Deficit Attention Syndrome
by Brian Pretti CFA, Contrary Investor. April 27, 2007
It has been a very long while since I have brought up the US trade deficit. It has been covered so heavily for years that, to be quite honest, there really has not been a whole heck of a lot to say over the recent past, until perhaps now. You know that really over the last decade, and in earnest clearly since the Asian currency crisis period of late 1997, the US trade deficit has been a one way street straight up, or down if you happen to prefer putting a minus sign in front of the trade numbers. Yes, we all know that our deficit with the Asian community has been a veritable mushroom cloud. And yes, imported crude oil has played an important role in helping the US dig an even deeper hole in recent years, helping to flood the planet with greenbacks. So, why so important now?
Let me cut right to the chase and then paint in just a bit of broader color since we're on the subject and I have not addressed the US trade deficit for many a moon. The good news is that at least over the recent past, there has been some shrinkage in the monthly deficit numbers. Hoorah! Finally, right? Importantly, what you see below is a chart I've been using for years, but has not graced these pages for quite some time now. Very simple stuff. It's simply the ratio of the nominal dollar value of US imports divided by US exports. Again, the blast off point post the Asian currency crisis of late 1997 is clear. And you can see the shrinkage over the recent past as the dollar volume of US exports has been growing faster than the dollar volume of US imports.
We can start breathing one big sigh of relief right about now, can't we? Well, breathing the sigh may be okay, but I'm not so sure total relief is the proper characterization just quite yet. The fact is that on a year over year basis, the rate of change in both US exports and US imports has been falling for a good number of months now. The growth rate in imports has just been falling a lot faster than the growth rate in exports as of late. It was October of last year when the year over year change in US import growth really began to falter meaningfully. Again, there is no question that a part of this decline is related to oil, but certainly not all. Not by a long shot.
Quite importantly, it's this change in the rate of growth in goods imports that may be a key tell regarding the broader economy. First, is it really any wonder that the rate of change in goods imports has been falling as of late when the annual rate of change in retail sales has slowed to levels last seen in early 2003? Of course not, as so many consumer goods are imported. Having said all of this, the following two charts are probably the most important in this portion of the discussion. First, the long-term picture of the year over year rate of change in US goods imports lies directly below. As you will clearly see in the chart, there has only been one time in the last three and one half decades where we have fallen below the current rate of change level and the US has not entered or already been in an official recession. That exception was the mid-cycle economic slowdown of the mid-1980's. The current possibility of a rate of change break below current levels may be more important than ever given the sheer nominal dollar magnitude of the current goods deficit as part of the overall trade numbers. As you know, the US runs a services surplus (tourism and travel related). The goods deficit is really larger than the headline US trade deficit. THAT's how important changes in goods imports and exports really are in the current environment.
So as we stand here today, the actual nominal dollar goods imports numbers are telling a story as are rate of change trends. Although a decline in goods imports may seem a good thing when it causes a contraction in the headline US trade deficit, the reality is that a contraction in the rate of change in imported US goods is also a meaningful signal of domestic economic slowing. That's the big message I want to get across.
It was only about five months back that the US trade deficit on a twelve-month moving average basis rested at record levels. That too has changed a bit with our apparent good fortune in having the headline trade deficit contract. But like above, the chart below suggests a contraction in the twelve-month moving average of the trade deficit can cut both ways. The last time we saw a contraction in this number, as is marked in the chart, we were headed straight toward the recession of 2001. Will it be so again?
So, the bottom line message is that a contracting trade deficit is not always and everywhere a positive (to be honest, I thought I'd never say that), so many may believe it to be. Moreover, keeping a very sharp eye on goods imports as we move forward will be important. For now, the anecdotes corroborating a US economic slowdown continue to mount. Funny, we keep hearing Hank Paulson talking about the greatest US economy in his memory. Is he talking about his own personal economy? The economic environment at Goldman specifically? Or the broad US economy? Of course, as you know, we're going to find out.
The 800 Pound Gorilla(s)
You get the importance of what's currently happening with the US trade deficit from the comments above. Before moving on, and while we're on the subject, just a few quick comments regarding perspective and a few questions to think about as we move forward. First, when talking about the US trade deficit, we're really talking about two issues of major importance - China and oil. Crazily enough, from a truly broad and long term perspective, what really are the most important forces on the planet that have the ability to materially influence forward global economic outcomes other than China and oil? From my viewpoint, not a heck of a lot. Anyway, a bit of perspective lies below.
The following are US imports from China. The numbers are not net, but gross nominal dollar imports. US exports to China run one-fifth to one-sixth these numbers, as China is certainly the country against which the US runs the largest deficit. You can see that current levels of nominal imports are five to six times what they were in 1997. It's no big mystery that US consumers have become addicted to cheap imported consumer goods from China. No massive revelation by any means. In like manner, a slowing US consumer will most impact China in terms of the relative nature of the US trade deficit. Again, no incredible insight. When that day ultimately arrives that the US consumer does indeed slow down, the important deal will be China's reaction to that slowing. Will they lower prices? Monkey with their currency (more than they already have)? We're not there yet, but if current US goods import trend deterioration continues, it may not be as far away as one might believe. We'll just have to keep watching.
