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.

Developing Local Markets Post Good Quarter as EM Currencies Continue to Strengthen

Currency strength versus the U.S. dollar for EM (Emerging Markets) countries as a group was led by continued risk appetite, signs of economic recovery, and the generalized weakness of the dollar. Short maturity, local currency denominated investments in emerging markets returned 4.46 percent for the quarter, as measured by the JPMorgan ELMI+ Index.

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.

Continued currency strength was most pronounced in Emerging Europe. Poland, the best performing country in the region, returned 10.69 percent. Q2 GDP growth of 1.1 percent year over year confirmed that Poland’s economy was the only one in the region with positive growth. Russia returned 6.55 percent as oil prices increased. In Hungary, where the International Monetary Fund (IMF) extended the stand by agreement, the recession continued. Hungary returned 7.49 percent on the quarter. In Turkey, where speculations continued about the necessity and plausibility of the IMF loan, the country returned 5.83 percent for the quarter.

Colombia led Latin America and the overall index with a 13.86 percent gain. The Central Bank surprised the markets with a 50 basis point rate cut. Brazil returned 11.08 percent powered by better than expected GDP growth. Moody’s upgraded the county’s long term foreign currency debt to investment grade bringing it in line with S&P and Fitch ratings. Mexico posted returns of -0.87 percent, as the country’s economy does not yet show signs of consistent recovery. Argentina posted a 4.60 percent return on the back of rumors of progress in negotiations on defaulted in 2001 debt; the news is being positively viewed by investors.

In Asia, China, returned 0.16 percent for the quarter; Q2 GDP printed at a sturdy 7.9 percent year over year. Indonesia returned 8.23 percent, boosted by the economic resilience of the country.

Although current and future portfolio holdings of the Fund are always subject to change and subject to risk, the following comments may help holders of the fund understand drivers of the Fund’s performance relative to the Fund’s benchmark.

Overall the fund outperformed its benchmark index, JPMorgan Emerging Local Markets Index Plus (ELMI+), for the quarter. Important contributors to relative performance were:

• An overweight to Brazil, which outperformed on the country’s improved economic picture, including stronger than expected 2Q growth
• An overweight to Poland which outperformed as the economy was the only one in EM Europe with positive growth
• An overweight to Colombia; the Central Bank surprised the markets with a rate cut signaling that it is ready to stand to sustain growth
• Cash backing strategies benefited performance helping to recoup losses incurred in 2008.

The following strategies detracted from relative returns:

• An overweight to China, which underperformed, despite continued signs of economic recovery
• An underweight to Hungary which outperformed despite the continuing recession
• An overweight to Mexico; the country underperformed on the back of the economic weakness
• An underweight to Russia; the ELMI+ Russia outperformed as oil prices improved
• An emphasis on Brazilian local rate duration, as local rates sold off for the quarter on investors’ concerns that the Central Bank will hike rates

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 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 time frame. 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.

In the “New Normal” Emerging Economies to Grow Faster than the Developed World

In the “New Normal” PIMCO expects that the most likely outcome, or base case, for the U.S. and other developed economies over the next year to 18 months is a U- shape recovery after a temporary boost in the latter half of this year. In this U shape recovery, the bottom may be longer and the upturn less sharp than in a more robust V- shape rebound. On the other hand, and as emerging economies overall are showing signs of a rebound, we believe that emerging economies should continue to grow faster than the developed world. In the cyclical horizon 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. In aggregate, emerging economies, especially China, should continue to grow at a faster pace, helped by aggressive stimulus policies.

In this “New Normal”, those Emerging Market countries which are in sound fiscal health and are of systemic importance to the global economy have shown some signs of economic rebound due to stronger domestic demand. These economies should continue to find internal and external support easiest to access. Countries such as Brazil and China will likely remain at the forefront, and we plan to continue to monitor countries such as Hungary and Ukraine whose continued external financing needs offer potential causes for concern.

From a fundamental perspective, the emerging countries, as a group, remain in excellent shape relative to their developed country counterparts. Debt ratios tend to be much lower and budgetary responses have been mild in comparison to those of the major economies. This implies potentially less government bond issuance relative to the size of their economies and less upward pressure on yields over the longer term. In addition, we have observed the beginning of long-awaited secular shifts in these economies toward more balanced drivers of growth. Finally, these economies have used increased government spending to invest in infrastructure, which helps to raise future potential growth rates while sustaining these economies in the transition toward increased domestic consumption.

The outlook though, does not apply equally to every country. The ability to delineate strong from weak sovereigns remains paramount. Not all countries have used the favorable growth environment leading up to 2007 to prepare their economies for tougher times. Some will face challenges in the New Normal, wherein capital is not handed out indiscriminately. PIMCO’s focus remains on sovereigns who—through a combination of strong initial conditions, a demonstrated ability to respond to the crisis, and access to external sources of financing—are likely to emerge from the crisis in better shape than they entered.

While the return of risk appetite has helped to fuel the current rally, a retracement is still not out of the question; spreads have declined in many countries, particularly those where the fundamental outlook remains uncertain. Nonetheless, opportunities remain in select sovereigns and quasi-sovereigns in the external debt space. In addition, a number of currencies remain cheap relative to their histories and local curves remain high and steep in many countries, offering appealing value. We remain cautious on those countries with either a limited ability to respond to a period of extended subpar growth globally or where politics complicate the outlook for receipt of external support.

Position Portfolios with a Bearish View on the U.S. Dollar

We plan to maintain an increased exposure to EM currencies given our secular bearish view on the U.S. dollar. Nonetheless, given our view that a retrenchment is possible, we remain somewhat cautious and will overweight only those countries that we believe are best prepared to weather a sustained period of market volatility. Countries such as China, Brazil and Poland will remain at the forefront.

Among European countries, we plan to maintain an underweight to the overall region but continue maintaining an overweight to Poland. In Poland we believe the country is well positioned given the size of its domestic market and the limited external financing need of the public and private sectors.

In Asia we plan to maintain an overweight to the index primarily through South Korea and China given the region’s economic resilience. Also, the relative undervaluation from a real exchange rate perspective of the currencies in the region plays a role in the region’s overweight.

In our local market portfolios overall, we will likely continue to hold positions in local rates where we continue to see favorable market opportunities and where we believe the authorities are unlikely to hike rates any time soon. This includes maintaining our local rates positions in Brazil and Mexico.

We plan to remain underweight countries such as Hungary and Romania which have the potential to suffer disproportionately from further episodes of global market volatility. We also plan to maintain a below benchmark allocation to Russia where the government could benefit from a depreciated ruble. We remain cautious regarding countries such as Argentina, where the economic fundamentals remain uncertain.