Bob Greer Executive Vice President PIMCO	Chris Caltagirone Vice President PIMCO

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PIMCO recently held a call to talk about commodity markets, inflation and real return investing in the current environment. Bob Greer, executive vice president and real return product manager, and Chris Caltagirone, vice president and product manager, discussed the tumultuous events of the past year, the outlook for the future, and the potential benefits of the CommodityRealReturn Strategy, which combines derivative commodities exposure and an actively managed Treasury Inflation Protected Securities (TIPS) portfolio.

Commodities Markets in 2008 and 2009

In the first half of 2008, investors still believed the global economy was growing. In particular, they expected the strength of the Chinese economy would continue to fuel increasing demand and higher prices for commodities. This dynamic was coupled with constrained supplies for some commodities: the expected decrease in Russian crude oil production after 2007’s peak and historically low inventories of wheat and corn, for example. Markets searched for equilibrium prices under the assumption that supply and demand were inelastic, spurring a rise in volatility and prices.

In the second half of 2008, the gains in the first half of the year were erased. The Dow Jones AIG Commodity Total Return Index ended the year down just over 35% as the economic outlook deteriorated sharply and the supply and demand dynamics were reversed. For example: • U.S. drivers clocked fewer miles and switched to more fuel-efficient cars.

• The U.S. Strategic Petroleum Reserve discontinued purchases of West Texas Intermediate light sweet crude oil.
• Nigeria, a large supplier of light sweet crude, had fewer production disruptions.
• Favorable crop conditions led to expectations for a global wheat surplus.
• In the fall, the credit crunch forced investors to exit commodity futures positions, making the market less liquid and exacerbating price movements.
• As the liquidity problems on Wall Street spilled over to Main Street, the expectation for a global recession drove commodity futures prices down further.
• While futures markets were less liquid, they continued to function properly throughout the credit crisis.

Commodities and Diversification: What Happened in Q4 ‘08?

Diversification does not necessarily mean commodity prices will always rise when prices of stocks or bonds fall. Rather it means that the fundamental factors driving commodity prices are different than the primary factors driving stock or bond prices. In the first half of 2008, commodities and equities moved in opposite directions, driven by completely separate factors. In the second half of 2008, commodities and equities both fell for related, but different, reasons.

• In the fourth quarter of 2008, bond prices were driven lower primarily by the credit crunch and liquidity crisis.
• The liquidity crisis morphed into an economic crisis, driving equity prices down primarily due to expectations for a global recession.
• Commodity prices, on the other hand, were driven lower primarily by expectations for falling demand and fewer supply constraints.

Outlook for commodities in 2009

The near-term outlook for commodities is uncertain, since we don’t yet know how long or severe this global recession will be. We do know that much of the reduction in commodity demand is due to slower economic growth, and we are beginning to see less correlation between individual commodities across the broader commodities market, as individual commodities are beginning to be affected by individual supply factors, rather than just demand expectations. We believe that the credit crisis and the decline in commodity prices are sowing the seeds of future commodity price appreciation.

• Due to lower commodity prices and tight credit, commodities producers are delaying projects for capacity expansion, which could constrain future supply when global growth resumes.
• For example, as the credit crunch encroaches on the agricultural markets, farmers cut their plantings because of falling prices for their crops and lack of financing to buy fertilizers, reducing supply.

A Volatile Year for TIPS

The decline in TIPS prices in 2008 makes TIPS attractive on an absolute basis and relative to nominal Treasuries. Even though the near-term outlook for inflation remains very low, PIMCO’s secular outlook for developed economies paints a supportive picture for TIPS, since inflation is expected to rise over the medium term.

• Break-even inflation rates are priced to reflect expectations for nearly 3% deflation over the next five years. This is not PIMCO’s outlook, and suggests that TIPS are significantly undervalued.
• While growth is expected to contract in 2009, government stimulus may reflate the economy in 2010 and beyond.
• PIMCO expects several months or quarters of negative year-over-year consumer price index readings due to excess capacity and production and lower employment levels.
• Over the near term, a lack of inflationary pressures along with the likelihood of below-potential growth should keep inflation subdued. The Federal Reserve and Obama administration are trying to fight the deflationary menace and avoid a potential liquidity trap – these policies are likely to reflate the economy over the 3–5 year secular horizon.
• PIMCO's outlook for year-over-year headline inflation is low to no-inflation.

TIPS and Commodity Exposure in PIMCO’s CommodityRealReturn Strategy Fund

The PIMCO CommodityRealReturn Strategy Fund derives its exposure to commodities from derivatives that track the Dow Jones AIG Commodity Total Return Index, and the derivatives are collateralized with an actively managed TIPS portfolio. This combination provides a “Double Real” return that captures specific commodity inflation through the index exposure and broad price inflation via the TIPS portfolio.

• Index exposure offers broad exposure to the entire asset class, without the complication of owning individual commodities.
• Commodities offer the benefits of diversification within a portfolio as well as a historical negative correlation with stocks and bonds over longer periods of time.
• The CommodityRealReturn Strategy Fund may add alpha over the long term. It is actively managed to employ the full breadth and depth of PIMCO’s investment process, and it seeks to take advantage of structural inefficiencies and risk premiums in the commodity markets.

Commodities within Broader Asset Allocations

There is no definitive level of exposure to commodities that is universally appropriate for all portfolios. One of the most important aspects of assessing the appropriate commodity allocation is to understand one’s risk tolerances and how commodities fit into overall risk factor allocations.

• An Ibbotson Associates study recommends an allocation of as little as 5% and as much as 20% in commodities in a moderate risk portfolio.
• It can be prudent to phase commodities into a portfolio over time – for example, by committing to half of a proposed exposure for the first 6-9 months in order to become accustomed to how commodities perform from month to month.

Conclusion: Benefits and Purpose of Commodities Investing

• Increased portfolio diversification
• Negative historical correlation to stocks and bonds
• Historical returns that are comparable to equities

PIMCO believes that a future increase in global demand for commodities along with a reduction in supply offers potential for price appreciation in this asset class. But again, PIMCO thinks the primary benefits of investing in commodities are diversification and inflation hedging. Don’t buy commodities because they are going up; buy them because you want to expect the unexpected.