Mark Kiesel

G L O B A L C R E D I T P E R S P E C T I V E S

Investors should focus on investing in “rising stars” in countries and industries with stable to improving fundamentals, in companies with strong bottom-up credit fundamentals and in securities with attractive valuations. A rising star is an investment opportunity with an improving outlook due to positive fundamental credit trends. The future should be bright for investors who embrace investing in rising stars.

Over the past year, senior members of PIMCO’s global credit team and I have travelled extensively around the world in search of companies with improving fundamentals. We are finding numerous opportunities in investments tied to emerging markets as these countries provide supportive macro-economic tailwinds of healthy economic growth, low leverage, rising consumer wealth and favourable demographics, and sovereign resources.

Globally, the banking, pipeline, energy, oilfield service, industrial, agricultural, paper and packaging, and metals and mining sectors all offer select attractive opportunities, as these industries benefit from positive longer-term secular and short-term cyclical trends. Not surprisingly, PIMCO’s internal credit ratings tend to be higher in companies in these industries than agency ratings such as Moody’s and Standard & Poor’s. We are finding numerous global opportunities to invest in “rising star” companies where our views differ from those of the market’s and where we see a positive credit trajectory in bonds, loans and other securities that offer attractive valuations.

PIMCO’s disciplined global investment process provides the step-by-step screening necessary to find attractive investment opportunities around the world which pass our top-down, bottom-up and relative value tests. Our on-the-ground global research in countries all over the world and face-to-face meetings with senior management provide the final due diligence necessary to confirm “rising stars”. This global investment process is conducted or supported by our team of 38 credit analysts and 30 portfolio managers focused exclusively on credit around the world.

The Secular Case for Rising StarsPIMCO’s global credit investment process starts with our secular, or longer-term, views which are favourable toward investing in companies with exposure to the emerging markets. We believe investments which are tied to emerging markets should outperform those in developed markets due to longer-term secular factors that support emerging markets. These secular features include lower public and

April 2011

Rising Stars

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G L O B A L C R E D I T P E R S P E C T I V E S

private sector leverage, expanding credit availability, improving education and infrastructure, and favourable consumer and demographic trends.

One of the most important reasons why the emerging markets can grow faster than the developed markets is that they are less levered than the developed countries both in terms of public sector and private sector debt levels. This factor is significant, as high and growing debt burdens act as a constraint on economic growth and impair a country’s financial flexibility. As an example, Greece, Ireland and Portugal are all now set to experience deep austerity measures and public sector spending cuts due to high debt levels which will likely result in these countries experiencing sharply below-trend economic growth for several years. As is the case with these countries as well as other countries with elevated debt levels, high debt service burdens and elevated current account deficits negatively impact a country’s ability to service their debt and experience strong secular growth.

Countries with high and rising debt burdens should grow more slowly than those countries with low debt levels. This is because high debt levels negatively impact financial flexibility and credit availability. The weak economic outlook for European peripherals is also a risk for core Europe due to cross-border banking and trade linkages throughout Europe

as well as growing fiscal transfers, which could weaken countries such as Germany, which has historically benefited from strong fiscal discipline and financial flexibility through low funding costs.

Fortunately for emerging markets, lower private and public sector debt levels allow the consumer, business and government sectors to grow at a healthy pace. This feature provides emerging markets the financial flexibility to take on more debt over time as wealth increases and as these regions develop deeper capital markets and financial intermediaries.

Another factor supporting investing in companies tied to the emerging markets includes a concept we call “catching up”. Emerging markets are picking up on a relative basis to developed countries due to improvements in education, infrastructure and productivity. Rising wealth has allowed emerging market countries to make significant improvements in both public and private sector education as well as invest in critical infrastructure throughout their countries. While poverty rates are still elevated and infrastructure is still lacking in many areas, significant progress has been made throughout the emerging markets to improve literacy levels and education and improve roads, bridges, airports, ports and railways. These developments support the secular trend of growing wealth and middle class “purchasing power” as these consumers “catch up” to the rest of the world.

Figure 1

Source: Government debt and 2010 GDP estimates from the IMF, as of October 2010. Private sector data for Japan, China, India, Brazil and Russia from Haver Analytics, estimates for 2009 actual, as of April 2010. Private sector data for U.S., U.K. and Germany from IMF, as of October 2010.

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t % G

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Emerging Markets’ Debt Lower

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Household Government

Non-Financial Financial

Figure 2

Source: World BankWorld Bank has defined the middle class as individuals earning an income falling between the per capita income of Brazil and the per capita income of Italy

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China East Asia ex. China South Asia Latin America

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Emerging markets have also embraced technological improvements and benefited from advancements and investments already made in the developed world. Emerging markets have shown a remarkable ability to transform and move up the learning curve at an accelerating rate. This combination of improvements and “catching up” has resulted in rising productivity, growing wealth and rising incomes. These developments have supported declining unemployment rates for the past two years in emerging market economies.

