February 2005

Simple Multiplication - The Real Problem Behind The US Trade Deficit?

Spread Em'...There are some "behind the scenes" trends in latest US trade deficit numbers that we believe are worthy of discussion.  Remember, all we're after here is trying to anticipate how global economic reality of the moment will influence specific investment sectors as we move ahead.  Ranting and raving about the magnitude of the current macro trade deficit is a waste of time over the very short term.  In terms of the macro, it will ultimately matter when it matters.  Until then, we just want to make sure we get the specific and more short term equity sector influence right.

First, as of the November data, we really can't blame the price of oil for the record $60+ billion monthly trade gap.  Although the volume of crude imports jumped 3.4%, the average price of a barrel of crude actually dropped 1.5% in November.  It's our consumption of crude that negatively impacted the monthly deficit, not the price.  One of the largest factors opening up a record trade chasm in November was a very sharp drop in US exports.  Real goods exports dropped 4%.  That's one of the four top monthly percentage drops in exports in the last eight years.  And what we are experiencing is a plainly noticeable dichotomy in the year over year rate of change between import and export growth.  As you can see below, history tells us that these rate of change numbers move in relative directional similarity.  They are reflective of the rhythm of the global economy.  For now, we're deviating from that historical experience.  If history is to hold true, either the rate of change in US export growth should be picking up quite smartly ahead, or the rate of change in import growth is about to fall meaningfully.  If we don't see this type of reconciliation ahead, it will be a direct sign that global trade and capital flow imbalances of the moment are moving to a new and higher level of "distortion".
      

What the chart above may also be telling us, despite headline commentary to the contrary, is that the foreign economies are slowing meaningfully.  And resultantly, despite a much lower dollar, their demand for US exports is waning.  You may know that 2004 experienced the largest one year inflow to foreign focused equity mutual funds in US history.  Given the track record of the public in terms of piling into an asset class "at the top", it's a warning sign regarding the foreign equity markets and economies near term.  Well, in the world of real economic statistics, here's another directional warning of sorts.  You are looking at China's equivalent of the US ISM series.  In essence, a gauge of directional manufacturing strength.  Is this a picture of an "on fire" Chinese economy?
                

Also corroborating the thought that the foreign economies are in the process of slowing is the fact that a good portion of the total US export decline in November can be pinned on a $1.5 billion month over month drop in capital goods exports.  As you may remember, capital goods and industrial supplies have been the two hottest US export sectors over the past few years.  This is what the global economy (primarily Asia) is demanding from us.  Below is a picture of the year over year rate of change in US capital goods imports and exports.  As is clear, the year over year rate of change in US capital goods exports is now in negative territory, while growth in imports of cap goods is running near 16% year over year.  We believe the large drop in capital goods exports is telling us something.  As you'd imagine, we'll be watching this closely ahead.  In addition, the export subcomponent of the ISM series will likewise be an important indicator ahead.  A few simple questions.  Should this type of a drop in exports have happened during a month (November) that experienced the largest one month percentage drop in the dollar for all of 2004?  Secondly, what do you think these numbers would look like if the dollar had rallied noticeably (as it has so far in 2005)?
      

One of our important themes/considerations for 2005 is the monitoring of the reflation trade.  (We detailed extensively our important investment themes and considerations in the subscriber portion of the site.)  Secondly, we also discussed weak dollar beneficiaries that are the materials, industrial stocks and the energy issues.  November's trade numbers tell us to be extra watchful ahead.  If the foreign economies slow, as is directly being implied by the trade deficit subcomponent numbers you see above, the macro reflation trade will be in question.  And, remember, this is one crowded trade as it worked so well last year.  Further, we had hoped that weak dollar capital goods beneficiaries would hold up the economic party in the US given signs of a weakening consumer sector.  If foreign demand for US capital goods, including industrials and materials, fades on a sustainable basis in the months ahead, should we then begin to anticipate recession or near recessionary conditions stateside looking into late 2005 and early 2006?  Is this exactly what the equity markets are seeing at the beginning of this year?  We'll see.  For now, we believe watching the following will be an important exercise for those still levered to the reflation trade.

The industrial and materials SPDR's are showing clear technical divergence over the last quarter plus.  Below are the weekly charts of each.  Notice the lower highs in both relative strength and the MACD line for each .  Not a wonderful sign as prices went to new highs with the market's liquidity rush late last year.  Secondly, the XLI bounced off major price resistance near $31.5.  It's going to need to convincingly clear that level to the upside as a sign that the macro reflation trade is still intact.  The XLB's did break major technical resistance to the upside in late 2004, but are going to continue to need to hold above that level.  A breach of 50 week moving averages to the downside in each would be a clear warning sign that the reflation trade is at least temporarily in trouble.
       

Although it's not absolutely representative of the entire Chinese stock market by any means, the China fund is at a critical technical juncture right here.  It's currently sitting on a two+ year trend line.  Moreover, the weekly MACD has broken for down.  In our minds, another key anecdote in assessing the reflation trade ahead.
       

