The Twin Deficits … an early look into 2006

I wanted to try to pull together some of my thoughts after various data releases of last week:

• The US September trade data
• The Chinese October trade data
• The October US budget data
• And from a bit earlier, the Treasury's 2005 borrowing estimates

Of course, all this is informed by the fact that a record US trade deficit number did not stand in the way of the dollar's rally, and, judging from today's data, the world is willing to finance $1 trillion US current account deficit .... Apologies in advance for a somewhat long post.

First, the budget numbers.  Dan Gross notes that the October 2005 deficit is smaller than the October 2004 deficit.  True enough.  But the fine print of the CBO's report on October suggests that $13 billion in payments that normally would be made on October 1 were sent out on the last day of September since October 1 fell on a weekend.    Add in those payments, and the deficit was about $6 billion bigger than in October last year, and spending is up around 9% y/y.   Revenues are up 12% -- an impressive sum, but less impressive than the 14.5% surge in revenues that brought revenues up from 16.3% to 17.5% of GDP in 2005.   Corporate tax revenues surged by over 1% of GDP between 2003 and 2005, reaching 2.3% of GDP in 2005 - their highest levels since 1980.  That surprised me.  Obviously, corporate profits are up and a few tax breaks expired, but given that big portions of the original Bush economic team thought the corporate income tax was unjustified double taxation, it is still is a bit strange that they ended up relying on the corporate income tax to reduce the deficit.

All in all, I suspect that a combination of Katrina spending and a slower pace of increase corporate tax revenues (no more homeland investment act related flows) will push the deficit back up toward $400 billion.   The Treasury seems to agree - they are looking to borrow more in FY 2006 than in FY 2005 (See p. 10 of this presentation ).  And they will have to sell more to the market, since expected issuance to state and local governments will do down.   UPDATE: Morgan Stanley estimates a FY 2006 deficit of $410 billion, up $90b from FY 2005.   Net Treasury sales of marketable debt are forecast to rise even more; Morgan Stanley estimates net Treasury issuance will increase by a bit more than $150 b , from $216b to $369b.

An increase in the fiscal deficit will tend to increase the current account deficit (the gap between savings and investment) barring offsetting changes in private saving and investment.   Such offsetting changes are certainly possible: leading indicators for the housing market seem to suggest that the pace of increase in housing prices will slow, and, who knows, housing prices might even fall in some places.  That, in turn, could well lead to higher personal savings and less consumption, through channels that are by now well known.  

These kinds of offsetting changes are certainly not out of the question.  In fiscal 2005, the fiscal deficit fell by about 1% of GDP.  But private investment rose (in part because of investment in residential housing) and private savings fell, as Americans cut in their savings to cover higher gas bills without cutting back on other purchases.  So the growing gap between private savings and investment overwhelmed the improvement in the government's balance. 2006 might see the reverse - a rising fiscal deficit could be offset by rising household savings or by falling private investment.  But at this stage, I would still bet that the gap between national savings and investment will rise in 2006.

What about the trade numbers?

Before talking about the most recent data, I want to put forward a few stylized facts:

US imports of non-oil goods were growing exceptionally rapidly at the end of 2004.

Graph 1 ($ billion)

They stopped growing in early 2005, for complicated reasons.  Consequently, most of the y/y growth in non-oil imports reflects the fact that December 2004 non-oil imports were a lot higher than January 2004 non-oil imports, not additional growth since then. 

Graph 2 ($ billion)

US export growth has been strong in both 2004 and 2005, with monthly exports rising from $90b in January 2004 to around $105b now.  I think that reflects the impact of the dollar's depreciation in 2003, and the fact that the dollar stayed weak in 2004.

As a result of stalled non-oil imports and solid export growth, the non-oil trade deficit was shrinking ever so slightly in 2005.  The increase in the overall trade deficit simply reflected the United States' growing bill for oil imports.   In September, though, changed that: the non-oil deficit got worse. 

The US oil import bill is a combination of price and volume.    y/y volume growth has been weak, but it is still positive.   Prices are obviously way up.

The basic trajectory of oil imports consequently is relatively easy to forecast.   In September, volumes were down but prices were up.  The US imported more refined "product" toward the end of the month, and also exported fewer "petroleum products" - all byproducts of the hurricanes.

In the fourth quarter, the Department of Energy is forecasting total US energy consumption will be about where it was in the second quarter - around 20.5 mbd.   But that demand will be met in a slightly different way - US production will be down by about 1 mbd  and imports of crude will be down by about 0.3 mbd.    However, imports of refined product will increase by a bit over 0.5 mbd - and, I suspect, the rest of the gap will be made up out of stocks and reduced exports.

Going forward, oil prices should be slightly lower than they were in September.  And, as refineries in the US come back on line, the US will have less need to import product.  For 2006, the energy department forecasts imports of refined products will fall from 2.5 mbd in q4 to a bit over 2.1 mbd - in part because domestic production in 2005 will be about 0.5 mbd higher on average than in q4.

Combining the price and volume data, US monthly petroleum deficit probably will peak sometime in September-October-November and then head down ... as imports of refined products fall off their recent peaks.  But all that assumes that there will not be another rally in oil prices.

I am more interested in two questions:

1. What will happen to exports? 
2. And will recent weakness in the growth of non-oil imports be sustained?

The September data was hard to read.   Boeing had basically no exports in September.   2 planes hardly counts. That is not going to continue.  But I don't expect a repeat of the very strong August sales either.   In August, 26 planes were exported - a 300 planes a year pace.   Look for 15 planes to count in the October data ...   One of my concerns for 06 is that Boeing's capacity to drive overall US export growth will peter out.  I do not think aircraft exports will fall, but they may plateau.  And that plateau may be a bit below the August number ...    

