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.

Positive Momentum of Emerging Markets External Bonds Continues amid Improved Market Sentiment

Amid improved market sentiment and increased appetite for risk, valuations for emerging markets U.S. dollar denominated debt continued to rise in the third quarter. In some EM (Emerging Markets) 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.

The effect of the risk rally can also be seen in the looking at the performance of the index by ratings category. B-rated credits returned 15.12 percent versus their BB and investment grade rated counterparts, which returned 12.16 percent and 8.31 percent, respectively.

Latin America led in performance among the EM regions, returning 10.77 percent for the quarter. Emerging Europe was the next best performer, returning 10.36 percent, followed by Africa, which returned 9.89 percent. Asia and the Middle East were the laggards for the quarter, returning 9.20 percent and 8.12 percent, respectively.

In Latin America, the region’s high-yielders led performance: Argentina, Venezuela and Ecuador, returned 33.53 percent, 24.67 percent and 24.22 percent, respectively. Returns for Brazil lagged its investment grade peers at 7.53 percent in spite of better than expected growth data. Mexico returned 6.87 percent amid continued negative growth numbers.

In EEMEA (Eastern Europe, Middle East, Africa) Turkey returned 7.59 percent as speculation about both the necessity and willingness of the government to secure an IMF program continued. Ukraine returned 16.20 percent despite the weak economic picture; Q2 GDP contracted 18.0% year over year in Q2 versus 20.3% year over year in Q1. Russia returned 11.16 percent as oil price remains above government budget assumption. Nevertheless, economic activity remains weak. Hungary and Poland returned 12.70 percent and 6.94 percent, respectively. In Hungary the recession continued to deepen and the IMF extended the stand by agreement.

In Asia, Indonesia outperformed with a 15.28 percent return amid positive rating actions and the sturdy GDP. China returned only 3.69 percent amid already tight spread levels and as macro releases suggest economic growth continues.

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, the JPMorgan EMBI Global Index, for the quarter. Positive contributors to relative performance included:

• An overweight to Russian corporates, which outperformed as credit sectors continue to benefit from the return of risk appetite
• An underweight to China which underperformed amid already tight spread levels
• An underweight to Turkey which underperformed amidst the government’s hesitancy to engage the International Monetary Fund (IMF)
• An underweight to Malaysia which underperformed despite the rebound in GDP in Q2 2009 to 13% quarter over quarter

The following strategies detracted from relative returns:

• An underweight to Venezuela, which outperformed on increased risk appetite
• A zero weight in Ecuador which outperformed during the quarter as appetite for risk continues
• An underweight to Argentina which outperformed on the back of rumors of progress in dealing with holdouts from the 2005 restructuring.
• An underweight to Ukraine which outperformed despite the bleak economic picture
• Off-benchmark allocations to Brazilian local rates detracted from performance. Local rates rose as the markets priced in rate hikes

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.

Maintain Defensive Positioning in the New Normal As EM countries will likely continue to differentiate into two groups, we will emphasize even more strongly the highest-quality and most attractively valued credits when constructing EM portfolios. Those countries of systemic importance to the global economy and with strong initial conditions when coming into the crisis will likely be at the forefront when constructing EM portfolios.

We plan to maintain our defensive stance across emerging markets portfolios, reflected primarily in continued underweight in EM spread duration.

We will continue to make tactical use of local currency opportunities where local curves remain steep and our analysis points to favorable risk-reward dynamics, such as in Brazil and Mexico. We will also seek opportunities to add value by substituting quasi sovereign and EM corporate credits related to key infrastructure investment for sovereign issuers.

We plan to make tactical use of select EM currency opportunities when fundamental factors suggest that currencies are undervalued