The next chart is really the important one in terms of defining and characterizing the US trade deficit, as we know it today. What we are looking at is the percentage of the total US trade deficit being driven by both imports of crude oil and imports from China. I've delineated each separately as well as presented their ongoing combined value in the blue columns. The message is clear. In 2006, 66% of the US trade deficit is accounted for by crude imports and the trade deficit with China. It's no wonder China/US trade circumstances are such a perceptual political flash point. Unless something acts to change the trajectory of these trends, it will probably only be a year or two until crude and China account for three-quarters of the total US trade deficit. Outside of crude and China, it almost seems trade with the rest of the planet is an afterthought in terms of the overall US deficit specifically.
Although this may sound both a bit philosophical and gloomy, here's the question. Just what is the US going to do to change this? Limiting trade with China means heightened domestic inflationary pressures. And crude oil is simply another story. As you know, the political answer to the crude import issue of the moment is to promote corn based ethanol, which is completely economically inefficient. Corn based ethanol is simply politics as usual (farm lobby) and guaranteed to raise the total price of energy to US consumers (that ought to do wonders for the economy). But that's for another discussion. For now, I see crude as intractable. China is open to debate.
Simple question. How do we stop what you see below? Talk about a two-decade up trend of significance. This has to be the biggie for the US economy. For now, this is not about to change any time soon. Talk of eliminating the US trade deficit in its entirety is whistling in the wind.
When Worlds Collide
So there you have it, the big message in the trade deficit report of the moment is that a contracting rate of change in goods imports has been a very important pre-recessionary indicator of the past. A message worthy of monitoring. Before concluding this discussion, a few comments on other pre-recessionary dominoes that are stacking up one by one as of late. First, the leading economic indicators are clearly pointing toward recession, if indeed historical experience is still to be any guide at all. I've been through housing stats so many times that I won't recant them here. Housing indicators of the moment are already in recessionary mode. Retail sales? Just have a look below. The following is the year over year rate of change in the quarterly moving average of retail sales. A method of smoothing out the trend a bit. The last time we saw this type of trajectory and level of change was right in front of the 2001 recessionette.
Finally, corporate capital spending. The rate of change in corporate spending has been slowing meaningfully as of late. The year over year change in non-defense capital goods orders is negative at the moment.
The trade numbers, auto sales, retail trends, housing conditions, slowing in corporate capital spending all point directly toward a recession as a very strong possibility based on historical precedent. But this real world of the US economy is colliding with really the global financial markets of the moment. Financial markets that are clearly being supported and elevated by acceleration in monetary accommodation as of late. Across the globe, the year over year rate of change in monetary aggregates in the major economies is running double digit. Here in the US, we know that M3 was bound, tied and thrown off the side of the ship into the deep blue abyss a year ago. But as a quasi substitute, MZM (money of zero maturity) is relatively broad in and of itself as a measure of monetary levels and acceleration. As an example of what's really happening in the land of money/credit creation stateside, the following table lists the annualized growth rates of MZM over the last one, two, three six and twelve months. Get the picture? Of course you do.
|Annualized Growth In MZM|
|Period||Annualized Growth For Period|
Any questions as to why the US and global financial markets seem oblivious to real world trends in housing, retail sales, domestic import trends, leading indicators, and a host of other indicators pointing directly at real world economic contraction? It's no mystery at all.
We're going to leave you with a quote that I first posted last year on our subscriber site and in our January open access monthly discussion. In the clarity of hindsight, it now takes on much more meaning and gravity. It's a quote from a Fortune Magazine interview with Treasury Secy. Hank Paulson from last November. As suggested when it was first posted, LISTEN CAREFULLY to what Paulson is saying. The editorial inserts (ed.) are mine.
Fortune: Aren't you concerned that GDP growth dropped to 1.6% in the latest quarter? That's kind of anemic, and we've seen a downturn in the housing market. Convince us we're not going to have a recession next year.
Paulson: "I can't convince you. But as I looked at the third quarter, I felt good because I saw a major correction in the housing market, and I knew that was going to take more than one percentage point off GDP. And then I'm looking at the rest of the economy - strong corporate profits (ed. this is now slowing) and investment (ed. slowing also), good growth outside the U.S. (ed. still true), strength in the construction sector away from housing (ed. this is now slowing), and then an equity market that has gone up and added $1 trillion in value.
I know how much people care about housing. But I would be quite hopeful that through 401(k) plans, pension plans, and elsewhere that the average American is feeling an uplift from the appreciation of the equity market that would be very offsetting to any potential decline in housing."
As I've suggested probably too many times, we're an asset inflation dependent nation. From stock bubble to housing bubble, and now back to potential stock bubble? What else could Paulson be referring to in his quote? Although you don't need me to tell you, directly from the horse's mouth, no? Do yourself a favor and savor the moment. After all, how often do you get a rare glimpse of truth on the Street? Ignore Paulson's comments at your own investment peril.
© 2007 Brian Pretti