By Byron Carson, Portfolio Manager, Principal Global Fixed Income
In one of our previous posts, we announced that we would communicate any changes in our Dynamic Risk Score (DRS), a proprietary tool used to assess and communicate the risk taking environment of our fixed income portfolios. To recap how the DRS works, the score, which can range from 1-10 with higher scores correlating to a more favorable risk taking environment, is adjusted based on an evaluation of the macro environment by our Fixed Income Strategy Group. Recently, we increased the DRS to 5 from a previous score of 4, communicating a macro risk taking environment that is more conducive to risk taking than it was at the beginning of January. From a historical perspective, since the implementation of the DRS evaluation in 2009, our score has ranged from 3 to 8.
In addition to communicating our view of the current macro risk taking environment to investors, our investment teams use the DRS to guide investment decisions and adjust the level of risk in portfolios as market conditions change. In examination of the macro environment, our Fixed Income Strategy Group decided to raise the Dynamic Risk Score, a decision supported by:
- Stable corporate profit margins and attractive spread valuations
- Improved markets and recently stronger global economic data
- Stabilization of oil prices and the U.S. dollar
- Strength of the U.S. economy
Further, the updated score of 5 is an indication of our belief that, in light of the current macroeconomic environment, fixed income corporate credit bonds will outperform over the next two months. Even though we feel this way now, we will be closely monitoring our market positioning in the face of high current market volatility and potential geopolitical and central bank events poised to take place as early as this month. That being said, the current, and updated score, is reflective of the following influences:
- Oil prices have stabilized and recent rig count data continues falling within North America, down 74% from the peak. This fall in North American supply is forecasted to continue throughout the year while OPEC supply is expected to increase. With global demand for oil increasing, many expect overall supply and demand to balance later this year or into 2017. Energy-related defaults will likely continue through 2016, although an in-depth banking review shows minimal systematic risk.
- China retail sales remain well supported, showing fourth-quarter GDP at 6.9%, year over year, while industrial production growth is exhibiting signs of a soft landing. This is positive as China continues to transition from an industrial-based economy to that of a consumer-led economy. Market participants expect a slow, managed pace of yuan depreciation over the course of 2016 along with capital controls to limit economic and market volatility in China.
- The U.S. economy remains strong, with wages tracing out a moderately increasing trend and U.S. growth maintaining a moderate growth pace in the face of global headwinds. Regarding employment, the United States has seen increased job openings, solid job growth, and a falling unemployment rate; all signaling that wages should continue higher. Regarding the U.S. economy, analysis suggests the drag from a strengthening U.S. dollar and lower oil prices will lessen as 2016 progresses.
Investors should view this change as a positive. However, as previously mentioned, we will be closely monitoring the macroeconomic risk environment specifically as it relates to: uncertainty around central bank actions throughout the year, a possible U.K. exit (BREXIT) from the European Union, the path of global growth, volatility of markets, and the management of currency in China going forward. As these events approach and clarity improves, we will refine our time horizon and Dynamic Risk Score as appropriate.