The trade deficit in October fell to $32.9 billion from a revised $35.7 billion in September. The trade deficit in September was revised down by $0.8 billion.

A decline in the trade deficit is unambiguously good news, especially as it comes in the context of both imports and exports rising (indicating that world trade is once again expanding). In October, our imports totaled $169.8 billion, up from $169.0 billion (originally reported as $168.5 billion) while our exports expanded to $136.8 billion from $133.4 billion (revised from $132.0 billion).

While the trade deficit had ticked up a bit in recent months, it is still down very significantly from where it was a year ago, and it now looks like that trend is continuing. Last October the trade deficit was $59.4 billion. Most of the decline, though, came for the “wrong reason,” as both imports and exports collapsed. Relative to a year ago, our imports are down 18.8% while our exports are down 8.6%.

To the extent the decline in our imports was due to a lower price of oil, that is a good thing, but to the extent it reflected just the collapse of world trade, it was not so good. The reduction this month in the trade deficit is much healthier in that it reflects a rapid growth of exports.

As can be seen in the first graph below (from http://www.calculatedriskblog.com/), oil plays a huge role in the size of or trade deficit (black line) and currently is responsible for more than half of the total trade deficit. The collapse in oil prices late last year was the principal factor in driving down the total trade deficit. We actually started to make substantial progress on the non-oil side of the trade deficit starting in early 2007, but that progress was masked by oil prices that were shooting up at the time. As oil prices have rebounded, we slid backwards in terms of the total trade deficit.

However, it is not all about price. The combination of the recession, and increased efforts at fuel economy and conservation have started to put a material dent in our oil habit. The decline in the oil trade deficit in October relative to September was due as much from lower quantites imported as it was from lower prices. In October the average price of imported oil was $67.39, down from $68.17 in September (due to quality differences and the time to transport, these prices will not follow crude oil futures exactly). However, even more significantly, we imported an average of 8.349 barrels of oil a day, down from 9.176 million barrels a day in September.

OK, a 2.55% increase in exports does not sound like that much, but remember it is a monthly figure, on an annualized basis — and that equates to a 35.3% growth rate. Will that be sustained?  Probably not, but to the extent that it does, it is very good for the trade deficit and the economy.

Let’s put the decline in the trade deficit into a bit more perspective. On a year-to-date basis, the trade deficit has totaled $303.96 billion. That is less than half the $610.83 billion trade gap we ran in the first ten months of 2008. That is a direct addition of $306.87 billion to GDP, or roughly 2.2% of GDP.

However, the trade deficit came as year-to-date imports shrank by $586 billion (from $2.163 Trillion to $1.577 Trillion) while our exports declined by $279 billion (from $1.552 Trillion to $1.273 Trillion). Yes, some of that is due to paying an average of $52.92 a barrel of oil so far this year, rather than the $102.53 a barrel we paid in the first ten months of 2008.

However, perhaps of even more long-term significance to the trade deficit is that we have imported an average of 9.176 million barrels a day this year, down from 9.865 million barrels a day last year. That is a 7.0% reduction. It will be very hard to separate out just how much of that reduction is due to lower economic activity so far this year, and how much of it is due to long-term improvements in energy efficiency, until we are more fully out of the recession and growing again. The drop in October’s imports relative to September is probably a short-term blip (the numbers can be volatile from month to month), but the year-to-date decline is extremely significant.

To the extent that we can continue to increase or level of energy efficiency, we can start to make a dent in the chronic budget deficits we face. If we are not able to, it will be extremely hard to bring them under control. However, there are a bunch of very encouraging long-term signs in this regard.

For starters, sales of pick up trucks and SUV’s have fallen far more this year than have sales of cars. Sales of smaller, more fuel-efficient cars have fallen much less than sales of larger less fuel efficient cars. While that hurts the profit margins of Ford (F) and General Motors, and even Toyota (TM), it provides long-term hope on the trade deficit. The slowdown in overall vehicle sales though means that the pace of fleet turnover has slowed down.

We will be reaping long-term benefits from the fleet turnover that has occurred. This is an aspect of the “Cash for Clunkers” program that is very much under-appreciated. The administration should consider resuming the program as part of its “Son of Stim” jobs program, but I didn’t see any reference to it in Obama’s speech earlier this week (which was, in any case, very short on details).

Keep in mind that it is the trade deficit, not the budget deficit, that drives our level of external indebtedness. If we really want to control how much of our paper that places like China and the Persian Gulf control, we need to bring the trade deficit down.

