Economy Continues to Stabilize; Abundant Slack Remains

Financial markets and the broader economy continued to stabilize during the third quarter after the extraordinary events of last year. The Barclays Capital U.S. Aggregate Index, a widely used index of U.S. high-grade bonds, returned 3.74 percent during the quarter. Treasury yields were less volatile than in the first half of 2009 and fell across maturities. The yield on the benchmark 10-year Treasury ended the quarter at 3.31 percent, down 23 basis points from the end of the second quarter.

Policy initiatives - such as the Federal Reserve’s purchase of mortgage and Treasury securities, the government’s support for consumer finance markets and near-zero short term rates - helped revive risk appetites and were the major factors behind enhanced stability. Two key programs were extended during the third quarter.

The Fed committed to complete its $1.25 trillion program to buy mortgage-backed bonds and extended the end date of the program to March 2010 from December 2009. Massive purchases of mortgages from this program, roughly two-thirds complete by quarter-end, helped hold down mortgage rates and supported the fragile housing market. The Fed and the Treasury also announced the extension of the Term Asset-backed Securities Loan Facility, or TALF program, which provides financing to investors buying consumer asset-backed securities. (ABS) Originally set to expire in December of this year, TALF was extended through March 2010 for consumer ABS.

Manufacturing and housing data showed improvement in the third quarter, suggesting that the recession was close to an end. Even so, substantial slack remained in the economy, leading the Fed to announce that it would keep the federal funds rate near zero “for an extended period.” The unemployment rate moved closer to 10 percent, making any revival in consumer spending highly unlikely. Businesses continued to draw down inventories, albeit at a slower rate than earlier in the year. Industrial capacity utilization hovered near record lows at below 70 percent, discouraging new investment. Policymakers faced with these dismal fundamentals were in no position to contemplate withdrawal of stimulus programs any time soon.

Summary of Real Assets

Treasury Inflation-Protected Securities (TIPS) gained 3.08 percent during the third quarter as represented by the Barclays Capital U.S. TIPS Index. Real yields declined across most of the maturity spectrum with the exception of the very long end of the yield curve, where real rates rose only modestly. Real coupon and positive inflation accruals, despite cyclical disinflationary pressures, also helped returns. TIPS outperformed comparable maturity nominal bonds overall despite underperformance for long-dated issues.

TIPS yields declined most for intermediate maturities, reflecting a reversal of second quarter’s largest increase in yields for this portion of the real yield curve. Despite cyclical disinflationary pressures, all maturities rallied given market expectations of slower growth amid worsened U.S. unemployment figures. Long-dated real yields declined the least due in part to investors pricing in slower inflation, resulting in their preference for long-dated nominal Treasuries. As a result, TIPS underperformed their long-dated counterparts; however, they outperformed all other maturities.

Breakeven inflation (the level of inflation where a TIPS return “breaks even” with that of a nominal Treasury or more simply, the difference in nominal yields and real yields) ended the period slightly positive for a majority of the curve. The 15-year sector and beyond posted lower breakeven inflation levels as markets priced in lower longer-term inflation expectations.

The Dow Jones-UBS Commodity Total Return Index gained 4.25 percent for the third quarter and is up 9.06 percent year to date, as commodities continued to benefit from increased risk appetite, a weaker U.S. dollar, and fundamental strength in the industrial metals, precious metals, and softs sectors.

The energy sector ended the quarter down moderately as languishing natural gas and crude oil prices weighed on the sector. Natural gas continues to be plagued by overproduction, while oil moved lower on concerns over slowing demand. Industrial metals benefited from continued strong import demand from China, particularly for copper, in addition to improved industrial production data in the developed world. Precious metals gained as gold and silver rallied over the period with a weaker U.S. dollar contributing to gains in addition to strong underlying jewelry demand providing support for gold at lower price levels. The softs sector, particularly sugar, posted strong returns with sugar futures gaining over 32 percent during the quarter. Prices were positively supported by a disappointing monsoon season in India and excessive wet weather in Brazil both hampering production. Grains prices were hurt by expectations for increased production in the coming crop year for corn and especially wheat.

The Dow-Jones U.S. Select Real Estate Investment Trust (REIT) Total Return Index posted a gain of 35.44 percent during the third quarter as REITs continued their torrid pace of price appreciation. All sectors posted strong gains as investors continued to pour into risk assets due in part to signs of economic recovery. Further supporting REITS have been normalization of credit markets and the ability to raise significant amounts of equity and debt year to date. The Office and Hotels sectors posted the strongest gains of 47.3 percent and 45.6 percent, respectively. Storage and Factory Outlets were the weakest at 17.3 percent and 16.4 percent, respectively.

