The combination of fiscal stimulus and a turn in the inventory cycle helped stabilize the global economy in the third quarter. Risky assets around the world, notably equities and high yield bonds, continued to respond with relief, rallying significantly. Still, sustained growth remained elusive as there were few signs of demand improvement outside of those sectors, such as autos, directly targeted by government policies. Emerging market (EM) economies, most notably China and emerging Asia, showed the most resilience, raising once again talk of the possibility that emerging economies might be able to “de-couple” from the G7. However, even within emerging markets growth was uneven, with some countries continuing to contract sharply. Fortunately, policymakers around the world continued to support their economies and markets with expansive monetary and fiscal policies. While various policy “exit strategies” were cautiously floated, most policymakers remained keenly focused on downside risks and recognized, at least implicitly, that premature tightening could have dire consequences.

Growth and Inflation

The third quarter saw stabilization in global GDP, with production bouncing and many sentiment indicators moving above the boom-bust threshold. However, final demand remained anemic, calling into question its ability to help the economy achieve the “escape velocity” necessary for a V-shaped recovery.

While U.S. GDP still contracted 0.7 percent in the second quarter, this was a significant improvement on the first quarter’s 6.4% decline. Moreover, higher frequency data indicated that the economy may have turned the corner in the third quarter; industrial production, for instance, posted gains in both July and August. Still, the staying power of these green shoots was questionable given the continued negative tone on the consumer side. Real disposable personal income continued to fall, making any revival in consumer spending highly unlikely beyond the expiration of “cash for clunkers” and other stimulus programs. And the employment looked little better: the unemployment rate hit 9.8 percent and cumulative job losses for the recession reached 7.2 million.

In the Eurozone, the European Commission survey showed improved sentiment, suggesting that a recovery might be underway. Still, hard economic data has been slow to develop: industrial production for July was disappointing, as were the September Purchasing Managers’ Index (PMI) readings. Data outside manufacturing have been mixed at best: while household confidence continued to improve and the pace of labor market deterioration slowed, the slide in German retail sales suggested that non-subsidized consumer demand remains soft. Similarly, the U.K. recovery looked suspect, as the surge in the PMI above the boom-bust mark in July was followed by two months back below 50. Meanwhile, the unemployment rate climbed to 7.9 percent, a level not seen since 1996, and the savings ratio rocketed by two percentage points to 5.6 percent, highlighting the economy’s downside risk.

Japan’s economy, too, looked to be improving in the quarter. Real exports and industrial production recovered strongly (albeit from a deep plunge), and consumption was supported by fiscal stimulus that will be reinforced by the newly elected government. However, sluggish machinery orders suggested lackluster business investment while falling employment and wages remained headwinds for households.

Emerging economies showed clearer signs of recovery than those in the developed world but continued to exhibit greater divergence as well: while Chinese industrial production rose at double-digit rates, Russian GDP slid an alarming -10.9 percent over the second quarter.

Government Policy

The Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BOE) and Bank of Japan (BOJ) left policy rates unchanged at extreme low levels and maintained or even increased quantitative easing (QE) programs. While the Fed and others did begin floating their thoughts regarding potential exit strategies, these comments were less an indication of an imminent policy shift than an effort to keep inflation expectations anchored. Indeed, most policymakers continued to express caution regarding the fragility of the economic recovery. The ECB was the most outspoken in terms of the exit strategy discussion, but even it continued to highlight downside risks. The Fed, while terminating Treasury purchases in October 2009, extended the expiration date of the mortgage-backed securities (MBS) purchase and the Term Asset-backed Securities Loan Facility (TALF) programs from December this year to March 2010.The BOE, however, remained the most concerned about the economic outlook and added another £50 billion to its asset purchase program, bringing the total to £175 billion.

For the most part EM central banks remained on hold as well, though a notable exception was the Bank of Israel, which became the first to raise rates since the crisis. Still, even EM policymakers remained focused on downside risks.

Financial Markets

Economic stabilization and improved risk appetite continued to lift financial markets: most global equity markets rallied and credit spreads narrowed. However, questions about the sustainability of the recovery led to pockets of volatility and a bout of risk aversion towards the end of the summer.