Longer term, an all new Boeing (the 787) will compete against an updated A330 in the middle of the market, and a new Airbus will be competing against an updated 747 at the top of the market.   So much will depend on the evolution of the broader aircraft market.

It also that even if you net out higher natural gas imports, non-oil imports started to resume their growth in September.   That makes sense to me.  Import growth in late 2004 was a bit too fast; import growth from January to August 2005 has seemed a bit slow, so I have long expected some kind of pickup.   

According to the IMF, US consumption growth was 3.9% in 2004 and 3.5% in 2005 - so consumption growth has not slowed, at least on a year over year basis.   Now there is little down that real consumption did stall in August and September - though the October data suggests that the stall may not last.   

But non-oil import growth basically stopped growing well before overall consumption stopped growing - import growth stopped in February, more or less.  Overall consumption did not stall still August.  There consequently is a bit of a gap between import growth and the cumulative increase in something like retail sales.  

Forward looking signs are mixed.   A slowing housing market should deliver a smaller boost to consumption.  But after the latest (October) retail data, analysts remained bullish (the stock market perhaps less so).  The FT:

Retail sales were stronger than expected in October as US shoppers shrugged aside rising interest rates and worries over the future of the economy.  .... Although overall figure slid by 0.1 per cent, sales excluding the volatile auto sector rose by 0.9 per cent. .... Economists said the figures were a positive start to the final quarter of the year and would raise expectations about a strong holiday shopping season.  The sales increase was even more impressive given than gasoline sales fell by 0.8 per cent due to falling prices.

With consumer confidence figures flagging, many economists have feared a slowdown in spending would not be long in coming. So far this has failed to materialise. "Consumers may be depressed but that has not stopped them from spending money," said Joel Naroff, head of Naroff Economic Advisors.

Vehicle sales fell by 3.6 per cent over the month. But some economists believe that this may now have bottomed out.  .... The strength in sales was relatively broad based, with the biggest gains in building materials, furniture and general merchandise.

Ian Shepherdson, chief US economist at High Frequency Economics said that the figures showed again that "what consumers do can be very different from their responses to confidence surveys."

That brings me to 2006. 

What do I see:

• Relatively high oil prices, at least judging from current market expectations.  $55-60 a barrel is not low - it is just lower than $70 a barrel.  So I do not see a big fall in the US oil import bill. 

• A dollar that is no longer weak.   The JP Morgan dollar is now at 93 or so - precisely its 1990-2004 average.  And during that period, US exports grew by an average rat e of 5.5% and US imports grew by an average rate of 7%.   In other words, so long as both the US and the world grow at close to average rates, there is little reason to suspect that the trade deficit will improve at the dollar's current level.   Turning to the Federal reserves' broad index, the dollar is now probably in the upper end of the 110-115 range  -- up from below 110 at the beginning of the year.  The dollar has weakened against some emerging economies - say brazil - even as it has strengthened against Europe and Japan, but on balance it is stronger.    Just for perspective, the dollar - on the Fed's index - was around 100 before the Asian crisis in 1997, and there was pretty solid evidence back then that a dollar at that level implied a slow widening of the trade deficit over time.  Since exchange rates matter, I suspect US export growth will slow in 2006.

• US interest rates (and growth rates) are high relative to Europe and Japan, supporting the dollar.  But hints of housing slowdown suggest that US growth is likely to slow a bit.  Slower growth portends slower growth in non-oil imports, but that may be partially offset by some rebound from the very low recent growth rates.

• Nothing yet suggests the surge in Chinese exports to both the US and the world is set to slow - at least not slow significantly.  The October y/y export increase was impressive.  Since I think exchange rates matter, I would tend to think the Chinese exports to Europe are more likely to slow than Chinese exports to the US - and lest anyone doubt RMB depreciation had an impact on China's trade with Germany and France, look at the graphs in Floyd Norris's Saturday article in the Times. 

• Japanese September exports were strong - and Toyota at least is planning on exporting more to meet US demand.  

Indeed, the scenario that worries me over the next year is one where the October pattern in the US auto market is generalized across the economy.   Overall auto sales (read consumption) were down.  But Ford and GM sales were really down, while Toyota did alright.  Imports may account for rising share of domestic consumption next year, just as imports/ plus transplants accounted for a rising share of October auto sales. 

Adding it all up, I certainly don't see enough evidence to suggest that exports are likely to grow 60% faster than imports - the necessary mathematical condition for the trade deficit to stay constant.    Both export growth and import growth could slow.  But I also think it is possible - given that non-oil import growth has lagged overall growth recently -- that non-oil import growth might pick up a bit (on a q/q basis) even if a slowing economy led retail sales growth to slow ...  Think of China; think of the impact of a stronger dollar.

The math in 2006 is nasty: 5% import growth implies a roughly $100 billion increase in US imports.  5% export growth implies a $60 billion increase in US exports.   Net, that gives a $40 billion increase in the US trade deficit. 

The interest on the debt sold to finance the 2005 current account deficit will add another $40 billion to the US external interest bill (5%*800).   And lots of short-term US external debt will be refinanced at a higher interest rate.   I don't think that a $60-70 billion increase in the US external interest bill in 2006 is out of the question.

That is a pretty benign scenario. Exports grow as fast as imports.  Indeed, they grow at close to their 1990-2003 average growth rate in the face of rising dollar.  The interest rate the US pays on its external debt remains pretty low - well below levels in say 2000.  Yet even this benign scenario generates a $100 billion or so increase in the US current account deficit.

And it is not hard to see how that could be consistent with a story where national savings fall just a bit - large fiscal deficits, and perhaps less corporate saving.  The fall in savings offsets a small fall in investment (higher rates, less investment in residential structures).   But it all hinges on whether the US consumer ignores Sebastian's advice, and continues to spend ...