Global Equity Markets Extend Rally in Third Quarter

Global equity markets generated strong returns in the third quarter as investors exhibited a preference for risky assets amid signs of economic stability and an improved outlook for earnings. Valuations rose sharply over the quarter as evidenced by the increase in the P/E ratio of the S&P 500 Index from 15.8 to 19.9. As an indication of market normalization, the VIX, a commonly referenced measure of equity market volatility, was relatively flat over the quarter.

Large cap domestic stocks, as represented by the S&P 500 Index, returned 15.6 percent, with the financials services sector again leading performance from the previous quarter. Small cap stocks beat their large cap peers as the Russell 1000 Index rose by 16.1 percent compared to a 19.3 percent gain for the Russell 2000 Index. Among both large and small cap stocks, value significantly outperformed growth. The Russell 1000 Value Index returned 18.2 percent versus a gain of 14.0 percent for its growth counterpart, while the Russell 2000 Value and Growth Indexes returned 22.7 percent and 16.0 percent, respectively.

Within developed economies, stock markets, as represented by the MSCI EAFE Index, rose by 19.5 percent in U.S. dollar terms and 14.8 percent in local currency terms. At the country level, equity markets in Australia and Greece generated the strongest returns, while those in Japan and Finland lagged.

Stock markets posted strong gains in emerging economies as the MSCI EM returned 20.9 percent in U.S. dollar terms and 16.8 percent in local currency terms, with equities in Peru and Hungary experiencing the largest gains.

U.S. Bond Strategies and Alternatives Market Performance

Spreads in the investment grade credit market tightened 77 basis points, finishing the quarter at an average level of 198 basis points. High grade credit spreads maintained their positive momentum as increased risk appetites boosted investor demand relative to lower yielding U.S. Treasury securities. The Barclays Capital U.S. Credit Index has outperformed Treasuries for six consecutive months. As spreads tightened, the investment grade credit market posted a 4.98 percent return.

The high yield market, as represented by the Bank of America Merrill Lynch High Yield Master II Index, was up 14.82 percent for the quarter and 48.54 percent year to date. With significant levels of cash on the sidelines to begin the year, and above average levels to start the third quarter, high yield bonds benefited from the general pursuit of yield, even at the expense of higher risk.

Inflows to retail high yield mutual funds significantly outweighed outflows, with net flows up $25.5 billion, the highest level seen since 2003 and comparatively larger than the $5.1 billion inflow this time last year. The primary market in high yield, which started off sluggish to begin the year, has been running full steam ahead since as $52 billion was priced in the third quarter, bringing year to date’s total to $120.4 billion compared to the full year 2008 total of $52.9 billion.

Amid improved market sentiment and increased appetite for risk, valuations for emerging markets (EM) U.S. dollar denominated debt continued to rise in the third quarter. In some EM countries, these gains were supported less by fundamentals than by positive technical conditions that helped push investors out of cash and toward higher yielding, riskier assets. EM spreads decreased by 96 basis points during the quarter to finish the period at 337 basis points over U.S. Treasuries. The JPMorgan EMBIG index returned 10.21 percent for the quarter. Despite their weaker fundamentals, countries such as Argentina, Pakistan, Ghana, Ecuador and Venezuela continued to benefit from the risk rally. This contrasts with countries such as Brazil, China and Poland, which, despite much stronger fundamentals, lagged the market.

Short maturity, local currency denominated investments in EM returned 4.46 percent for the quarter, as measured by the JPMorgan ELMI+ Index. Currency strength versus the U.S. dollar for EM countries as a group was led by continued risk appetite, signs of economic recovery, and the generalized weakness of the dollar. For the quarter, Emerging Europe turned in the strongest performance, posting a 7.78 percent return. The Middle East/Africa and Latin America followed, returning 3.92 percent and 2.71 percent, respectively, for the quarter. Asia, the worst performing region, returned 1.92 percent for the quarter.

Emerging local market bonds continued their positive momentum and delivered a total return of 8.65 percent for the third quarter, as measured by the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified Index. Monetary easing, disinflationary forces and continued strength in EM currencies versus the dollar as risk appetite increased led the market higher for the period. For the quarter, Emerging Europe was the strongest performing region, returning 13.30 percent; Latin America and Asia followed, returning 7.31 percent and 6.49 percent, respectively. The Middle East/Africa lagged with a return of 4.90 percent for the period.