Sovereign bonds rallied, regaining some ground after last quarter’s selloff. Ten-year U.S. Treasury yields were at 3.3 percent at the end of September, 23 bps lower on the quarter, while government bond yields in the Eurozone, U.K. and Japan declined 17, 10 and 6 bps, respectively.

Inflation-linked bonds (ILBs) performed well as real yields fell across developed markets. Breakeven inflation rates (the difference between nominal and real yields) rose, most notably in Japan where continued buybacks from Japan’s Ministry of Finance boosted prices of ILBs.

Agency MBS continued to outperform U.S. Treasuries as the Fed’s MBS Purchase Program compressed mortgage yield premiums to the narrowest levels ever seen when measured versus interest rate swaps. Non-agency mortgages also rallied as investors recognized the value in this sector relative to corporates and other asset-backed securities (ABS). Consumer ABS also enjoyed strong gains owing to robust demand for TALF-eligible assets.

Corporate bonds continued to rally in the quarter; investment grade spreads tightened 77 and 86 bps in the U.S. and Eurozone, respectively. The financial sector outperformed in both markets as asset valuations improved and continued steep yield curves helped support banks’ net interest margins. Across the quality spectrum, lower tiers, especially high yield, rallied the most upon heightened market optimism.

Spreads on EM external bonds narrowed sharply, ending the quarter 96 bps tighter. Similar to corporate credit, lower quality spreads benefitted the most. Local markets also reacted positively to improved sentiment and continued inflows into the asset class, with Europe, Middle East and Africa (EMEA) leading the rally, followed by Latin America and Asia.

On the currency front, the U.S. dollar underperformed almost all currencies upon improved risk appetite, ending the quarter weaker against the euro (4.3 percent) and the Japanese yen (7.4 percent). The pound sterling (-2.9 percent) was a notable underperformer as investors looked to it as a potential new funding currency. Commodity currencies such as the Australian dollar (9.5 percent) and Brazilian real (10.5 percent) outperformed as investors looked to take advantage of the improved outlook for commodity importers like China.

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 the JPMorgan GBI Global ex-US FX NY Index Unhedged in USD, for the quarter.

The following strategies added to quarterly returns:

• Above-index duration in the U.S., Eurozone and U.K. as yields declined
• An overweight to bonds issued by financial companies, which outperformed the broader corporate market
• Holdings of high quality consumer asset-backed bonds and non-Agency mortgage securities, which continued their recovery amid a return of market liquidity
• An overweight to Agency mortgage backed (MBS) securities, as valuations of these securities benefited from continued purchases by the Fed

The following strategies detracted from quarterly returns:

• Curve steepening positions in the U.S. and Europe as long maturity yields declined more than the short end

PIMCO believes the global economy and markets are on a bumpy, multi-year journey to a “new normal” destination characterized by anemic growth, limited inflation pressures, and lackluster financial market returns. The current stage of this journey is one of post-crisis recovery; continued fiscal stimulus and an inventory bounce should support a reasonable level of global growth for the remainder of this year. Into 2010, however, in the absence of sustainable sources of demand, the stimulus-led “sugar high” is likely to wane, producing a prolonged U-shape recovery, rather than the sharp V-shape currently priced into financial markets. While industrialized countries may continue to grow, they are unlikely to see the above-trend growth rates of recent years. And while well-positioned emerging markets (EM) will outperform, in the near term they do not have sufficient size to fully offset the drop in industrialized country demand. Given the fragile state of the economy, G3 central banks are unlikely to raise rates in the near future, despite increased talk of “exit strategies.” As for financial markets, we believe they have overshot on the upside, and investors are likely to be disappointed as the economic fundamentals turn. Thus, we continue to focus on high-quality investments and reduce risk into the rally, while maintaining a slightly long duration stance.

Growth and Inflation

Global GDP is likely to see a temporary boost over the next two quarters as government stimulus continues to work its way into the economy and businesses continue to rebuild their depleted inventories. The outlook for the global economy into 2010 is less rosy, however, as sustainable sources of final demand, either on the consumption or investment side, remain conspicuous by their absence. Furthermore, G3 fiscal deficits have grown rapidly, sparking concerns about public debt dynamics and the willingness and ability of these governments to implement future stimulus measures. The bottom line is that we remain skeptical of the global economy’s ability to achieve “escape velocity” and close the substantial gap between actual and potential output. Disinflation should therefore predominate in the near term.