Over the long term, that means reducing the amount of oil we burn. It is not just a question of using less energy and using it smarter. It is a question of oil specifically — not all energy. Most of the natural gas we use comes from the U.S., and to the extent it is imported, it comes from Canada, which due to NAFTA (and geographical proximity), is more tightly integrated with the U.S. economy than that of any other country. While our trade deficit with Canada did increase in October to $2.0 billion from $1.5 billion, it is a relatively small part of the total.

As the domestic shale plays open up, even the amount of gas we import from Canada is likely to decline as a share of the total.  Thus any efforts we make to replace oil consumption with natural gas consumption will have a positive long-term effect on the trade deficit and thus the economy. We also export coal, not import it — but for environmental reasons, relying on more coal usage does not make a lot of sense (an no, there is no such thing as economically viable “clean coal;” while carbon sequestration might be promising, it will be extremely expensive).

While it makes a lot of sense to increase renewable power sources like wind and solar, those sources represent such a small fraction of our current energy portfolio, that it will take years and years of very fast growth to become a significant part of the mix. The sooner we get started, the better, but it is going to be a long-term process.

Oil is primarily used as a transportation fuel, while natural gas is mostly used for heating and to a lesser extent electricity generation. Thus to move towards greater use of natural gas (which incidentally has a much lower carbon footprint per BTU than does oil, and a far lower one than coal — not to mention the long list of other pollutants like mercury associated with burning coal) we have to find a way of using it for transportation. Technically it is not difficult to produce vehicles that run on natural gas, but we would need an infrastructure for refueling them.

That is not a problem for vehicle fleets that return to the same spot each night, like city buses for example. It is a much bigger problem for family cars, but not one that is insurmountable (after all, most homes do have natural gas service already).  The other way to go is to make the shift indirectly and move to electric cars (or plug-in hybrids) and use natural gas (and eventually renewable sources) to generate the electricity. While clearly such a move towards using more natural gas would be good for the big gas companies like Chesapeake (CHK) and EnCana (ECA), it would also be very good for the economy over the long term.

It appears that the weakness in the dollar is starting to have an effect on the trade deficit. As the dollar falls, it makes our exports more competitive versus products made elsewhere, most noticeably in Europe. It also makes what we import more expensive. That is the key downside to weakness in the dollar — its potential impact on inflation.

However, inflation is still very much under control, and shows no signs of increasing significantly. The weak dollar is only offsetting major deflationary forces in the economy, most notably the huge amount of slack in the system in the form of very high unemployment and very low rates of capacity utilization. Thus, it seems like a very worthwhile trade off right now.

The fact that oil makes up so much of the trade deficit makes it a problem that is very tough to solve, since as the dollar goes down, the price of oil will tend to go up. While higher relative prices for oil will help encourage conservation and switching to other sources, it is a slow process (already, natural gas is selling for the equivalent of oil at $31.55 on a per BTU basis).

The other big problem with the trade deficit is that the dollar has not fallen at all with China, the country that we have the biggest bilateral trade deficit with by a very large margin. While the overall trade deficit declined in October, the trade deficit with China increased to $22.7 billion from $22.1 billion last month. That is a 2.7% increase in just a month, or 37.9% annualized.

Put another way, our trade deficit with the Middle Kingdom was 69.0% of the total in October, up from 61.9% of the total in September.  Most of the trade deficit is from goods, not services (we tend to run a service surplus). If we just look at our trade deficit in goods, it totaled 46.1 billion in October, down from 49.6 billion in September. China’s share of the goods trade deficit, though, rose to 49.1% from 44.6% in September.

A year ago, the total trade deficit for goods with China was higher, at $27.95 billion. However it represented just 37.4% of the total gap in goods. Year to date, the share of the goods trade deficit with China has soared to 46.4% from 31.4% a year ago. As long as the Yuan stays fixed to the dollar, no change in the value of the dollar against the Euro or the Yen is going to have that much of an effect. Yes there is an indirect effect, as General Electric (GE) has the playing field tilted in its favor relative to Siemens (SI), but that effect is small versus what would happen to the trade deficit if the Yuan were going up along with the other major currencies.

For the world to regain its balance, not only must the dollar decline in value over time, but the Yuan must go up in value over time.  As it stands now, the yuan is actually falling in value relative to the Euro, causing China’s trade surplus with Europe to expand along with its surplus with the U.S.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.
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