Contact

A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

News

 

Mind the Gap


The U.S. trade gap in June was so shockingly wide that many economists almost doubted the numbers on Friday.

But if it's confirmed, the trade gap offered a fairly grim warning about global economic growth, along with the outlook for U.S. inflation and interest rates.

Economists, on average, expected the trade deficit with the rest of the world to measure $47 billion in June, according to Briefing.com.

Boy, did the Commerce Department have a surprise for them, reporting a whopping $55.8 billion gap, a record. Economists' forecasts are often wrong, but this miss left them scratching their heads.

"Because it was such a big change, out of the blue, my caution is just to say, let's wait a second," said Joel Naroff, president and chief economist at Naroff Economic Advisors. "Maybe we should sit back, digest this number and see what comes of it."

"If we sustain these numbers, that's worrisome."

One certain effect of June's numbers is that the second-quarter gross domestic product (GDP) annual growth rate, the broadest measure of the economy, will be cut sharply from the 3 percent first reported -- perhaps more than offsetting the positive effects of stronger-than-expected retail sales and inventories in June.

"It could take us below 3 percent, an important psychological level," said David Sloan, senior economist at 4CAST Ltd., a market and economics research firm in New York. "Below 3 percent really looks bad."

Rejoicing over the potential for bad economic news, bond prices rose after the report, sending yields -- which move opposite to price -- lower. But this reaction may have been irrational -- the longer-term implication of record trade deficits could be that the dollar will weaken, inflation will swell and interest rates will rise.

That's because, by running such deficits, the United States is buying stuff from other countries on credit. In order to keep that up, foreign investors have to be willing to keep extending that credit.

And so far, they have been perfectly happy to keep pumping money into U.S. markets, the broadest and most stable in the world. The risk is that, some day, they'll decide they've had enough and will ask for some incentive to keep extending credit.

At that point, stock and bond prices may have to fall to attract buyers. Overseas currencies will strengthen relative to the dollar. Interest rates will rise as bond prices fall and the Federal Reserve fights inflation.

Dollar responds

Perhaps with all this in mind, the dollar weakened Friday. The Fed certainly had to be paying attention, too.

Minutes of the central bankers' June policy meeting revealed that big deficits were clearly on the minds of Greenspan & Co., who commissioned a staff study of the deficits and their impact.

According to the minutes, the study found that deficits were "quite large" and "could not be sustained indefinitely." The study also said, however, that a re-adjustment "was not necessarily imminent."

When the adjustment comes, the Fed study found, it could happen painlessly -- but it could also involve "wrenching changes."

So far, analysts are betting on the painless outcome.

"If there's a dramatic collapse in the dollar in response to trade flows, we would see the Bank of Japan and the Chinese central bank intervening again, buying Treasurys in larger numbers," said Sloan of 4Cast. "So there's some degree of protection there."

But other foreign investors seem to have developed a bit of a bellyache after feasting on U.S. assets for so long -- net foreign purchases of U.S. stocks and bonds fell for four straight months ended in May, the latest data available.

Ashraf Laidi, chief currency analyst at MG Financial in New York, said the June data will likely show another decline -- bad news for the dollar.

"Given the declining trend in net foreign purchases of the past five months, we doubt whether these would be sufficient in covering the $55.8 billion trade deficit," Laidi said. "In that case, markets should expect intensifying damage for the dollar."

Global slowdown on the way?

If there was a silver lining in the report, it's the fact that imports rose, even adjusting for higher oil prices, a healthy sign of demand among U.S. consumers and businesses.

But exports were much uglier, falling 4.3 percent, a sign that either U.S. companies had simply given up exporting goods to the rest of the world, or -- perhaps more likely -- overseas demand had fallen sharply.

So far, most economists don't believe the rest of the world is facing much of an economic slowdown.

But GDP growth in Japan, the world's No. 2 economy, slowed dramatically in the second quarter. Earlier this week, Germany, the world's No. 6 economy and an engine of growth for the Eurozone, also reported fairly anemic GDP growth. South Korea's central bank cut interest rates. China's massive economy has slowed.

In fact, the trade data may be consistent with a pronounced and long-lasting global industrial slowdown, according to the economists at the Economic Cycle Research Institute, a private firm that tracks leading indicators of growth and inflation for the United States and the world.

The ECRI's leading indicators for growth have been heading south for several months, giving an advance warning of the recent U.S. slowdown.

The ECRI's indicators point to weakness in the rest of the world, too, and June's trade data are perfectly consistent with that, said Anirvan Banerji, the ECRI's director of research.

"People are only beginning to grapple with the idea -- and they're not quite there yet -- that this is not a temporary 'soft patch,'" Banerji said. "It's a growth rate downturn, a cyclical downturn that's very broad."

Banerji hastened to note that the signals aren't pointing to a recession -- not yet, anyway. But the possibility of below-average economic growth was very real.

"Most importantly, because there is no sign of an uptick in the leading indexes we follow, it means there is no recovery in sight," Banerji added. "There's no chance of a return to robust growth this year.”