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InvestmentOutlookBillGross

January 20

Just a Singer in a Rock & Roll Band

I spent all day writing this Outlookand allI got for it was this lousy T-Shirt! Actu-ally Im referring to the IO that just hit mylibrary trashcan. That one just didnt cut it,and this one may not either! Writing Out-looks is getting a little bit harder these days.

Dont do this, dont do that, cant youreeeead the signs, scream the in-houselawyers. Go easy on Iraq, careful aboutwomen and minorities, eliminate refer-ences to politics, religion, and sex, and forGods sake dont mention any of our clientsor their products, which by the way knocksout about 250 of the Fortune 500 and everymajor industry in the U.S. Actually, as youmight have noticed, that hasnt stopped mefrom stirring up the politically and legallycorrect waters in recent years. But I sup-pose I tiptoe a little more carefully thesedays, if only in recognition that PIMCOs afranchise and not a start-up and there arenow many more livelihoods at stake thanmy own. Renting a soapbox right acrossthe street in Newports Fashion Islandcould be a much less expensive way to ventmy iconoclastic views I suppose.

And too, as many of you already believe,I am in Moody Blues parlance just a

singer in a rock and roll band. Theresnothing about being a bond market wizthat necessarily qualies me to opine onworld events, or anything else for thatmatter. The purpose of these introduc-tory paragraphs, however, has always beento liven-up a somewhat unfathomableand inherently boring topic and in thatI undoubtedly have succeeded beyondsomeones wildest dreams. The interest-

ing problem I nd these days besidesthe untouchable topics is that Im tryingto write less about me, and more aboutyou and human interaction, but nding itvery difcult to do. I tried to write a fewparagraphs once without ever using an

I, me or mine and found it almostimpossible to do and still sound interest-ing. Mark Twain undoubtedly could havedone it but then, as Senator Bentsen mighthave suggested, Im no Mark Twain. Assuch, I guess Ill have to stick to the ap-proach used by my wife Sue on many ofour frequent weekend walks around theneighborhood. After discussing an hoursworth of her problems shell turn to meand say But enough about me, lets talkabout you. What do you think about me?Ah, humor at its best. Its Sue that shouldbe writing these Outlooks if only she hadthe time.

Actually, Sue might stumble a little bitwhen it comes to the meat and bonesof bond market strategy. While she hasmastered the interest rates up/bond pricesdown maxim, she couldnt distinguish aBund from a Bond if she met one on thestreet, but then thats the only thing I can

do that she cant. And it was Bunds, notbonds that made the performance differ-ence for us in 2004. That along with TIPSand some strategically timed forays intoemerging markets. In a year that con-founded most bond managers, becauseof falling, instead of rising intermediateand long-term rates, we managed to avoidextreme duration statements and insteadproted by shifting money into reationary

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Investment Outlook

January 2005

beneciaries in the U.S. (TIPS) and neardeationary economies outside our bor-ders (Bunds).

2005 will witness a changing environmentin some ways slower global growth,somewhat higher short-term rates butthe dominant moneymaking themes inthe bond market should be the following:1) The Fed stays relatively low, 2) Chinarevalues its currency, 3) Spread productunderperforms, 4) Europe remains sick,and 5) Cash is Prince.

Let me elaborate:(1) The Fed stays relatively lowOur belief that the Fed stays relatively low

(% real short rates or less) is a long-stand-ing one and based on several secular andcyclical observations. Since the primaryglobal economic problem is a lack of whatis known as aggregate demand, centralbanks everywhere will continue to rem-edy the afiction by keeping real short

rates low. Low short yields help stimu-late demand by creating gradually risingination, and nurturing capital gains inequity, real estate, (and yes) bond markets.In addition, the highly levered U.S. con-sumer and their main conduit mortgagedebt require low short rates just to keeptheir heads above water. Thirdly, with theFed now implicitly on board in support ofadjusting our balance of payments decitvia a depreciating currency (and a reduceddecit), low real short rates are the mon-etary policy tool of necessity. Whether theFed stops at 2, 2, or 3% is really moreof a debate as to the future of U.S. ination,not the fact that real short rates must staydown for a long, long time.

(2) China RevaluesAdmittedly our most problematic moneymaking theme, if only because of its timing,is our belief that 2005 is the year whenChina/Asia revalue their currencies up-ward. Actually, the decision is entirely in

Chinas hands, but evolv-ing events should forceat least a semblance of aresolution. China will be

more inclined to revalueif internal ination ac-celerates (currently notthe case), their bank-ing system stabilizes,and/or tariff pressuresfrom the U.S. threaten tokill the golden goose offree trade. Perhaps justas important, Chinasgradual evolvement fromWTO inductee to poten-tial kingmaker at futureG8 economic policy dis-cussions argues for sometype of symbolic movethat speaks to coopera-tion in a global context.Chart I

Source: Department of the Treasury International Capital (TIC) Reporting System,Logical Information Machine. Copyright 1990, 2005 Bianco Research, L.L.C. Used by Permission.

