-dollar assets should outperform dollar-denominated investments since relatively sluggish U.S. growth points to a weaker U.S. dollar and lower asset price appreciation than in the rest of the world. Commodities may offer diversification benefits versus paper assets as inflation edges higher. PIMCO plans to pursue these opportunities where possible within the fixed income arena, as summarized below:

• Interest Rate Strategies – PIMCO plans to reduce overall duration in anticipation of higher long-term rates over the next several years. However, we plan to maintain an overweight to shorter maturities in anticipation of a steeper yield curve. Over a cyclical time frame this steepening is likely to occur as the Fed should cut short-term rates later this year and early next to offset the negative impact of the housing downturn on the U.S. economy. Over a longer time horizon the yield curve could also steepen because of continued diversification away from longer maturity Treasury bonds by developing countries with large currency reserves.
• Emerging Market Bonds – To participate in the rapid growth expected in developing economies, PIMCO plans to take exposure to locally issued emerging market bonds. Local EM bonds are poised for continued growth in new issuance, liquidity and investor participation. Their yields, many of which are in the high single digits, are likely to compress as economic fundamentals continue to improve. Yield premiums relative to Treasuries on local EM bonds tend to be more attractive than those on mostly dollar denominated, external emerging market debt, which already reflect the strong growth prospects for these economies.
• Currency – PIMCO plans to take advantage of expected weakness in the U.S. dollar by building currency positions, comprised largely of EM currencies. Local EM bonds, which are typically denominated in home country currencies, can be effective vehicles for taking EM currency exposure.
• Developed Non-U.S. Markets – PIMCO plans to take exposure to short maturities in the U.K., where yields reflect more central bank tightening than we expect.
• Mortgage- and Asset-Backed Bonds – While mortgages should remain an important source of high quality yield in portfolios, PIMCO plans to target neutral allocations versus the index and look to add value via security selection. In the case of asset-backed bonds such as those backed by home equity loans, PIMCO will continue to emphasize the highest quality short-term issues that offer credit enhancement and payment priority.
• Corporates – Historically tight credit premiums point toward a continued underweight of this sector, as better opportunities to enhance yield exist elsewhere.