Importantly, improved literacy, job growth and infrastructure have accelerated a secular trend, which is already firmly in place – rising emerging market consumer demand growth. Indeed, consumption is picking up as fiscal and monetary stimulus is set to gradually fade. The “hand off” from government, business investment, and exports to the emerging markets’ consumer is gradual, but nevertheless an important step in the emerging markets’ eventual transition from developing to developed economies.

Favourable demographics, rising consumer wealth and significant natural resource assets are all additional factors which should allow emerging markets to sustain faster economic growth. Unlike in most developed economies such as in the US, UK, Europe and Japan, emerging markets have faster growing and

younger populations. In addition, emerging markets benefit from competitive labour cost advantages in the case of China, and significant energy, metals and mining, and agricultural resource assets in the cases of Russia and Brazil. These sovereign assets allow emerging markets to grow wealth at a faster rate. As evidence, wages in China and Brazil are rising significantly faster than wages in the US, UK, Europe and Japan.

The benefits of attractive labour and resource assets allow emerging markets the opportunity to grow faster on a secular basis versus the developed markets. Over the past several years, select emerging markets have grown significantly faster than the developed markets.

Figure 3

Source: Bureau of Labor Statistics (BLS), Instituto Brasileiro de Geografia e Estatística (IBGE) and Federal Service of Statistics Russia

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U.S.BrazilRussia

Figure 4Source: U.S. Census Bureau as of 12/31/2010

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Figure 5

Source: National Bureau of Statistics of China and Bureau of Economic Analysis

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Emerging Markets vs. Developed Market Growth

Emerging Markets “Running Fast”

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G L O B A L C R E D I T P E R S P E C T I V E S

This stronger economic growth profile is an

important factor in picking “rising stars” because

emerging markets’ demand growth alone

can significantly drive positive fundamental

improvement in a credit.

For all the above reasons – lower debt levels,

expanding credit availability, attractive labour

and resources, and favourable demographics –

investing in credits tied to the emerging markets

secular growth engine is a strategy we continue

to believe in. While there are some cyclical risks

in emerging markets, investors should focus

on these secular themes and focus investments

in areas that stand to benefit most from these

positive long-term trends.

The Cyclical Case (and Risks) for Rising Stars

Our cyclical, or near-term, views remain

favourable for emerging markets and for

companies tied into strong near-term economic

growth in emerging markets. In terms of our

cyclical economic growth outlook, we expect

emerging market economies such as Brazil,

Russia, India, Mexico (BRIM) and China to grow

real GDP at 5.5% to 8.5% and nominal GDP at

12.5% to 13.5% over the next year versus only 1%

to 3.5% real GDP and 1.5% to 5.5% nominal GDP

for the developed market economies, such as in

the US, UK, Europe and Japan. World real GDP

we estimate at roughly 3.25% to 3.5%, and 6%

nominal over the next year. The sharp contrast

in the outlook for economic growth between the

emerging markets and the developed markets

is striking and supports an investment strategy

which favours “rising star” companies linked to

stronger economic growth in emerging markets.

PIMCO’s Cyclical Outlook for Real GDP and Inflation (Across Regions)

Country Real GDP Growth (%)

Headline Inflation (%)

United States 3.00 – 3.50 2.75 – 3.00

Euro-area 1.25 – 1.50 1.50 – 1.75

UK 1.00 – 1.25 2.75 – 3.00

Japan 1.00 – 1.25 0.25 – 0.50

China 8.00 – 8.50 4.50 – 4.75

BRIM 5.50 – 6.00 7.25 – 7.75

World 3.25 – 3.50 2.75 – 3.00Source: PIMCO, Q2 2011 – Q1 2012 forecast

Figure 6

The main macroeconomic risk for emerging markets over our cyclical horizon is inflation and how policy makers respond to rising food and energy prices. Global economic growth is “picking up” and emerging market growth is “running fast” causing concerns over rising inflation. To be clear, fiscal and monetary policies in emerging markets are set to gradually tighten. As evidence, fixed income markets are pricing in higher rates and tightening, particularly across the emerging markets. However, we believe emerging market countries are more concerned about the growth effect than the inflation effect of higher commodity prices, particularly in the case of oil. As a result, we believe emerging market countries are unlikely to raise rates aggressively, but rather will “tap

Figure 7

Source: Morgan Stanley, as of March 14, 2011

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Market Pricing in Rate Hikes, Particularly in Emerging Markets

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on the breaks” gradually through a combination of increasing government subsidies, gradual emerging market currency appreciation and measured fiscal tightening measures. A gradual tightening of fiscal and monetary policy should prevent over-heating in the emerging markets. Nevertheless, inflationary risks are rising in developing economies and will remain a critical factor to monitor throughout this year.

