Global Equity Rally Continues

Global equity markets continued to rally as more capital flowed back toward riskier assets in the third quarter. The global economy, which got a boost earlier this year due to unprecedented fiscal and monetary stimulus, got another boost from an upturn in economic activity spurred by inventory restocking. Investor sentiment is being influenced in particular by data from the factory sector, which improved mainly because in many industries production had fallen below sales. Global equities benefitted from the improved tone of the economic data. This is likely to continue until there is a break in the ever-improving tone of the data, although there are some signs that investors are already looking past the inventory cycle.

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 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.

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.

Riskier Fixed Income Assets Extend Gains despite Fragile Economy

Valuations of corporate bonds, mortgages and asset–backed securities continued to richen in the third quarter. These gains were supported less by fundamentals than by positive technical conditions and government policies that helped push investors out of cash and toward higher yielding, riskier assets. The following summarizes fixed income sector returns:

• Agency mortgage-backed securities (MBS) continued their powerful rally during the third quarter, outperforming like-duration Treasuries. The success of 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. A lack of new issuance over the last two years and anticipation of demand from the Public Private Investment Program drove non-Agency prices higher. Consumer ABS enjoyed strong gains versus like-duration Treasuries, owing to robust demand for TALF assets and the re-emergence of unleveraged cash investors such as pension funds and insurance companies.
• Corporate bonds, especially high yield credits, were among the best performing fixed income assets during the quarter, buoyed by highly favorable market technicals. Credit premiums continued to tighten and approached levels last seen in 2007 as fund flows into corporate credit were very strong and the supply of available bonds began to contract slightly after years of growth. These circumstances benefitted lower-rated credits the most. Performance was strongest in the financial sector, which gained from improved asset valuations, a continued steep yield curve and increased fee-based income as capital markets revived.
• Municipal bonds outperformed Treasuries by a wide margin during the quarter. Municipal yield ratios relative to Treasuries moved closer to historical averages after widening dramatically last year. As with corporate bonds, technical factors were positive in the municipal market. Inflows into municipal funds remained strong amid heightened expectations for future tax increases. Municipal new issue supply was relatively modest as issuance was diverted into taxable Build America Bonds.
• Treasury Inflation-Protected Securities (TIPS) outperformed their nominal counterparts during the third quarter, supported by positive inflation accruals and lower real yields across most of the maturity spectrum.
• The rally in emerging market (EM) bonds continued in the third quarter. EM bonds denominated in U.S. dollars outperformed Treasuries as credit premiums tightened on most bonds amid an increase in risk appetites and positive flows into the EM sector. EM assets denominated in local currencies also had strong returns, led by monetary stimulus in most EM countries. EM currency appreciation also helped boost returns of EM local assets.
• Yields on government bonds fell modestly in most developed markets during the quarter as concerns about the extent of global economic recovery lingered. Interest rate volatility generally decreased from recent periods. Among developed markets, U.S., U.K. and Eurozone bonds fared the best.

Commodities Lose Momentum and REITs Continue to Rally

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 a general rise in risk asset prices, 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. 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%and 45.6%, respectively while Storage and Factory Outlets were the weakest at 17.3% and 16.4%, respectively

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.

The Fund slightly underperformed its benchmark for the quarter and on a year-to-date basis

The following strategies contributed to third quarter returns:

• Bottom-up security selection strategies and interest rate strategies that seek to benefit from yield curve steepening
• A modest exposure to diversified commodities and gold and real estate through REITs
• Overweight to emerging market equities and exposure to high quality emerging market (EM) bonds as the rally in these asset classes continued in the third quarter

The following strategies detracted from third quarter returns:

• Underweight to global developed equities as equities continued to rally on the back of fiscal and monetary stimulus and inventory restocking.
• Positioning the portfolio to benefit from a steepening of the U.S. yield curve as the curve slightly flattened
• Tail risk hedging strategies as hedges lost value due to a rally in risk assets and time decay

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.

Tactically Manage Risk as Valuations Richen

PIMCO will maintain moderate exposure to risk assets as powerful rallies in these assets, driven primarily by favorable technicals and government policy, have caused valuations to richen. We believe this approach will help protect the portfolio in the event the economy slips back into a recession and should allow PIMCO to reinvest at more attractive valuations later.

• Asset Allocation Strategies – PIMCO’s asset allocation strategies continue to focus on risk factor diversification in addition to asset class diversification. Given the recent rally and the secular headwinds facing the global economy, we plan to be underweight the equity risk factor. We will look to obtain equity risk factor exposure higher-up in the capital structure through holdings in high-quality emerging market bonds. Despite the recent spread tightening between EM bonds and comparable maturity U.S. treasuries, we believe they still provide low-risk exposure to equity-like risk.
  
  Among key bond risk factors, we will look to overweight the interest rate risk factor and position the portfolio to benefit from a steepening of the yield curve. While shorter maturity yields are unlikely to move much from current lows, there could be downward pressure on longer maturity yields should the economy weaken over the next year. We also plan to retain money market futures positions in the U.S., Europe and U.K. as we anticipate that central banks will tighten more slowly than markets expect.
  
  Finally, the portfolio will be positioned to underweight the inflation risk factor in concert with PIMCO’s view of cyclical deflation and secular inflation. Thus, we may further trim exposure to inflation linked bonds and have exposure to Gold and payer swaptions to hedge against a sudden spike in inflation.
• Global Equity Strategies – Given the speed and strength of the recent equity rally, PIMCO will be taking a wait and see approach towards equities. We believe given the sharp recent rally and rich valuations, equities are likely not the place to be in the cyclical horizon. Within the equity allocation, we are overweight emerging market equities based on our outlook of a secular hand-off of growth from developed economies to emerging economies. We don’t consider emerging markets to be cheap at current valuations. Even at fair value, however, we favor them over international developed markets. They stand to benefit if economic growth turns out to be stronger than anticipated and longer term should benefit from strong demographics and more robust growth.
• Fixed Income Strategies – PIMCO will look to trim agency mortgage holdings which are now expensive. We will also trim corporate bond positions, especially those that have appreciated the most such as senior bonds of high quality banks. While we plan to underweight the corporate sector overall, we will retain an emphasis on recession-resistant sectors such as telecom and utilities as well as energy.
• Currency Strategies – PIMCO plans on taking exposure to high quality EM credits such as Mexico, Brazil, Korea and Russia, which have relatively little debt coming due in the near future and a high level of reserves. We plan to take similar positions in EM currencies, with the exception of Russia, and also plan to take exposure to the Chinese Yuan, anticipating that faster growth in these economies should allow their currencies to gain versus the U.S. dollar.
• Inflation Linked Bond Strategies – PIMCO plans on trimming exposure to inflation linked bonds. While TIPS offer a potential hedge against long-run inflation risks, their valuations compared to nominal bonds are unappealing over a cyclical time frame. As a consequence, we have significantly reduced exposure to real duration in the portfolio.
• Real Asset Strategies – We will continue to have modest exposure to diversified commodities and gold, but have trimmed our exposure to REITs. Commodity returns have remained relatively flat with the exception of gold, mainly due to volatile commodity demand prospects and a lack of clear direction. Commodity fundamentals remain generally consistent with the coincidental economic indicators that remain much weaker and more volatile than the positive leading indicators which are driving the equity rally. We have also significantly pared our exposure to REITs due to cyclical refinancing concerns. The Office of the Comptroller of the Currency announced that it was considering a move to order banks to begin writing down losses on commercial real estate loans. This announcement could have negative implications for commercial real estate as banks are forced to liquidate these marked down loans.