The most likely outcome for the global economy over the next year is a soft landing with modest disinflation. Central banks will help avert a recession in developed economies beset by the subprime-induced credit crisis, though the restructuring process brought on by this crisis could have at least another 18 months to run. The U.S. economy should continue to decelerate into “stall speed” growth in the 1–2 percent range. PIMCO’s outlook is defined by the following themes:

• Contagion—In contrast to 1997–1998, when financial market turmoil started in emerging markets and spread to developed economies, this time contagion began in the U.S., the U.K., Australia and Europe. Contrary to expectations of many investors and even the Federal Reserve, the follow on effects of a weak U.S. property market and the subprime debacle were not contained within the U.S. mortgage market but spread more broadly, dampening global risk appetites and contracting liquidity.
• Decoupling—Over a cyclical time frame, subprime contagion should mute the decoupling of global  growth across regions that was in evidence prior to the crisis. Over the longer run, however, PIMCO remains an advocate of the decoupling thesis, which holds that growth in global economies, especially rapidly  expanding emerging markets, will move ahead even as U.S. growth cools.
• Re-intermediation—Avoiding a global recession will depend on how smoothly assets from  subprime-related financing vehicles can be re-intermediated back into the traditional banking system. Overall credit availability is likely to tighten as traditional banks are forced to honor financing commitments to non-bank and off-balance sheet entities in the “shadow” banking system. The percentage of banks tightening mortgage lending standards has already jumped, as seen in the following graph:

• Normalization—Central banks will try to ease re-intermediation and create a more normalized financial environment. PIMCO expects the Fed to take the federal funds rate into the high 3% range to achieve this  aim. Other central banks are likely to ease or shelve plans to raise rates, implying steeper yield curves worldwide. Relatively low U.S. rates point to a soft U.S. dollar.
• Financial Turmoil to Crimp Growth in Europe, Japan—Robust capital spending and exports should keep Europe’s growth higher than the U.S. Still, financial market turmoil will mitigate this decoupling, as European businesses find bank financing harder to get. Capital spending has also spurred growth in Japan, but heightened global risk aversion could reduce the incentive to borrow cheaply in yen to buy risky assets. Resulting upward pressure on the yen could hurt corporate profits and discourage investment.
• Resilient Emerging Economies—Emerging economies, including China, are contributing greater shares of global GDP and consumption growth. Even so, they should not be unaffected by slower growth in the developed world since they will be reliant on external demand for years to come. A positive for many emerging markets will be their low debt to GDP ratios, which should allow them to use fiscal stimulus to counter weakening demand from the developed world.

High Quality Focus; Select Exposure to Riskier Assets

PIMCO believes that financial restructuring and an expected economic slowdown brought on by the subprime crisis are likely to extend throughout our cyclical timeframe. We will therefore plan to retain an emphasis on higher quality assets as well as strategies that take advantage of expected monetary easing and a weakening U.S. dollar. At the same time, we will seek to add holdings of credit-related assets where valuations are compelling. Key strategies are summarized below:

• Interest Rate Strategies—In an attempt to exploit expected curve steepening in the U.S and U.K., PIMCO will focus on the front end of these yield curves as the centerpiece of its interest rate strategies. We remain bullish with respect to the direction of interest rates but believe the yield curve effects will be the most powerful. Our duration position will be neutral to slightly overweight and represent a smaller contribution to overall risk exposure.
• Mortgage and Asset Backed Bonds—Mortgage yield premiums, which reflect the market’s expectation of future volatility, appear more attractive now that volatility has spiked upwards from historically low levels. As a result, PIMCO plans to overweight high quality, agency-sponsored mortgages to capture this incremental yield. We will seek to insulate portfolios from the subprime crisis by holding only modest levels of short duration, high quality asset backed bonds with solid collateral protection.
• Credit—The significant widening in credit spreads in the third quarter has made certain corporate bonds and bank loans more attractive. PIMCO will trim its corporate underweight in this environment, employing bottom-up credit analysis to select corporate credits with compelling valuations. The auto and financial sectors offer especially good potential.
• Currency—PIMCO plans to continue to take advantage of expected weakness in the U.S. dollar with currency positions comprised largely of emerging market currencies. Preferred currencies will include those of countries with substantial trade surpluses and strong economic fundamentals, such as the Brazilian real, the Mexican peso and the Russian ruble.
• Emerging Market Bonds—The EM asset class has the potential to add significant value to portfolios over the next several years. High quality credits such as Mexico, Russia and Brazil could see upgrades given large and growing currency reserves and strong fiscal positions. Locally issued EM bonds are an efficient way to take this exposure since they offer currency as well as interest rate/credit exposure.
• TIPS and Munis—With our forecast of relatively benign inflation amid a weakening economy, we do not expect to increase holdings of TIPS in the near term. There is still value, however, in modest TIPS allocations to help offset the risk of a spike in inflation. Municipal bonds have fared poorly recently amid the downturn in credit-related assets and the Treasury rally. PIMCO may add to currently modest holdings in light of more attractive valuations.

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 $720 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 September 30, 2007.