U.S. Trade Deficit Decline Mainly Due to Improved Balance of Trade with 10 Largest Partners

Since U.S. exports and imports both peaked in July 2008, the monthly trade deficit has fallen from $64.891 billion to $25.962 billion (May 2009). That was the lowest monthly trade deficit since November 1999 when the monthly trade deficit stood at $25.745 billion. A further unwinding of the U.S. trade imbalance is likely in the months ahead.

A closer examination of the data reveals that the U.S. trade deficit was not driven sharply lower due to a pickup in U.S. exports. Instead, the data revealed:

• The trade deficit fell sharply because U.S. imports plunged much more rapidly than U.S. exports. Since July 2008, U.S. exports are down 25.0%. Meanwhile, U.S. imports had declined 34.9%.

• Improvement in the trade balance with the nation’s 10 largest trading partners (the ten largest partners in July 2008) accounted for 94% of the decline in the monthly U.S. trade deficit.



• With the 10 largest trading partners, U.S. exports fell 26.3%, while imports declined by 41.1%. Excluding China, with which exports and imports both fell more modestly, exports fell 27.2% and imports plunged 45.4%

• U.S. imports from Venezuela and Saudi Arabia—mainly crude oil—contracted more than 65% on account of reduced U.S. oil consumption and a decline in the price of crude oil. Overall, imports contracted by 40% or more with 5 of the nation’s 10 largest trading partners.



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Fed Beige Book: Economy Possibly Near Its Bottom

The Federal Reserve’s latest Beige Book on current economic conditions by Federal Reserve district, revealed a stabilizing economy. The report noted:

Reports from the 12 Federal Reserve Districts suggest that economic activity continued to be weak going into the summer, but most Districts indicated that the pace of decline has moderated since the last report or that activity has begun to stabilize, albeit at a low level. Five Districts used the words "slow", "subdued", or "weak" to describe activity levels; Chicago and St. Louis reported that the pace of decline appeared to be moderating; and New York, Cleveland, Kansas City, and San Francisco pointed to signs of stabilization. Minneapolis said the District economy had contracted since the last report.

Overall, several themes were set forth in the report’s findings. Those themes included:

• Signs of macroeconomic stabilization are present.

• Economic activity and changes in that activity are uneven across Federal Reserve districts and by economic sector.

• No significant rebound in consumer spending is evident.

• The manufacturing sector is still sputtering.

• The residential real estate market shows signs of stabilizing in numerous districts.

• The commercial real estate sector continues to weaken.

The following table provides a brief summary of developments in the various Federal Reserve districts.



Upcoming releases of the Beige Book on September 9 and October 21 will provide evidence as to whether the current indications of stabilization led to a near-term turnaround in the economy. The latter data will also furnish additional evidence as to the strength of any near-term recovery. For now, weak consumer spending, the possible adverse impact of deteriorating commercial real estate market conditions, and historic experience following the collapse of major real estate asset bubbles hint at a rather sluggish recovery.

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Latest Data Indicates Housing Prices May Be Stabilizing

For the first time since July 2006, the S&P/Case-Shiller Home Price Index for 20 cities registered an increase. The data for May 2009 showed that home prices rose 0.5%. However, on a seasonally-adjusted basis, home prices continued there slide, albeit a slowing descent. The seasonally-adjusted 20-city index fell 0.2%.

The latest data may be signaling a stabilization of home prices over coming months. For March 2009, just 1 of the 20 cities saw home prices increase. In April, 4 cities experienced price gains. In May, 8 cities registered price gains. In Cleveland and Dallas, home prices rose more than 1%. Cleveland, Dallas, Denver, and Washington, DC have now experienced a rise in home prices for two consecutive months. In Denver, home prices have risen for three consecutive months.

However, some cities continued to experience precipitous declines in home prices. Las Vegas, Miami, and Phoenix all saw home prices fall more than 1%.

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In a potentially discouraging note for some of the hardest-hit housing markets, four of the five cities that registered the biggest price declines in May were among those that had seen peak-to-trough declines in excess of 40%. Those cities, along with their home price declines to date, are:

Las Vegas: 53.3%
Los Angeles: 41.4%
Miami: 48.3%
Phoenix: 54.3%

Among the cities benefiting from the biggest monthly home appreciation, just one (San Francisco) had seen a 40% or greater drop in home prices.

That data hints that where the asset bubble was most pronounced, not where home prices have fallen most, could see the slowest recovery in home prices. Instead, a recovery in home prices could commence soonest in regions in which the economy is most resilient and the housing bubble was less pronounced.

In the months ahead, four factors will probably play an important role in shaping any housing recovery that commences:

• Changes in long-term interest rates. The nation’s short-term fiscal situation, namely its ability to continue to finance its enormous stimulus efforts, and changes to its long-term fiscal trajectory could impact long-term rates.

• Rising unemployment. Rising unemployment could dampen consumer confidence and increase risk-aversion toward major purchases, including homes. It could also strain the finances of families with mortgages, leading to increased foreclosures and increased inventory.

