Bill Gross Co-Founder and Co-CIO PIMCO	Mohamed El-Erian CEO and Co-CIO PIMCO

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As the global financial crisis continues to evolve, investors want to know how to position their portfolios appropriately for both the journey we are on and the destination we are moving toward. PIMCO Co-Founder and Co-CIO Bill Gross and CEO and Co-CIO Mohamed El-Erian spoke to clients about the extraordinary events of the past year and a half, the financial and economic fallout, the near-term outlook and PIMCO’s approach to investing in these uncertain times.

The problematic nature of the current recession

• Traditionally, economic growth has been a delicate balance between finance and production, with the growth/recession cycle determined by monetary policy rates and inventories. However, the makings of the current recession included the additional long-term “trans-generational” element of leveraging in the housing and financial markets.
• This recession is the result of typical imbalances–-an oversupply of houses–-but also of a global economy that was fueled by a leveraged financial complex and a level of debt that was unsustainable.
• The increasing leverage in the U.S. economy goes as far back as the era of the Bretton Woods agreement in the mid-1940s, accelerated in the 1970s and 1980s with the advent of financial leverage, and topped out in recent years with the Shadow Banking System—which was not well recognized or regulated by policymakers—and U.S. housing bubble.
• This is not a mild inventory correction; it’s a delevering, deflationary debt-liquidating cycle.

Policy changes posed by deleveraging of balance sheets throughout the global economy

• Multiple, ongoing sequential deleveraging has made the unthinkable thinkable: Housing began to deleverage in the summer of 2006; the financial sector began to deleverage in 2007; consumers started to deleverage in 2008; after September 15, the rest of the world started to deleverage.
• When so many balance sheets contract at the same time, the only balance sheet that can possibly offset the impact on asset prices is the balance sheet of the government. The U.S. has led this effort, but around the world we are seeing governments making their balance sheets available to fix and temporarily skirt the broken banking system to target interest rates paid by consumers and homeowners.
• Massive job losses have awakened policymakers and reduced resistance to stimulus proposals.
• The complexity of the deleveraging process is likely to result in a sequential yet non-linear recovery. There are questions about the necessary size of policy responses, the ability to effectively implement programs in the required timeframe, and the balance between non-market-based and market-based solutions.
• Part of the consequence of the deleveraging and government involvement will be lower potential for growth. Over the next few years, there will be less leverage to stimulate growth, a larger propensity for consumers to save rather than spend or invest, and dampened animal spirits following wealth and income shocks. Lower growth will also likely be spurred by collateral damage from government involvement in the corporate environment.
• “Speed limits” on growth will be mitigated to the extent that richer emerging market countries step up and reduce their saving rate and start consuming more.
• Investors can’t just wait for a mean-reversion to previous growth and investment returns. This time around, strategies must reflect the substantial changes that are underway for the global economy. Consolidation and de-risking of the banking system, as well as the drastic shift in leverage around the world, will mean that many business and investment strategies will no longer be viable.

Overview of PIMCO’s recent and current investment strategies

• As PIMCO anticipated a burst housing bubble, debt-deflation cycle, systemic deleveraging and Federal Reserve rate cuts, the initial investment strategy was to own the front end of the curve in Treasuries and similar instruments.
• Now, governments are shifting from monetary policy responses to asset price support, with guarantees or purchases of broad asset classes. In response, PIMCO’s investment strategy shifted from focusing on the front end to “shaking hands with the government”:
  • Partnering with the government means buying assets that the government is supporting, at or above the level in the capital structure where the government buys.
  • Bonds are preferable to equities – common shareholders are being diluted or taken out by government interventions.
  • While our purchases of bank debt earlier in 2008 were somewhat premature, we remain firmly committed to our strategy of investing with an eye toward what the government is doing.
• It’s not enough to be at the top of the capital structure. In this environment you need to purchase bonds that are explicitly protected or of extremely high quality.
• The investible universe can be seen as concentric circles of increasing risk:
  • Treasury bills/Fed Funds are safe, but low yielding and expensive
  • Mortgages still offer attractive carry, but are no longer cheap
  • Investment-grade corporate debt should be considered only if extremely high quality
  • High yield, equity and private equity remain too risky in this environment

PIMCO remains focused on high-quality corporate debt

• We see a significant differentiation in the corporate sector:
  • Investment framework is anchored by both economic and policy considerations.
  • For each credit, we must have a fundamental reason to believe that the current price dislocation will be corrected over the next several quarters, or that there will be additional catalysts that will accelerate price recovery.
  • Focus on staying high on both the corporate capital structure and the economic capital structure.
• Lower-quality corporate bonds appear more vulnerable amid a deteriorating economy and continued stress in credit markets and the banking system. Corporates came into this economic cycle with strong balance sheets, but their “self-insurance” has been devoured.
  • Cash levels are down as retail sales plummet.
  • Banks are hesitant to renew credit lines.

High quality agency-backed mortgages still appear attractive, but for different reasons

• PIMCO initially purchased agency mortgage-backed securities (MBS) in anticipation of government programs to support the housing market and the agencies.
  • The government has announced it will buy up to $500 billion in Agency securities, which represents roughly 20% of the outstanding mortgages held outside of the Agencies.
  • This announcement is now largely priced in, and most mortgages are trading above par.
• Agency MBS are yielding 4% plus-or-minus in terms of carry yield, which is still attractive compared to 2%–3% on swaps and even lower on Treasuries.
  • PIMCO is content with what we have, and will continue to move into other higher yielding, but what we believer are equally safe, sectors.
  • Agencies remain a safe haven in our view, their securities are guaranteed by the government, supported by Fed purchases, and likely to be subject to less volatility.
• Higher-coupon mortgages should get steady price support over the next six months, despite potential short-term volatility and uncertainty related to potential refinancing.

Investors want to be in those long duration assets that are going up in price.

Many times bonds don’t move together as an asset class and it’s important to remember that current and future holdings are subject to risk.

• PIMCO prefers longer duration in sectors where government policy support is relatively clear – sectors that are receiving funds from the Troubled Assets Relief Program (TARP) in the form of equity investments, FDIC guarantees on unsecured debt, and access to the Fed’s liquidity facilities.
• We are seeking to avoid or maintain short durations in riskier areas, such as high yield, emerging market bank loans, and commercial MBS.
• Probability for deflation is low, though higher than previously thought
• PIMCO anticipates several months, if not several quarters, of minor negative consumer price index readings due to excess capacity, production and employment levels.
• The current intent of government policy is to reflate the economy, and PIMCO believes it will be successful. The Fed and the administration are trying to combat the deflationary menace, and avoid a potential liquidity trap.
• Deflation is not our forecast, but it is a tail risk, i.e. deflation would be the result of a failure of all the current and future policy programs, which is not our baseline outlook.

Inflation is likely to rise over the medium term, but not in the near term due to sharply reduced demand

• There are currently few inflationary pressures, and the immediate outlook is for subdued inflation. Demand will stay lower than the potential growth rate of the economy, commodity prices have declined sharply, and unemployment is putting downward pressure on wages.
• Over the medium to longer term, we’re likely to see inflation stemming from the government’s policy measures. They are likely to overdo the response and flood the system with liquidity, which will lead to higher inflation once the global economy regains traction.