Trade Gap Will Gut Stocks
By Peter Eavis
Senior Columnist for RealMoney.com
The bulls' biggest fear reared its very ugly head Wednesday.
Most stock market optimists have recognized that America's gargantuan trade deficit could undermine their hopes for a strong market rally in 2005. Their big hope was that the sliding dollar would reduce the trade deficit this year, since weaker currencies are supposed to reduce imports and boost exports.
But even though the dollar has been falling in value for over two years, the trade deficit keeps hitting record highs. It rose to $60.3 billion in November, according to figures released Wednesday by the Commerce Department.
Economists, most of whom subscribe to the belief that a weaker currency automatically leads to lower trade deficits, had expected the deficit to fall to below $54 billion in November. In October, the Commerce Department said the trade deficit was $56 billion, meaning it expanded a stunning 7.7% in just one month.
Given the increase in consumption in December due to the holidays, it's possible that the deficit could be even higher in December. The speed of the deterioration is also scary. Two years ago, the trade deficit was half this size.
Trade deficits have to be financed by foreigners, who do that by lending money to Americans and its government or by investing in American businesses. Trade deficits thus show that domestic savings are insufficient and need to be made up with foreign savings. And at a pathetic 0.8% of disposable income, the U.S. savings rate is well below that of other countries. The last annual trade surplus America had was in 1975.
Now, the really scary aspect of the November trade figures was that exports fell so steeply in November -- by $2.2 billion, to $95.6 billion. This will confuse most mainstream economists, who were taught, and now preach, that big trade imbalances can be corrected by letting the value of a country's currency fall.
In reality, a cheaper currency is never enough to cut a large trade deficit, and it can in fact exacerbate the trade deficit by making indispensable imports -- like oil -- more expensive.
History shows that it takes a massive contraction in domestic consumption -- i.e., a recession -- to cause a stubborn trade deficit to shrink. Clearly, Wednesday's horrific trade number shows that must happen in the U.S.
Not all trade deficits are bad, but this one is. As Detox has pointed out before, a deficit that is run up chiefly to finance investment in new production is good, since the new productive capacity can produce the earnings to pay off the debts that financed it. But currently, the deficit is consumption-fueled. In other words, foreigners are lending to the U.S. and its government in order that they can consume more. By definition, consumption doesn't produce returns that can then be used to pay off the foreigners' debt in the future.
And the decline in exports in November is very strong evidence that not enough investment is taking place in export-boosting activities. "As domestic savings continues to decline, America becomes less able to finance the capital investments necessary to increase the production of consumer goods, thereby diminishing its ability to export. Today's data evidences this perfectly, as imports rose 1.3% while exports fell 2.3%," says Peter Schiff, an economist at Euro Pacific Capital.
Market participants seem unfazed by the latest trade debacle; major indices were down only slightly Wednesday. But if the market is wrong now, when exactly will it wake up to the fact that a weaker dollar will not save America but sink it?
Here's a projected path into the abyss. The Federal Reserve won't try to slow the economy with big rate hikes to correct the trade deficit, and that means the markets will take the lead -- and take it with a vengeance.
The crackup should begin in the bond markets, where big holders will bail from U.S. fixed-income assets, pushing up market interest rates. Investors aren't showing long-term commitment to U.S. government paper. In shorter-dated Treasury notes, the big marginal buyer is foreign central banks, and in longer-dated securities it is leveraged hedge funds, Euro Pacific's Schiff points out.
Neither group is in these assets because believe they are a good long-term investment, Schiff reckons. It makes most sense to speculate on the foreign central bank buying, which is being driven by Asian central banks. These institutions choose to recycle the dollars earned by Asian companies into U.S. government debt.
It's impossible to know what the exact timing might be of a selling wave by Asian central banks. They have seen such faithful buyers of U.S. government debt till now because they are not rational investors. They are not investing for a return on those assets. Instead, they are investing to further a policy aim: To keep the U.S. economy growing so that it can suck in ever-growing amounts of Asian exports.
But the Asian governments surely realize that the main reason the U.S. hasn't had a currency crack-up already is that they are pumping capital into U.S. No creditor likes to find out that it's the only reason a borrower keeps spending.
That's why the November trade number is seriously bad. It shows the Asians that the much hoped for "out" -- higher U.S. exports from a weaker currency -- just isn't happening. That will strengthen the hands of Asian policymakers who want to move their economies away from such a U.S.-dependent model. And as the facts allow those policymakers to gain the upper hand, purchases of dollar paper by Asian governments will slow markedly.
It's only a slight exaggeration to say that the fate of the U.S. stock market lies in the hands of a bunch of bureaucrats on the other side of the world. And it won't be long before their decisions start a series of events that send U.S. indices in the same direction as its currency. |