• Financial system fragility that inhibits home lending, particularly if the commercial real estate sector experiences a sharpening descent. Already, 15 of the 64 bank failures this year have occurred in states in which cities saw the biggest home price declines in May. Hence, a self-reinforcing relationship between home price trends and bank failures is a possibility.

• Whether an economic recovery takes root or fizzles.

In the near-term, even as home prices are showing signs of stabilization, further declines are still likely. The epicenter of price declines will likely remain California, Arizona, Nevada, and Florida. A recent worsening of the housing situation in the Pacific Northwest may indicate continuing softness there. Afterward, even when the 20-city index bottoms out and begins to rise, regional differences in home price trends could persist for some time.

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Historical Experience: Standard and Poor's 500 Index Could End 2009 in the 900 to 1,100 range

As U.S. stocks have continued to rise from their March 9, 2009 bottom, a development that typically precedes the end of a recession by 3-6 months, speculation concerning how high stocks might rise by year-end has abounded. Historical evidence from the six most recent recessions suggests that the upside potential could be limited relative to the 982.18 figure at which the S&P 500 closed on Monday.

The following are implied closing figures based on the past six recessions, using the S&P 500’s March 9 closing price of 676.53 as the bottom.

1960-61 Recession: 932.24
1969-70 Recession: 974.23
1980 Recession: 988.95
1981-82 Recession: 1,121.34
1990-91 Recession: 920.41
2001 Recession: 907.94

Mean: 984.69
Median: 972.59

Ultimately, how key factors play out will determine the magnitude and duration of the current recession and its impact on corporate profits in 2009. Some of those factors include:

• The continuing evolution of the economic challenges, likely impacting commercial real estate and consumer credit.
• Long-term deleveraging that reduces the role of the consumer in the overall economy. Currently, real personal consumption expenditures account for just over 70% of GDP. That figure could slowly decline below 70% of GDP in succeeding quarters.
• Impact of rapidly rising U.S. debt levels. If foreign capital inflows slow or even reverse, a currency crisis could unfold.
• Possible geopolitical shocks that could complicate or exacerbate the nation's challenges.

For now, with the economy showing signs of stabilizing, the historic experience suggests that the S&P 500 could end 2009 within 100 points of 1,000 should the recession end in the third or fourth quarter of this year. Such a close would indicate that the sharpest gains in equities prices have already occurred.

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U.S. Middle East Talks: Iran Should Be The Priority

The Middle East has been a cauldron for geopolitical stability throughout the duration of the post-World War II era. That region has been gripped by international conflicts, the Cold War rivalry, ethnic and religious rivalries, and terrorism. At the same time, the region remains a vital interest for the United States and of crucial importance to the world at large given its petroleum resources.

Amidst that backdrop, the U.S. has restarted a peace initiative aimed at resolving the historic Israeli-Palestinian dispute. Reuters reported:

The United States launched a fresh drive on Sunday to restart Middle East peace talks, sending senior officials to the region to deal with issues ranging from Jewish settlements to Iran's nuclear ambitions.

The visits by Middle East envoy George Mitchell, Defense Secretary Robert Gates and National Security Adviser Jim Jones were a strong signal from U.S. President Barack Obama of his intention to keep Israeli-Arab peacemaking high on his agenda.

Without question, the historic Israeli-Palestinian dispute has had significant ramifications for Middle East stability. However, a U.S. focus on that dispute might be taking away time and effort that could otherwise be applied toward addressing Iran’s nuclear ambitions through the diplomatic process. It is that latter issue that, if unresolved, could have far-broader and much greater implications for the region and globe at large.

The date at which Iran could develop a nuclear weapons capability is drawing closer with each passing day so long as Iran maintains pursuit of its uranium enrichment activities. A nuclear-armed Iran would dramatically shift the balance of power in the Middle East. It would give Iran a potential capability to shut down Persian Gulf shipping, allowing Iran to place a chokehold on the world’s access to energy were Iran to exercise that capability. It would radically transform the power calculus between the Middle East’s Sunni and Shia Muslims. It would create a potential umbrella by which Iran could aid terrorist organizations ranging from Hezbollah to Hamas with little threat of military consequences for such assistance.

Considering these consequences, a nuclear-armed Iran could potentially mark the end of the existing nuclear non-proliferation framework. In the wake of such a development, the Middle East’s states would need to develop a robust and credible deterrent to Iran’s nuclear capability. Such a deterrent would almost certainly depend on a U.S. nuclear guarantee, as a number of the Persian Gulf states and Israel are geographically tiny. In addition, the need to develop a credible deterrent could give rise to a scramble by numerous states to develop their own nuclear weapons capability. In turn, the spread of nuclear weapons could increase the risk of an accident or miscalculation.

In terms of the historic Arab-Israeli dispute, including that between Israel and the Palestinians, a nuclear-armed Iran could make it “safe” for the more radical elements to exercise a de facto veto. Hence, a nuclear-armed Iran could make resolving the historic dispute, as difficult as it already is, even more challenging.