The U.S. will likely go through financial rehabilitation in the context of low growth. Monetary and fiscal stimulus, along with inventory restocking, will be tailwinds for the economy for the rest of 2009. With these positive effects beginning to fade in 2010 and consumer spending still constrained by very high levels of debt and unemployment, the medium-term outlook remains bleak.

The Eurozone will also grow slowly, hampered as it is by the export-dependence of the core countries and the precarious finances of those on the periphery. The drop in the external demand is leading to sharp adjustments in trade balances and raising questions over the ability of external growth to be a locomotive for countries such as Germany. The U.K. will also be stuck in a low growth world, but with greater vulnerability to domestic and or external financial instability, and thus higher tail risk compared to the Eurozone or the U.S.

Similarly, Japan will continue to see near-term lift of GDP, but face growth headwinds as its economy is encumbered by fiscal stress and dire demographics. The new administration party’s socially-oriented policies, while providing much needed support for households, are unlikely to help the corporate sector or improve Japan’s long-term growth potential.

Emerging economies, especially China, should grow at a faster pace, helped by aggressive stimulus policies. The bifurcation among EM economies will continue: those 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 – should show more resilience.

Government Policy

As the global economy and markets have stabilized and the “Armageddon” scenario has been avoided, policymakers have begun to shift their attention to a discussion of eventual exit strategies. While some have interpreted this discussion as indicative of a potential near-term policy change, we believe that for most central banks’ rate hikes, and even a retreat from quantitative easing, are some way off. As we see it, policymakers are attempting to walk a thin line: on the one hand they would like to comfort markets with the knowledge that rates will be “low for long,” but on the other they recognize the need to reassure those who might be concerned about the potential inflationary implications of an extended period of monetary ease. They know that failing to keep inflation expectations anchored could be detrimental to the recovery.

That said, we continue to believe G3 central banks are unlikely to begin tightening before the summer of 2010 at the earliest. Those in the developed world facing smaller output gaps, however, are likely to raise rates sooner. Indeed, the Reserve Bank of Australia (RBA) has already begun to tighten and others such as the Norges Bank may not be far behind.

PIMCO will maintain a high quality bias and tactically reduce risk exposures in portfolios following powerful rallies in spread sectors. We look to harvest gains from our earlier positions as valuations become rich and are driven primarily by risk appetite rather than economic fundamentals. We believe this approach will protect portfolios in the event the economy slips back into a recession and should allow PIMCO to reinvest at more attractive valuations later.

• Interest rate strategies - We will target a slight overweight to duration in the U.S. and Eurozone, focusing on short to intermediate maturities of the yield curve. With front-end yields anchored by low policy rates and long yields subject to supply pressure, short to intermediate maturities remain a favorable place for duration exposure.
• Inflation-linked – We look to maintain lighter exposure in inflation-linked bonds. While these securities offer a potential hedge against long-term inflation risks, still-large output gaps in the industrialized world suggest that inflation is unlikely to materialize over the cyclical horizon.
• Mortgage – We have moved towards a neutral to underweight position in Agency mortgage-backed securities (MBS). The Fed’s MBS Purchase Program has supported a strong rally in these securities and driven yield premiums close to fair value. Meanwhile we look to take tactical positions in the Eurozone covered bond markets which are likely to benefit from European Central Bank’s buy-back program, and have added exposure to Australian mortgages.
• Corporate - We maintain our bias towards high quality financials, but look to underweight the overall corporate sector as credit premiums have narrowed significantly during the recent rally of risk assets. We continue to avoid high yield and other low quality investments, which are vulnerable to potential market reversals and rising defaults in a weak economy.
• Emerging Markets - We are neutral on the broad emerging market sector, but continue to look for opportunities in countries, such as Brazil, with sound economic fundamentals and fiscal strength.
• Currency - We are underweight the U.S. dollar against a basket of higher-yielding developed and EM currencies including the Chinese Yuan, Korean won, Brazilian real, Australian dollar, and Norwegian krone. The krone and Australian dollar are likely to be boosted by rate hikes, while the EM currencies should benefit from strong fundamentals compared to those in the G3.