Market Environment

Foreign equities continued gaining momentum that started in the second quarter, posting a 19.5% return during the third quarter as measured by MSCI EAFE Index. The Index continued the rally that began in mid-March, registering positive returns in each of the three months this quarter, up since its early March low. Stocks appreciated as the economy showed broad signs of improvement. The majority of economic data released during the quarter came in above expectations. Manufacturing reports were largely positive, a slew of housing reports showed signs of stabilization, and consumer confidence improved overall. While the global recession appears to be nearing an end, the labor market is still weak. The Federal Reserve and the Bank of England each kept their target short-term interest rates steady at historic lows, with the fed funds rate at 0%–0.25% and the Bank of England Bank Rate sitting at 0.50%. The European Central Bank (ECB) also continued to keep rates at historic lows and unchanged since May at 1.00%. It is widely believed that the ECB and the Bank of England will not begin raising interest rates until next year.

In many ways, the third quarter represented the extension of the second quarter. As the market continued its recovery during the third quarter, broad based gains extended across all sectors with more cyclically oriented sectors—financials, materials, and industrials—continuing to lead the way.

Stylistically, value stocks outperformed growth stocks. Most developed markets around the world posted double digit gains in the third quarter while emerging markets led the way with an increase in the MSCI Emerging Markets Index.

Many European stocks were broadly higher during the quarter (the MSCI Europe Index was up) with positive returns across different European sub-regions. Most countries recorded gains for the quarter.

Asian stocks continued to experience a strong increase throughout the region (the MSCI All Country Asia ex Japan gained). Japan’s stock market was a global laggard in the third quarter, with the MSCI Japan Index rising. Japanese companies plan to deepen investment cuts as profits slump. The yen’s 8% gain in the last three months is another blow to Japanese exporters but boosted USD denominated investor returns. There was a change in political power in Japan with the Democratic Party of Japan winning general elections in August and taking over from the Liberal Democratic Party for the first time since 1955. The latest Tankan survey of corporate sentiment showed that the key confidence index for large manufacturers in Japan rose to -33 points from -48 points in the previous quarterly survey in June and a record low of -58 in March. This improvement matched many economists’ prediction, and only brought the index on par with the level during the 2001 recession.

After experiencing over 35% growth in the second quarter, China continued its steady growth during this quarter (MSCI China Index was up).

The Allianz RCM Disciplined International Equity Fund was up in the third quarter of 2009 and outperformed the MSCI EAFE Index. Overall, the slight outperformance was mostly attributable to sector allocation decisions while stock selection hurt. Specifically, the underweight position in consumer discretionary, specifically in automobiles & components and consumer durables & apparel subsectors helped performance. On the other hand, the underweight position in financials and banks in particular hurt performance.

Out of the top 5 biggest contributors to returns, 4 came from the financials sector: Prudential, Alpha Bank, Societe Generale and HSBC Holdings. Completing the top 5 contributors is the French company PPRS.A., a luxurious apparel holding which owns a 99% stake in Italian luxury goods company Gucci Group, and luxury brands Alexander McQueen, Bottega Veneta, Stella McCartney, and Yves Saint Laurent, among others.

The largest detractors on a stock basis were Japanese holdings Sumitomo Mitsui Financial Group, Nintendo, and Nippon Electric Glass. Sumitomo was down on fears that new Japanese government will increase regulations, as well as because of increase in NPLs (non-performing loans) due to the weak economy in Japan. Nintendo was down on downward EPS revisions, but we still own it and have been opportunistically increasing this position because of attractive valuations. Nippon Electric Glass was among the big winners in the second quarter and we have been adding to this position on recent weakness as we still believe global demand for LCD glass continues to be strong.

The third quarter brought about the continuation of an encouraging equity market rally, an increase in investors’ risk appetite and some signs of economic stabilization. As we look forward to the remainder of the year, we are optimistic that the world economies will continue to stabilize or even grow in the coming months. Among growing economies, Japan was an exception. While we were surprised by how badly the Japanese market performed, we used this opportunity to increase our positions in a number of Japanese holdings such as already mentioned Nintendo and Nippon Electric Glass, as well as Kurita Water Industries, a specialized international maker of water treatment equipment, and Benesse Corporation—a provider of education, lifestyles, nursing care and language study services.

Given our expectations for economic growth, we maintain our positive outlook on equity market returns. Improving investor sentiment, stimulative monetary and fiscal policy initiatives and a high level of available cash to invest help support our view. We believe the market gains may slow compared to the sharp rebound experienced earlier in the year. Further, the recent rally has been broad-based and led by economically exposed sectors. We believe we are entering a stock specific environment that will reward companies able to improve their businesses and grow profits.