U.S. Treasury Purchases by Japan and the Yen

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Plaza Accord

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840 Newport Center D

Newport Beach, CA 9

949.720.

ness and ineptitude in not climbing onboard the risk-taking train during a year inwhich corporate prots soared, the econ-omy stayed out of trouble, and investorschased yield like those buccaneers used tochase skirts at Disneylands Pirates of theCaribbean ride (discontinued in lieu of po-litical correctness). Still as forward-look-ing investors in search of predictability, itis fair to ask whether near historically lowspreads for corporate bonds as shown onChart II can be maintained or extended forlong. Our answer is probably not, buteven if they do, spreads are so slim thatthe capital gains inherent in spread nar-rowing are no longer likely and the yieldspreads offer little compensation for future

risks of an economic or geopolitical nature.

(4) Europe remains in its sickbedWith the Euro soaring and Euroland ina-tion moving down not up, German Bundsremain a better alternative than U.S. Trea-suries despite their 50 basis points loweryields. One should recognize that this 50basis point negative hook come FebruarysFed hike will be completely eliminated ona currency hedged basis. Additionally, ac-

counting changes for insurance companiesand other European nancial institutionswill soon mandate the purchase of longdated xed income assets that could mimicthe behavior (and inversion of its yieldcurve) of U.K. markets in recent years.Finally, Asian currency/asset diversica-tion points toward further accumulationof Bunds as opposed to Treasuries over thenext 12 months. They may not make ouryear in 05 like they did in 04, but theresmore life left in that old German mare.

(5) Cash is PrinceFinally, it seems difcult to imagine howmany if any xed income maturities/

sectors can outperform good old cash in2005. Take the example of a 5-year Trea-sury for instance whose duration and yieldpretty well reects that of the bond marketitself. At 3.60% and with a duration of 4.25years an increase of only 15 basis pointsover the next 12 months will lower its totalreturn to 3% for 2005 a return that mostinvestors believe will be available fromshort-term commercial paper. The skirtsthat todays bond market buccaneers arechasing therefore, are not only politicallyincorrect but needlessly risky relative tocash alternatives. Cash may not exactlybe King in the current 2-3% range, but letscall it a Prince. Better than being a 1% frogI suppose, like it was for much of 2004.

The successful 2005 bond strategy there-fore, will likely be to avoid duration, avoidspread product and to ock to the stabilityof cash, TIPS, and foreign bonds issuedby strong currency countries in an openlyreationary world. If so, bond marketreturns of 3-4% for the year may be all aninvestor can rationally expect, and if thoseAsian investors ee for the exits then longerduration portfolios might even wind up

in the red. As always, I/we thank you foryour condence in PIMCO these manyyears and I in particular promise to benicer and more sensitive when writing myInvestment Outlooks (and if you believe that,you likely believe that Bush will actuallycut the decit in half, that well be out ofIRAQ in a few years time, and that privati-zation of social security will x a suddenlybankrupt system! As to my opinion ongay marriage,

censored by PIMCO lawyers.)

William H. GrossManaging Director

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Past performance is no guarantee of future results. The charts port rayed in this article are not indicative of thepast or future performance of any PIMCO product. This article contains the current opinions of the author and suchopinions are subject to change without notice. This article has been distributed for informational purposes only and isnot a recommendation or offer of any particular security, strategy or investment product. Information contained hereinhas been obtained from sources believed to be reliable, but not guaranteed.

Each sector of the bond market entails risk. Mortgage-backed securities and Corporate Bonds may be sensitive tointerest rates. When interest rates rise, the value of xed income securities generally declines and there is no assurance

that private guarantors or insurers will meet their obligations. An investment in high-yield securities generally involvesgreater risk to principal than an investment in higher-rated bonds. Investing in non-U.S. securities may entail risk dueto non-U.S. economic and political developments, which may be enhanced when investing in emerging markets.Ination-indexed bonds issued by the U.S. Government, also known as TIPS, are xed-income securities whoseprincipal value is periodically adjusted according to the rate of ination. Repayment upon maturity of the originalprincipal as adjusted for ination is guaranteed by the U.S. Government. Neither the current market value of ination-indexed bonds nor the value a portfolio that invests in ination-indexed bonds is guaranteed, and either or both may

uctuate.

The Collateralized Debt Obligations (CDOs) market, which includes Collateralized Loan Obligations (CLOs) isa special purpose investment vehicle, established to purchase and hold a portfolio of assets managed by an investmentmanager. The investments of the CDO are funded through the issuance of several classes of securities, the repaymentof which is linked to the performance of the underlying securities that serves as collateral for the CDO liabilities.Use of these instruments may involve certain risks such as liquidity risk, interest rate risk, performance of the underlyingcollateral, callability risk and rating volatility of senior notes.

No part of this article may be reproduced in any form, or referred to in any other publication, without express writtenpermission of Pacic Investment Management Company LLC. 2005, PIMCO.