The PIMCO All Asset All Authority Fund underperformed its primary benchmark, the S&P 500 Index, for the quarter and year to date. PIMCO’s emphasis on what it believes are attractively priced high quality assets, especially those with government support, was beneficial for performance. Tactical asset allocation decisions that were positive for third quarter performance include:

• Allocations to investment grade and high yield; credit spreads narrowed and performance of these sectors posted gains as market risk appetites continued to help drive performance
• Exposure to the emerging market (EM) sector through dollar denominated bonds, locally denominated debt, and currencies; Certain EM countries continue to display strong fundamentals and resiliency following the financial crisis
• Exposure to commodities, which rallied from sector specific fundamentals in addition to a weaker U.S. dollar

Tactical asset allocation decisions that were negative include:

• Low equity exposure, as global equity markets benefited from increased risk appetite amid stabilizing economic conditions
• Negligible exposure to real estate investment trusts (REITs); REITs rallied strongly along with other risk assets

Recovery To Be Weak in 2010 After Temporary Boost

PIMCO believes that the most likely outcome for the U.S. economy will be a weak recovery in 2010 after a temporary boost in the latter half of this year. On the downside, the U.S. could slip back into recession sometime next year. Emerging market (EM) economies, especially China, should continue to grow at a faster pace than the developed world, helped by aggressive stimulus policies. The rationale for our forecast is outlined below:

• Limits to U.S. Growth – A slower pace of inventory drawdown by businesses and positive effects from stimulus programs should support growth in the third and fourth quarter of this year, but this boost will not be sustainable. The reasons include excessive levels of consumer debt and an expected increase in savings to work these levels down; a stubbornly high unemployment rate; and weak business investment in the face of record lows in capacity utilization.
• Muted Monetary Policy – PIMCO expects the Federal Reserve to retain near-zero policy rates for some time. Even so, the impact of low rates and the Fed’s huge liquidity injections may be largely muted by overleveraged consumers’ reluctance to borrow.
• Weak Recoveries in Europe, U.K. and Japan – The rest of the developed world is expected to face similar challenges with the sustainability of demand into 2010. In Europe, large public debts and economic linkages to the U.S. and U.K. are likely to impose constraints on recovery. Japan’s recovery will face limits arising from its reliance on U.S. demand for its exports, especially autos, and weak capital spending, as capacity utilization rates remain low.
• China to Grow Faster – China is likely to grow far faster than more developed economies. Its fiscal stimulus has been especially large to compensate for a decline in exports. A surge in infrastructure investment has readjusted China’s GDP back toward its critical growth target of 8 percent.
• Bifurcated Emerging Markets – Emerging economies overall are showing signs of a rebound. PIMCO believes that EM economies that are more reliant on external demand – such as Korea, Mexico and Russia – will face greater headwinds for sustained recovery. Countries driven more by internal demand – including Brazil and India – would appear to be more resilient.
• Tame Inflation – Substantial excess capacity in labor and product markets should keep inflation low over a cyclical timeframe. Over the longer run, inflation risk may be heightened by the massive liquidity the Fed has injected into the financial system. For now though, transmission of that liquidity into the broader economy will continue to be constrained by strong demand for cash among financial institutions and consumers eager to pay down debt.

Summary of Tactical Asset Allocation Views on Nominal Bond, Real Return, and Equity Strategies

Within the underlying funds, PIMCO will likely continue to favor high quality, yield-oriented securities in an environment of low growth and continued downside risks driven by persistently high unemployment and a consumer that may be inclined to save more instead of spend. Tactical asset allocation will likely continue to focus on risk reduction given the strong technical rally in risk assets. Valuations in higher risk investments such as equities, high yield credit and emerging market credit do not offer compelling value in light of the downside economic risks that still exist.

• As a result, the core Treasury Inflation-Protected Securities (TIPS) allocation will likely continue to increase given ongoing reduction of higher volatility assets, TIPS lower volatility relative to other assets, and their ability to diversify a portfolio of fixed income instruments.
• A core allocation to investment grade credit will likely be maintained as it serves as an attractive alternative to equity allocations, which should continue to be pared in the event equity prices continue to rally. Equity prices may be overvalued as they currently display a premium when viewing their price-to-earnings ratio of approximately 19 vs. their historical average of about 16.
• Allocations to EM strategies will also likely continue to be trimmed given continued strong performance, resulting in increased conservative allocations to TIPS, investment grade credit, and even short-term fixed income strategies.
• Commodities allocations should continue to be adjusted in response to changing momentum signals and changes to correlations with equities. More positive momentum signals will lead to larger allocations and vice versa, while lower correlations to equities will likely increase commodities allocations and vice versa.
• Within the All Asset All Authority Fund, leverage will likely remain constant and used to fund purchases of investment grade credit