As we described in our January 2011 Global Credit Perspectives, Running Fast, economic growth will likely continue to “run faster” in the U.S. than in Europe and Japan due to accommodative monetary and fiscal policy. The outlook for inflation in the developed markets is similar to that in the emerging markets in that inflation has troughed on the cyclical basis. Globally, inflation risks are tilted to the upside as output gaps have closed with supportive monetary and fiscal policies, import prices have risen due to strong economic growth in the emerging markets and tight supplies across numerous commodities and inflation expectations are beginning to pick-up in most emerging market economies as well as in some developed economies. From a cyclical perspective, running fast in emerging markets and running faster in the US means inflationary risks will continue to be biased toward the upside.

We believe the Federal Reserve will be on hold throughout the balance of this year and not raise interest rates until the first quarter of 2012 at the earliest. The Federal Reserve’s dual mandate of full employment and low inflation argues that the Fed will maintain an inflationary bias over the near-term due to high US unemployment. This “reflationary policy” is evident in short-term US real interest rates which remain negative. In contrast, the European Central Bank (ECB) and even the Bank of England (BOE) are likely to tighten monetary policy this year due to rising inflationary pressure. Nevertheless, we do not expect tightening to be significant or more than what has already been priced into the forward

curve and market in either Europe or the UK due to weak economic growth. Finally, Japan’s economic growth should be negatively impacted over the near-term due to the devastating earthquake and destructive tsunami and ongoing nuclear reactor uncertainty at the Fukushima Daiichi nuclear power plant. These tragic developments should keep the Bank of Japan (BoJ) highly expansionary over our cyclical horizon. As a result, monetary policy across the developed economies should remain supportive for economic growth.

Finding Rising Stars Around the WorldWith global inflation set to pick-up and economic growth supported over a near-term cyclical horizon, investors should focus on industries and sectors which stand to benefit from strong economic growth in emerging markets, solid near-term economic growth in the US and rising inflationary pressures throughout the world. Importantly, companies in various industries around the world are set to be both positively and negatively impacted given this economic backdrop.

Specifically, companies which are tied most directly into the strong economic growth engine in the emerging markets should have the most “pricing power” and ability to either “pass through” rising costs or absorb them without a significant margin

Figure 8

Source: Federal Reserve and Bureau of Labor Statistics, as of 2/28/2011 Fe

d Fu

nds

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et R

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Fed Policy Bias Towards “Re�ation”

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G L O B A L C R E D I T P E R S P E C T I V E S

hit. In contrast, companies which are less exposed to emerging markets, and more dependant on growth in the developed markets, will likely have less “pricing power” and be more negatively effected by rising prices for both food and energy prices.

A company’s “pricing power” today is more important than ever because emerging markets, which not long ago exported deflation throughout the world, are increasingly transforming and in the process are starting to export inflation. Importantly, policies to prevent emerging market currency appreciation are promoting an additional inflationary bias into the global economy as rising import prices for both food and energy are now being increasingly “passed through” into higher finals goods prices throughout the world. Companies that can “pass though” these higher costs have “pricing power” and those companies that can not “pass through” do not.

In general, multinational and emerging market companies which do a significant amount of business in the faster growth emerging markets and which have stronger brands and products stand a better chance of being rising stars than developed country companies which are primarily exposed and dependant on a slower growth domestic market. For the large cap multinational and emerging market companies, strong top-line sales growth allows for significant cash flow generation to pay down debt and de-lever, even in an environment where inflation is rising. In contrast, for the smaller, domestically exposed companies, a weaker revenue outlook and rising costs should result in margin compression and more limited financial flexibility and ability to de-lever.

Given this outlook, we find the most “rising stars” today in banking, pipeline, energy, oilfield service, industrial, agricultural, paper and packaging, and metals and mining. Banks in the US, UK and in the emerging markets have “turned the corner” due to strong government support, accommodative monetary policy and improving economic growth.

Banks in these regions are now experiencing significant improvements in asset quality trends and capital ratios. Given this backdrop, credit fundamentals have turned positive and many banks should experience improving credit trends and ratings migration over the next year.

