In stark contrast to the panic gripping global markets late last year, the third quarter of 2009 was distinguished by rising confidence. Stocks traded sharply higher, as investors rushed to participate in one of the hottest rallies in decades. Reports showed Japan, Singapore, Hong Kong, Thailand, Germany, France, Norway, Brazil and Israel officially exiting recession. The MSCI Emerging Markets Index added to its rally during the second quarter. From the ashes of last October, the benchmark has more than doubled. On August 3, it broke through its closing high from the day before Lehman Brothers filed for bankruptcy. For the July-September period, emerging Europe produced the best results, followed by Latin America, emerging Asia and the combined BRIC countries (Brazil, Russia, India and China). Chinese stocks lagged amid expectations for tighter bank lending and fear of the dilutive impact from new equity issuances. Up to 20% of Chinese bank loans were diverted toward share purchases this summer, according to The Economist. The Chinese government lifted a moratorium on IPOs in June.

The Allianz NACM Emerging Markets Opportunities Fund gained in the third quarter and trailed its benchmark, the MSCI Emerging Markets Index. Performance was helped by stock selection in the Industrials, Consumer Staples, and Energy sectors but hurt in Financials, Materials and Information Technology. From a country perspective, select names in Taiwan, China, and Brazil contributed positively while stock selection in Korea was a significant detractor.

Turk Hava Yollari, a Turkish airline company, was the biggest contributor to relative performance during the quarter. Investors have supported a continued rally based on achieved passenger number growth and expectations of global business expansion during the economic recovery. The biggest detractor was Axis Bank. The Indian bank, one of the portfolio’s performance stars during the second quarter, underperformed as its tier-1 ratio weakened and forced the bank to issue a secondary offering to increase its equity base. The secondary offering diluted existing shareholders by roughly 10%.

During the third quarter Samsung Electronics, a mega consumer electronics and semiconductor company, was the biggest buy. Analysts are optimistic about the company’s growth prospects with the improvement of consumer confidence and the economic global recover. The biggest sell was Taiwanese LCD panel maker AU Optronics. The company’s growth prospects have diminished as the global inventory of panels has increased while their price continues to fall.

At the end of the period, on a bottom-up stock basis, the portfolio was overweight Consumer Discretionary and Consumer Staples and underweight Financials and Materials. On a country basis it was overweight Turkey, Indonesia, and Thailand and underweight Taiwan, Korea, and South Africa.

After this summer’s massive bull market rally, stocks are beginning to look expensive compared against historical valuations. The MSCI Emerging Markets Index was priced at 13.1 times earnings in September, a twenty-one month high (IBES; twelve-month forward-looking). That compares with an average of 11.1 over the past ten years and a peak of 17.7 in January 2000. In part, the higher valuations reflect improved fundamentals in the developing world. Still, the road ahead could present challenges, particularly for export-dependent economies. Since March, the U.S. dollar has lost 14% against a trade-weighted basket of currencies. This makes foreign goods more expensive both in America and countries with currencies effectively pegged to the U.S. dollar, such as China and Hong Kong. If the rest of the world recovers faster than the U.S. and the Federal Reserve lags global peers in monetary tightening, the drop in the dollar could accelerate. At Nicholas-Applegate, we believe our products are well positioned to capitalize on the changing market environment.