The U.S. Trade Deficit rose in December to $40.18 billion from $36.39 billion in November, $33.39 billion in October and slightly below the $41.86 billion deficit a year ago. This was a very disappointing number since the consensus expectations were for the deficit to only come in at $35.8 billion.
The trade deficit is a direct input into GDP (net exports) and the worse-than-expected numbers thus point to a downward revision of the fourth quarter GDP numbers (the initial figure was 5.7%). A back-of-the-envelope calculation suggests that if nothing else were to change, the disappointing trade report should shave that growth to about 5.3%.
The good news is that the Trade Deficit is increasing because imports are rising more quickly than exports, not because exports are falling more slowly than imports. Since the U.S. is far and away the largest trading economy in the world, the fact that both our imports and exports are rising points to a recovery in international trade.
The Fall of 2008
The financial panic of the Fall of 2008 caused an absolute collapse in world trade. On paper, that actually helped cushion the decline in our GDP in the fourth quarter of 2008 and the first quarter of 2009. The extent of the decline in both exports and imports, and the subsequent rebound, is shown in the first graph below (from http://www.calculatedriskblog.com/).
From a national income accounting point of view (i.e. how we get to the GDP numbers), imports subtract from GDP while exports add to it. So from that point of view, the collapse in imports a year ago really saved our bacon. How much? Well if nothing else had changed, and our level of imports had not fallen, in the first quarter of 2009 the economy would have shrunk not by the 6.4% it did, but by 13.0%!
However, we were not the only country affected by the financial meltdown, and so our exports also fell. But even taking that into consideration, the decline in the domestic economy alone would have been 9.0%. For the full-year 2009, the trade deficit was $380.66 billion, a huge improvement over the $695.94 billion gap for all of 2008 — a decline of 45.3%.
In other words, in 2008, we were importing $1.38 worth of oil and computers and clothes, etc. for every dollar worth of grain and investment banking services we exported. In 2009, that fell to $1.25 worth of imports for every dollar of exports.
In December, we exported $142.70 billion, a 3.33% increase over November, on top of a 0.85% increase in November. Our exports were up 7.36% from a year ago to $182.88 billion. The December ratio of imports to exports was $1.28, up from 1.26 in November.
However, for 2009 as a whole, our exports were 15.0% below all of 2008, and even 5.5% below all of 2007. Our imports were $182.88 billion, a 4.81% increase for the month on top of a 2.57% increase in November. Relative to December 2008, our imports were up 4.63%.
The Big Deal About Trade Deficits
I have to admit to a bit of an obsession with the trade deficit numbers. They are what drives the country’s external indebtedness. The fiscal trade deficit actually has nothing to do with (or only indirectly affects) how much we owe to the rest of the world. They are the reason we are so far in hock to the Chinese and the Saudis.
If you buy more than you sell, you have to go into debt for the difference. The trade deficit is matched dollar-for-dollar by a capital account surplus. So we now owe $40.18 billion more to the rest of the world than we did a month ago.
The U.S. economy is deeply unbalanced, with Consumption representing much too large a share at 71%. The sum of Consumption, Investment and Government spending exceeds 100% because net imports is a negative. If we could eliminate the trade deficit, we could raise the investment share of GDP without having to reduce consumption in absolute terms and bring the economy back into better balance.
The Major Driver? Oil
So what is the major driver of the trade deficit? In a word, Oil. The second graph, (also from http://www.calculatedriskblog.com/) breaks the trade deficit down into the petroleum deficit and the non-petroleum deficit. More than half our total trade deficit is due to our addition to foreign oil.
The overall trade deficit deteriorated steadily from the late 1990’s until the middle of 2005 — then it found a floor where we were consistently running trade gaps of a bit over $60 billion a month, until the financial meltdown resulted in more than cutting the deficit in half in the course of just a few months. However, the deficit excluding oil found its valley floor more than a year earlier, and by early 2007 started to show a sharp improvement. That improvement was masked by a sharp deterioration in the oil trade balance as the price of oil skyrocketed until it peaked in the summer of 2008.
The vast bulk of the improvement in the trade deficit in late 2008 and early 2009 came from lower oil prices. Oil prices have since more than doubled off their panic-bottom, but remain about half of the 2008 peak levels.
The trade deficit from oil is a particularly thorny problem. When the dollar declines, the price of oil tends to increase. After all, just because the dollar is strong is no reason for the price of oil the Japanese import to fall in Yen terms, or for the price of oil that the Germans import to fall in Euro terms.
