The latest headline gross domestic product (GDP) number gave investors reason for cheer as third quarter data showed economic growth at a stronger-than-expected 2.9% pace. Last quarter's growth was the fastest pace over the last two years and may have eased some concerns about a potential slowdown.
"The number came in great versus what we have seen recently. This, combined with earnings, is giving people a little hope," says JJ Kinahan, chief strategist at TD Ameritrade.
Consumer spending once again played a big part in the third quarter gains, contributing 1.5 percentage points to the growth number. An upturn in inventory investment, an acceleration in exports and an uptick in federal government spending also contributed to the third quarter growth number, the Commerce department said.
The perplexing question that continues to loom large is the lack of inflation in the current environment. "Under normal times when the economy is expanding, this leads to inflationary pressures on wages and prices, and we aren't seeing that now," Kinahan says.
The Federal Reserve's preferred inflation gauge – the personal consumption expenditure (PCE) – remains stuck below the 2% target at 1.7% in September. "We have to see something give," Kinahan says. "Either inflationary pressures will start to pick up, or the economy will start to give and slow down. The concern is whether an interest rate hike will be the match that lights the slowdown candle.
This leaves the Fed caught between a rock and a hard place, says Sam Stovall, chief investment strategist at CFRA. The central bank is widely expected to stand pat on an interest rate hike at this week's meeting. But all eyes are focused on the December 13-14 meeting, with the market pricing in a 70% probability for a rate increase then, according to the CME Group FedWatch Tool.
Stovall notes that the Fed wants to hike the fed funds rate closer to a more historically normal level. "They want to have more arrows in their quiver to fight the next recession," Stovall says. The federal funds rate currently stands 0.25-0.50%, while a more historically normal rate was at 3.00% or higher.
On the other side of the coin, higher interest rates could strengthen the U.S. dollar, which in turn could be a drag on the export sector, Stovall says. Also, "higher interest rates would require the Treasury to roll over debt at a higher interest level, which would increase our debt level," he says.
Digging deeper into the latest GDP reading, the devil did show up in the details and so-called “special factors” may have contributed to the bigger-than-expected output number. Stovall highlighted trade and inventory building as "transitory factors that are not expected to repeat next quarter."
CFRA forecasts growth in 2016 around 1.5% and for the pace to increase to the 2.0-2.5% range for 2017. "While it is not a lot to write home about, the U.S. is still stronger than the rest of the developed world. Normal economic growth in a recovery tops 3% and since 2009 growth has been below 2.5%," Stovall said.
Pre-Election Portfolio Review
With the presidential election in one week, Kinahan says investors should be reviewing their portfolio right now. Looking ahead, "GDP will be influenced by the election outcome and by future Fed rate hikes. Are you comfortable with your allocations? What do you believe about which sectors will win or lose depending on the outcome of the election and if the Fed hikes rates?" Kinahan asks.
While many investors normally wait until the end of the quarter to review their allocations, Kinahan says this year that might be too late. TD Ameritrade clients can utilize the Portfolio X-Ray tool for a visual snapshot of their current allocations, as shown in figure 1 below.