The bottom line is that the economic numbers and the stock price charts are telling us to be extra vigilant in terms of the ongoing reflation trade and generic strength of the global macro economy.  Moreover, if this trade breaks down as a macro investment theme ahead, we firmly believe the two words "recession" and "deflation" will creep back into mainstream commentary.  As you know, this would have implications for the commodity complex and may indeed provide us a nice buying opportunity.  Same deal for emerging market equities.  Likewise, it's not inconceivable that bonds become more overvalued on a supposed deflation/growth slowdown scare.  Lastly, for now, we could make the case that energy may be a bit immune from a potential deflation/growth slowdown scare based simply on global supply and demand conditions, to say nothing of geopolitical concerns (are you watching Venezuela?).  As with commodities and other beneficiaries of a reflation theme, we'd consider any serious weakness in the group as a longer term buying opportunity.

Simple Multiplication...It's no mystery that all of the academic commentary and theory regarding a declining dollar being good for US export markets is falling flat on its face in the current environment.  And it's not hard to understand why.  The changing nature of the global economy is the key.  You'll remember our single overriding investment consideration of the moment - think globally like never before.  As you can see below, since the value of the dollar peaked back in February of 2002, our trade deficit has only widened.  As of the November trade report, we're now officially 33 months past this dollar peak and we have nothing to show for it in terms of trade reconciliation.  In February of 2002, US imports exceeded US exports by roughly 40% on an absolute dollar basis.  As of November of last year, we're now looking at a 63% dollar valued gap between US imports and exports.  As you can see, November is a record spread.
      

Although we won't drag you through the charts, back in the 1980's when the major G7 countries agreed on allowing the dollar to drop and the US trade deficit to shrink, the lag between the peak in the dollar and the beginning of the reconciliation of the US trade deficit was close to 24 months.  So what's different this go around?  Why are we 33 months into a dollar decline with no US trade deficit bottom in sight?  First, have a look at the data below:
            

Although we're only breaking out the major trading blocs, you can see that 35+% of the total US trade deficit is with two countries who either have a definitive or de facto currency peg to the US dollar - China and Japan.  Again, although we won't present all the data, when we aggregate all of the smaller countries (Hong Kong, Malaysia, etc.) who have either definitive or de facto dollar pegs, the number climbs higher to 45% of our total trade deficit.  So, just shy of one half of the total trade deficit is occurring in terms of trade with countries wherein a declining dollar means nothing to the US.  The existing foreign currency pegs and de facto pegs to the US dollar negate any potential currency cross rate movement in terms of global trade.  THIS IS completely different than was the case in the 1980's and really explains for us the meaningful difference between the two periods.  It also suggests to us that until the mercantilist global flows of capital that continue to flow from Asia to the US financial markets either stop or reverse, and until the pegging and de facto pegging of currencies in a manipulated manner comes to an end, the US is facing a structural trade deficit problem, not a cyclical one.  And, of course, longer term, capital flow and currency cross rate reconciliation will not occur without pain.  Pain will be shared among many countries, not just the US.  The larger the imbalances grow, probably the greater the ultimate reconciliatory pain.

There is another issue that we believe is super important and corroborates completely our bifurcation of wealth in the US investment theme for 2005 (we discussed this in the January piece).  Really, it can all be boiled down to simple multiplication.  Here's the thinking.  In typical historical economic recoveries, the usual stimulation provided to the economy by both the Fed (monetary policy) and the Administration (fiscal policy and tax cuts) acts to lower borrowing costs and stimulate both corporate and personal spending.  Historically, through the multiplier effect (money turning over in the economy), corporate capital spending has positively influenced increased domestic job creation and wage acceleration.  The greater the magnitude of job creation and wage acceleration, the more the kick up in personal spending, and the virtuous circle created by this multiplier effect reinforces the self sustaining nature of the economic recovery itself.  But this time it's different.  Much different.  And we believe this is the heart of the matter.

You already know from our discussions that absolute payroll headcount and wage recovery in the current post recessionary economic environment is the weakest of anything seen over the last three and one half decades at least.  In our minds, THE key ingredient missing is the very multiplier effect itself.  First, it is clear that US corporations are spending, but the capital expenditures are largely happening in foreign economies, not in the US.  Jobs are being created and wages are accelerating meaningfully, but that's happening primarily in China and other Asian countries.  So, during the current economic recovery cycle, US corporations have not just outsourced jobs and physical plant and equipment, THEY HAVE EFFECTIVELY OUTSOURCED THE MULTIPLIER EFFECT!  

As you know, a very good chunk of our US imports are goods being produced by US companies via foreign manufacturing operations.  And, as we've already mentioned in past discussions, this is one of the major reasons corporate profitability stateside has gone to record levels via this structural cost cutting.  Again, as we have mentioned in the past, stock prices are up as a result of corporate outsourcing and US consumer debt spending positively influencing bottom line corporate results.  US monetary and fiscal stimulation has accrued to the foreign economies and US capital (as we discussed in January), but not to US payroll and wage growth.  The trade deficit is the transmission mechanism by which this is happening.  As we stated when we discussed Wal-Mart Christmas results, it's our bet that the hollowing out of the bottom of the wealth and income strata among the US consumer base is and will continue to happen.  They would be the very folks that would be the primary and most visible beneficiaries of a US multiplier effect that is non-existent stateside in the current recovery.