The dollar declined sharply relative to other major currencies during the first half of the decade, as shown in the third graph. That decline made our exports relatively more competitive, and our imports more expensive, which was a major force in turning around our non-oil deficit.
Some of the improvement came from companies like Caterpillar (CAT) being able to sell more heavy equipment abroad, but also some of it came from domestic buyers discovering that Caterpillar’s products were priced more competitively than similar equipment from Kubota (KUB).
Alternative Fuels Key
While I strongly feel that a weaker dollar is a good thing for the U.S economy at this point, it alone will not be sufficient to solve the trade deficit problem. It can help greatly on the non-oil side, but it is unlikely to do anything on the oil side. To solve that problem, we have to shift over to non-oil energy sources.
At one point, the U.S. had very large reserves of oil (people forget that for decades the U.S. was the world’s largest oil exporter). That oil has already been burned. There is no way we can drill our way out of the problem. No new drilling is going to result in a significant increase in domestic oil production — it can’t.
Most oil is used for transportation, so coal is not a very useful alternative. However, it is technically very feasible to shift to the use of natural gas as a transportation fuel, particularly for fleets that return to a home base each night, for example city buses. We have very abundant and growing supplies of natural gas thanks to the emerging shale plays.
I think that we will eventually move in this direction. That would be very good news for the more gas-oriented exploration and production companies like EnCana (ECA). I suspect that is also a very big part of the reason that Exxon (XOM) is buying XTO Energy (XTO).
Moving to plug-in hybrids would also substantially cut into the amount of oil we import. For environmental reasons, I would favor that electricity (at the margin) coming from a combination of Wind, Solar and Natural Gas. Gas is a perfect supplement to wind and solar sources, which tend to be intermittent (a cloud rolls in or the wind dies down) since they can be fired up very quickly to general incremental power.
However, wind and solar are just a very small part of our overall energy mix, so we would really need to see exponential growth for a significant period of time before they made a substantial dent in the problem.
Nukes — nuclear power — probably also could play a role, but first we would have to solve the toxic waste issue. And then there’s this consideration: in an age of terrorism, the LAST thing we need is a lot more unguarded highly radioactive material floating around that could be used to create a dirty bomb.
Unfortunately from an environmental standpoint, coal will probably at least hold its own in terms of total output. If carbon sequestration can be made commercially viable, that might be OK, but that is probably a very long way off, as we don’t even have working pilot programs up and running yet. So far, clean coal has been sort of like a kosher ham and cheese sandwich — an oxymoron.
Of course, improving the efficiency of the cars we drive is the most effective and generally the cheapest source of “new oil.” That was a very significant ancillary benefit to the Cash for Clunkers program, in addition to being remarkably effective as an economic stimulus program.
Another part of the reason why the trade deficit is going to be a hard problem to solve is that our biggest single bilateral trade deficit by far is with China. The Chinese currency, the Yuan, is pegged to the dollar, so there is no real direct effect on that part of the deficit. There is some indirect effect (a Chinese firm decides to by the bulldozer from Caterpillar, rather than Kubota) but a falling dollar does not make the cost of all the Chinese stuff that fills Wal-Marts (WMT) across the country any more expensive, nor does a rising dollar make it any cheaper.
There was a little bit of good news, though, on that front. In December, our trade deficit with China fell to $18.1 billion from $20.2 billion in November, or from 55.5% of the total deficit to 45.1% of the total.
The other bilateral trade balances confirm that the problem in December mostly came from the oil front. Our deficit with OPEC increased to $6.8 billion from $6.1 billion in November, while the deficit with Venezuela increased to $2.1 billion from $1.6 billion and the deficit with Canada (by far our largest source of imported oil) doubled to $3.0 billion.
Overall, this was a very disappointing report. Yes, it is nice to see world trade rebounding, and that is important. However, the country is another month older and another $40 billion in debt to the world.
Over the long term, the trade deficit is simply unsustainable. A weaker dollar will help, but alone is not likely to solve the problem. Those who a month or so ago were treating the decline in the dollar as some sort of crisis are, in my opinion, dangerously misguided. Given the tumble in the market since the dollar started to strengthen, its pretty clear that Mr. Market agrees with me.
The downside of a weaker dollar is that it can push inflation higher. However, given the vast amount of slack in the system (9.7% unemployment rate, manufacturing capacity utilization at 68.8% when the long term average is more like 80%) means that inflation really is the least of our worries right now. Aside from oil, and a few other commodities, a weak dollar is not going to cause any serious inflation problems any time soon.
The Fed should keep interest rates low for an extended period of time. The low rates should help contribute to a weaker dollar.
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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