- Inflation is approaching 2% as the current dollar GDP has increased to 4.4%.
- Both inflation and GDP growth will force the FED to take action – the selloff in yielding assets will continue.
- Nondurables consumption leads to GDP growth alongside exports and inventories buildups questioning GDP growth sustainability.
Last Friday, the Bureau of Economic Analysis released the GDP data for Q3 2016. At first, it looked surprisingly good with the GDP growing at an annual rate of 2.9% for the quarter. This is excellent news as it takes the economy out of its anemic growth rhythm seen in the last two years.
Figure 1: Real GDP percent change from preceding quarter. Source: BEA.
The market didn’t react that well to the news and was down 0.31% by the end of the day. In today’s article, we’ll investigate deeper into the GDP release to grasp important trends for better portfolio positioning.
GDP Release – Inflation Will Force The FED To Increase Rates
The current dollar GDP increase of 4.4% compared to the real GDP increase of 2.9% is a significant difference. But this simply means inflation has started to kick in. The price index for gross domestic purchases increased 1.6% in Q3 and 2.1% in Q2. Higher inflation and strong real GDP growth will force the FED to increase interest rates in order to prevent a ramp-up in inflation.
In principle, this shouldn’t be a bad thing but given the abnormally low rates over the last 7 years, there is a high degree of uncertainty on how higher rates will impact, not so much the economy, but financial markets. This week’s jobs report will be another very important piece for the puzzle of potential rate increases.
It’s impossible to predict exactly what effect increased rates will have on markets because panicking investors could easily send markets into bear market territory. On the other hand, interest rate increases could be considered mild and the markets could remain flat.
Unfortunately, as the markets are filled with speculators that run after tight spreads, any small change in fundamentals will have a strong impact on financial markets. The December 2015 rate increase wasn’t the main culprit of the market correction that followed the announcement, but it certainly did have an impact. As soon as the FED postponed further rate increases the market stabilized.
Figure 2: S&P 500 in the last two years. Source: Yahoo Finance.
Increased rates are going to have an inevitable impact on yields. And yields have already been steadily increasing in anticipation of the rate hike and good GDP news.
Figure 3: U.S. 10-year treasury yield. Source: Bloomberg.
Bonds and stocks whose main selling point is a dividend yield will be hit by higher rates as treasuries hold the lowest risk. With higher yields, it is inevitable that riskier yielding assets will decrease in value. One asset that is expected to decrease in value as interest rates go up and the economy expands faster, is gold.
Another implication of higher rates will come from the stronger dollar. Higher rates lead to increased demand for the dollar, at least in the short term. A stronger dollar will lower the dollar amount of international revenues and earnings for U.S. corporations and make them less competitive in global markets.
Figure 4: U.S. dollar index. Source: Bloomberg.
The dollar impact might not be that strong if corporations manage to cover for international losses through domestic demand coming from increased GDP growth.
GDP Release – Sector Impact
Consumer spending is the largest contributor to GDP growth and accounts for two thirds of total GDP output which is above the global average of 60% for upper income countries. A big part of the consumer spending jump came from spending on durables.
The second largest contribution came from exports which increased by 10% despite the stronger dollar. The third came from businesses increasing inventories which indicates that they are more bullish on future demand.
Trade and inventories are considered the most unreliable GDP indicators as they can be easily influenced by on/off events like the current surge in soybeans exports and by seasonal effects like early inventory build-ups before the Christmas season. We’ll have to wait for a few more quarters to see if this spike in GDP is a structural phenomenon or just a temporary one.
The largest detractor from GDP growth was residential investing indicating that real estate prices are slowly reaching their top and can’t contribute to GDP growth until a new credit cycle emerges, which is highly unlikely given the potential for higher rates.
Consumer spending on nondurables—like food and clothes—has fallen 1.4% on an annual basis. The impact has already been felt in the sector, but could have further repercussions.
Figure 5: Nike, Kroger, Macy, Whole Foods stocks price in last 12 months. Source: Nasdaq.
Business investing in equipment remains negative and a detractor to GDP. This continues to be a drag for companies like Caterpillar that are struggling to find the way back to growth.
GDP growth should always be good news, but in this case it seems different. Consumer spending leads the growth by increased spending on durables which are bought to last, indicating a spending contraction in the future. Exports and higher inventories are also shaky under the influence of seasonal effects.
It’s important to relate the above GDP information to the risks your portfolio is exposed to. From the impact of increased yields to a stronger future dollar. Rebalancing your portfolio from the relatively expensive yielders to the cheaper asset classes is a good move to lower your risks. Be careful not to be too exposed to sectors and assets that are going to suffer from increased yields and inflation.