Outside of select banking opportunities around the world, resources are the other main “rising star” opportunity in today’s global market. Rising inflation and accommodative monetary and fiscal policies support investing in hard assets in select pipeline and paper and packaging companies which stand to benefit from improving asset coverage ratios as well as pricing power due to capacity reductions and industry consolidation. Finally, strong economic growth in the emerging markets, improving growth in the US and a weak dollar provide a positive backdrop for investments in the energy, oilfield service and metals and mining industries as well as in the industrial sector where US exports should pick-up.

In terms of industries where we see heightened risks given the macro-economic backdrop, we would reduce exposure to companies selling into developed markets in industries which are unlikely to be able to offset rising food and energy prices and which are likely to experience a hit to margins. Several industries to be cautious on include companies primarily exposed to developed economies in autos, auto parts, airlines, retailers, food and beverage, consumer products, gaming and lodging. Highly leveraged companies in these sectors will be the most vulnerable given their reduced financial flexibility.

Investing in Rising StarsGiven our top-down and bottom-up outlook, we favour investments in bonds, loans and other securities in companies where fundamentals are improving. These areas are where investors will find the most “rising stars”. Four specific opportunities where this is happening most rapidly include in companies domiciled in the

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emerging markets which sell their products into other fast growing emerging markets, in specific bank investments around the globe, in “asset rich” sectors such as pipelines and in multinationals companies in energy, oilfield service, industrial, agricultural, paper and packaging, and metals and mining sectors which stand to benefit most from a weak dollar and healthy global growth, particularly in the emerging markets.

In the case of companies domiciled in the emerging markets, select investment opportunities offer investors the ability to invest in companies with strong asset coverage, low leverage, solid top-line revenue growth and attractive valuations. We continue to favour investments in companies with strong balance sheets, healthy sales growth, low cost structures and where revenue growth is coming from other fast growing emerging markets. Within this group of companies in the emerging markets, we find the most attractive opportunities in the energy, pipeline, metals and mining, and banking sectors, as these areas offer the “rising star” characteristics of strong growth and improving bottom-up credit fundamentals.

In addition to specific investments in the emerging markets, we favour select investments in “rising stars” in the global banking industry given improving fundamental trends. As an example, core Tier 1 capital ratios for the major US banks

have improved significantly over the past several quarters. These investments stand to benefit from attractive yields in bonds with spread tightening potential given many banks are improving their balance sheets, de-levering and de-risking.

Finally, asset rich companies like pipelines and multinational resource companies should benefit given an environment where emerging markets are “running fast” and where the US economy’s growth is picking up over a cyclical horizon. Accommodative global monetary and fiscal policies should remain in place this year in these regions. This backdrop should result in a rising inflation bias as well as a weaker outlook for the US dollar. Commodities and commodity exports should benefit, particularly in fossil fuels as the crisis in Japan could lead to less expansion of nuclear power generation facilities around the world. As a result, “rising stars” are likely to be found in these sectors as positive credit fundamental trends help investments in these areas.

Rising StarsPIMCO’s secular and cyclical outlook suggests global inflation has troughed and is set to pick-up over time. A main driver of this outlook is the emerging markets where these economies are “running fast” due to rising demand growth and many other secular and cyclical factors

Figure 9

Source: JP Morgan (for EM Corporate) and Barclay's (for U.S. BBB Corporate) with maturities on both between 7–10 years

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Figure 10

Source: JP Morgan Banks include BAC, JPM, WFC, C, PNC, BK, BBT and USB.

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

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highlighted above. Investments which leverage healthy top-line growth in the emerging markets have the potential to outperform relative to developed markets over the long-term due to these economies’ ability to maintain higher rates of economic growth relative to that in the developed world.

Emerging market countries’ rising consumer demand growth and transition from exporting deflation to exporting inflation is a major secular trend which will significantly influence the winners and losers in the global credit markets. As a result, investors will need to pay more attention to companies which will likely be most positively and negatively impacted by these trends. Those companies which have “pricing power” and the ability to “pass through” rising costs and import prices are likely to be the winners whereas those companies which can’t will likely face a material hit to profit margins and be the losers.

PIMCO leverages our top-down, bottom-up and relative value global investment process to identify “rising stars” or investment opportunities with an improving outlook due to positive fundamental credit trends. Our global team of 68 credit analysts and dedicated corporate bond portfolio managers travels around the world to conduct due diligence and have face-to-face meetings with senior management in companies we believe could be “rising stars”. Today, we believe select investments in the banking, pipeline, energy, oilfield service, industrial, agricultural, paper and packaging and metals and mining sectors offer investors the most attractive opportunities as these industries stand to benefit most from our longer-term secular and short-term cyclical outlook.

Mark Kiesel Managing DirectorMarch 13, 2011