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 financial 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 in emerging economies posted strong gains 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 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 unlevered 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.

The StocksPLUS® Fund outperformed its benchmark, S&P 500 Index, for the quarter and YTD. PIMCO’s emphasis on attractively priced high quality assets, especially those with government support, was beneficial for performance.

The following strategies helped third quarter returns:

• Broad exposure to the yield curve, which provided incremental yield and positive price performance as yields declined moderately
• Money market futures in the U.S., Europe and the U.K, which gained as central banks indicated short maturity rates would remain low longer than markets had expected
• Money market futures, which gained as central banks indicated short maturity rates would remain low longer than markets had expected
• An emphasis on Agency mortgage pass-through securities; valuations of these bonds benefitted from continued purchases by the Fed
• Holdings of high quality consumer asset-backed bonds and non-Agency mortgage securities, which gained amid strong government policy support

The following strategies were negative for quarterly returns:

• An allocation to money market instruments, which provided a liquidity buffer at the expense of reduced yield

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 reduce risk exposures after rallies in non-Treasury assets caused valuations to richen; this should protect portfolios if the economy slips back into recession and allow PIMCO to reinvest at more attractive valuations later
• Maintain extended duration and broad yield curve exposure to capture additional yield; we expect the U.S. yield curve to remain relatively steep
• De-emphasize Agency mortgage-backed securities (MBS), which are expected to cheapen as the Fed’s mortgage purchase program nears its end next March
• Trim corporate bond positions, especially those that have appreciated most such as senior bonds of high quality banks; retain an emphasis on recession-resistant sectors such as telecom and utilities as well as energy
• Look to boost yield by earning premiums on written options
• Take modest exposure to high quality emerging market credits such as Mexico and Brazil that have little debt coming due in the near future and a high level of reserves
• Plan to take positions in select emerging market currencies in light of an expected long-run decline in the U.S. dollar