All in all, the profound consequences of a nuclear Iran, along with the finite time during which a diplomatic solution might be feasible, argues strongly that the priority for U.S. diplomatic efforts should be placed on addressing the challenge posed by Iran’s nuclear program. While it would be prudent for the U.S. to maintain some diplomatic activity on the Israeli-Palestinian front, the Middle East’s challenges require prioritization.

Based on Palestinian President Mahmoud Abbas’ rejection of Prime Minister Olmert’s peace proposal—an initiative that offered even more generous terms than President Clinton’s December 2000 bridging proposal—and unwillingness to cede the demand that Palestinian refugees and their descendents have a “right” to settle in Israel, prospects for a near-term solution on that front are bleak. Hence, the greatest thrust of U.S. diplomacy should be focused where the need is most urgent (the finite time during which Iran can become a nuclear-armed state makes that issue the more urgent matter) and the stakes are highest (no other issue has the broad implications Iran’s acquisition of nuclear weapons would have). In the end, Middle East stability and the prospect for peace rests more on what happens with respect to Tehran than in Jerusalem and Ramallah.

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IMF Concludes Its Consultation with China

Earlier this week, the International Monetary Fund (IMF) announced that its Executive Board had completed its consultations with China. The IMF released a summary of the consultation. Key findings included:

• China’s robust fiscal and monetary policy stimuli facilitated an economic recovery. China’s policies have contributed to regional and global economic stability.

• Global economic challenges may make it difficult for the world’s economies to absorb China’s increased production capacity. As a result, the IMF expressed support for China’s measures aimed at boosting domestic consumption spending and reducing China’s reliance on exports.

• China’s low level of public debt should afford the country flexibility in pursuing additional targeted fiscal stimulus measures.

• The IMF called for China to closely monitor its financial system for indications of a decline in credit quality.

• The IMF welcomed China’s intent to participate in its Financial Sector Assessment Program to identify possible areas for financial system reform.

To date, the ongoing discussions in academic and regulatory circles in China concerning the possible deployment of monetary policy to mitigate the risk of an emergent real estate bubble should provide some degree of comfort when it comes to avoiding a serious deterioration in credit quality. Possible monetary tightening would tend to squeeze out marginal borrowers.

Nonetheless, given the limits of monetary policy, regulators will need to carefully watch bank lending for signs that loans are being concentrated disproportionately in any single economic sector such as real estate, down payments are being reduced significantly, or up-front inducements to encourage borrowing are being offered. Should capital inflows pick up dramatically in coming quarters, that situation would also warrant close monitoring, as such inflows could fuel a credit boom that provides access even to marginal borrowers. Those were some of the symptoms of the decay that took place in lending standards during the run-up of the recent U.S. housing bubble.

So far, China’s policy makers appear to have taken to heart a possible role for monetary policy in mitigating the rise of asset bubbles. It remains to be seen how China’s regulators will respond in seeking to preclude any material decline in credit quality, particularly as China’s economy experiences a return of robust growth.

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House Passes Paygo Budget Rules: Major Exemptions and a Key Challenge

Yesterday, the U.S. House of Representatives passed H.R. 2920, which would reinstitute a pay-as-you-go requirement of budget neutrality on new tax and spending legislation, by a 265-166 margin. 241 democrats and 24 republicans voted in favor of the legislation while 13 democrats and 153 republicans voted against the bill. In essence, the legislation would require any new expenditures or tax relief be offset by spending reductions and/or tax increases to maintain overall budget neutrality.

Nonetheless, a significant share of the federal budget would be exempt from the legislation. Exemptions would apply to, among other programs or laws, physician payments made by Medicare, provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Jobs and Growth Tax Relief and Reconciliation Act of 2003 via scoring (calculating) adjustments. In other words, should Medicare physician payments rocket, no budgetary offsets would be required. At the same time, renewal of expiring provisions associated with the 2001 and 2003 tax relief measures also would not require offsets.

Arguments can be made to rationalize those and other exemptions. For example, allowing the tax relief provisions to expire altogether might prove too economically disruptive, especially at a time when the economy remains weak.

However, on the Medicare front, the exemption is particularly difficult to justify given the long-term fiscal imbalances associated with that program. In that case, the exemption merely serves to postpone the federal government’s starting to tackle the issue of mandatory spending program reforms necessary to put the nation on a more sustainable fiscal path.

Aside from the above-noted exemptions, the first major test of Congressional budgetary resolve could come in the form of health care reform legislation. To date, the Congressional Budget Office (CBO) has estimated that the major legislation likely to be considered would increase the nation’s budget deficits. That raises the question as to whether Congress will make changes to the legislation necessary to make it budget neutral to begin establishing credibility on the fiscal discipline issue or whether Congress will adopt the legislation, even as it would increase the nation’s budget deficits. Considering the exemption put in place for Medicare physician payments, odds probably favor the latter course, though such a course does not ensure that the health care legislation would be adopted. It only suggests that the legislation probably will not be made budget-neutral.

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