So what's going to change this set of circumstances and theoretically bring the very much needed multiplier effect "back home"?  We wish we had a good answer.  Let's suppose the global economies really begin to slow, as is exactly being implied in the below the headline dynamics of the current trade deficit numbers.  Won't the push for US corporate outsourcing/cost cutting only increase?  Isn't it a natural that US corporations would look to further reduce costs?  If indeed something like this happens, we would expect our trade deficit to only worsen.  At least initially.  Putting the recapture of the multiplier effect even further out of reach.  In one sense, the changing nature of the global economy is making the US trade deficit situation the ultimate catch-22.  It is now becoming clear that perhaps the only way for the US to begin to reconcile its foreign trade deficit, given current global circumstances of the moment, is through a domestic recession where there occurs a drop in aggregate demand, plain and simple.  Unfortunately the recession scenario also implies more corporate cost cutting and further outsourcing.  Without sounding melodramatic or perennially pessimistic, we really can't see any orderly way the US trade deficit can be reconciled without both domestic and global economic pain.  Pain that almost by default will spread to the financial markets.  Why?  Very simply, because of the changing nature of structural globalization.  As you know, we're just trying to think globally like never before.  And when we do, this is what we see.

Again, the only thing that matters to us is what this set of circumstances implies for various investment sector outlooks directly ahead.  Simply put, the reflation trade appears at risk near term.  And for now, we expect any very meaningful decline in materials, industrials, perhaps energy, the metals, and emerging market equities in response to a slowing global economic environment near term to ultimately provide us a wonderful buying opportunity with the outlook that longer term, these are the items the burgeoning Asian bloc will need to accumulate for many moons to come (emerging market equities, of course, being a reflection of the long term growth possibilities of the Asian bloc).  Longer term, we're betting on a secular rise in the Asian bloc economy.  But as with all things financial and economic, it won't be linear.  It will be cyclical around a longer term secular up trend.  Simple enough?  

The Service Station...Just a very brief check-in on how the new era US service economy is faring in terms of global markets and global trade.  But first, some perspective.  As of November month end, and using the $60 billion monthly deficit number, an annualized quarterly number for the total deficit may be approaching $180 billion of red ink.  Of that, the net contribution of US services to the total trade deficit is running roughly $12 billion in positive territory, or about $4 billion monthly.  In other words, there is absolutely no way that services exports are going to bail us out of the total US trade deficit problem, let alone even make a ding in the side of the ship.

But what we consider more important long term is the historical direction of net US service sector exports.  It's on display for all to see directly below.  And the absolutely very well defined trend of the last decade is crystal clear and completely uninterrupted.
       

Very simply put, we are losing our US trade surplus in services.  With the growth of the service driven economies of India and other parts of Eastern Europe and Asia, along with the insatiable appetite of US corporations to cut costs, we expect the US will soon enough be running a service sector trade deficit.  It's only a matter of time.  Just what does this say about the future of the worth of the US service sector to the global economy?

The Most Important Transfer Of Them All?...As a very last, and what we believe extremely important, point of information that is tangentially being driven by the US trade deficit is an update of a chart we have shown you before.  If you remember the chart, you'll remember our comment that, in all sincerity, it's one of the most important pictures we can possibly think of at the moment.  The data is taken from the 3Q Fed Flow of Funds statement.  It's a look at US assets owned by the foreign community relative to foreign assets held by the US community.  And we've put the net number on top of US GDP for some perspective as to magnitude relative to the total size of the US economy.  As of the end of 3Q 2004, the foreign community owned $4.5 trillion more in US assets than did the US own of foreign assets.  You may remember that in his bearish comments regarding the dollar and his rationale for why he's loading up on foreign currency as a hedge, Warren Buffet explained that the US "is transferring it's net worth offshore by the day".  Point blank, the following relationship is exactly what he is referring to.  This is a simple picture of how the US has miraculously transformed itself from a net creditor to the largest net debtor on the plant in 35 short years.  After all, time flies when you're having fun, right?  In our minds, it's the very symbol of the result of gross global structural financial and economic imbalance.
          

Again, all of this review is not to rant and rave.  It's our humble attempt to logically and factually explain the US and global economic and financial circumstances of the moment.  We have no immediate bias as to whether this is all right or wrong.  From the standpoint of maintaining investment flexibility, it's neither.  It is what it is.  How it will impact financial markets ahead is our only concern.  Watch the current beneficiaries of the reflation trade closely directly ahead.  If they break down meaningfully, we believe recession and deflation will again be bantered about in the investment community.  Clearly this has short term implications for the equity sectors we have mentioned as well as the bond market.  Long term, we may be presented with some wonderful buying opportunities if, and/or as, the global economy slows.  If you remember nothing else, remember to think globally like never before.