Orlando's Outlook: Inflection point on trade
Bottom Line We already know that Gross Domestic Product (GDP) in this year’s first quarter plunged by a negative 2.9%—the worst such reading since the depths of the Great Recession in 2009—as the widening trade gap shaved 1.53 percentage points from economic growth. But we may be at a positive inflection point on trade. Recently rising imports imply a strengthening domestic economy, while improving exports—despite a stronger dollar—mean that economic expansion is gaining traction among our overseas trading partners. These collectively suggest that net trade may be a smaller drag on second-quarter GDP, with the potential to be a more positive boost in the second half of this year.
Trade deficit peaks After plunging in November 2013 to negative $35.2 billion—its lowest level in four years—over the next five months the trade gap surged by nearly 34% to its widest level in two years, finishing April of 2014 at negative $47.0 billion. That coincides with the advent of our brutal winter and its negative impact on GDP, which fell from a healthy 4.1% gain in last year’s third quarter to 2.6% in the fourth quarter to the aforementioned negative 2.9% in this year’s first quarter.
But in the recently reported month of May, the net trade deficit fell sharply by 5.5% to $44.4 billion. Exports rose to an all-time record high of $195.5 billion, while imports at $239.8 billion were just under April’s record high of $240.5 billion. To be sure, the monthly trade balance had troughed for this cycle in May 2009 at a deficit of $26.0 billion, so we’ve still got quite a ways to go to return to that level. However, the improved May trade deficit, with record exports and near-record imports, suggests that not only is the U.S. economy strengthening, the global economy is starting to gain traction, too, at least among our key trading partners. So, net trade’s huge negative impact on first-quarter GDP should begin to ease in the recently completed second quarter. If these dual positive trends continue through year-end, that augurs well for a more sustainable GDP bounce in the second half of 2014.
Who are our major trading partners? Not surprisingly, our five most important trading partners, who are the second-, third- and fourth-largest economies in the world (after the U.S.) and our North American neighbors to the north and south, comprise two-thirds of our total export volume in 2014:
- Canada, 27.4% of total U.S. exports
- Mexico, 21.0%
- China, 9.2%
- Japan, 5.4%
- Germany, 4.1%
Consensus expectations for economic growth from 2013 through 2015 are incrementally positive for four of these trading partners, with the exception of Japan, which is now dealing with the economic fallout from its recent Value Added Tax (VAT) increase. How successfully—or not—Japan manages to extricate itself from this self-imposed economic down cycle may provide the U.S. with an incrementally positive export opportunity.
What’s up with Japan’s VAT? With one of the world’s highest debt-to-GDP ratios at roughly 250%, Japan’s Prime Minister Shinzo Abe decided to increase the VAT on April 1 from 5% (which was increased from 3% in 1997) to 8% to generate incremental revenue to pay down that excessive level of debt. In addition, Abe plans to increase the tax again to 10% in October 2015. Not surprisingly, Japan enjoyed a surge of pre-buying among consumers and businesses to beat the tax increase in the first quarter, with GDP growth posting a powerful gain of 6.7%. But economic activity fell off the proverbial cliff in the second quarter, with the most bearish GDP forecast—from our research friends at Cornerstone Macro—predicting a decline of 7.5%, which will be flashed on August 12. The questions are how long and deep this economic downturn will be and what catalysts might spark a subsequent economic recovery.
Is the past prologue in Japan? The last time Japan attempted to push this same Keynesian button in 1997, the economy fell into a deep recession that lasted four quarters. But the Asian financial crisis and existing weakness in Japan’s banking industry at that time may have exacerbated the economic downturn.
Whither the third arrow? After aggressive fiscal and monetary policy stimulus sparked a powerful 90% rally in Japanese stocks from November 2012 through year-end 2013, cynics are asking what Abe plans to do for an encore to reverse the negative impact from the ill-advised VAT tax hike.
- Lower corporate tax rate Abe plans to stimulate business investment by cutting corporate tax rates from the current 35% level, the second-highest in the world behind the U.S., to below 30%. He may cut it to as low as 25%, the global corporate average for developed economies.
- Labor reforms Japan’s current population of 127 million is declining at an annualized rate of 0.7%, with an aging population that is expected to be 40% elderly by 2060. Abe hopes to stabilize the population at 100 million by 2050. To mitigate the declining participation of younger workers, he plans to shrink the gender employment gap by initiating legislation to allow more women to enter the workforce, including adding more child-care centers and tax incentives for more women managers. Abe’s “womenomics” initiative could boost Japanese GDP by an estimated 15%, according to our research friends at Goldman Sachs. Abe also plans immigration reform to allow more temporary working visas, visa-free entry to tourists from Indonesia and fewer restrictions on visa issuance to people from Vietnam and the Philippines.
- GPIF reform Abe also plans to reform the pension system, including the Government Pension Investment Fund (GPIF). The goal is to revise the benchmark portfolio to the GPIF to be more diversified with a spotlight on smart beta by cutting domestic bonds to 35-40% and by increasing domestic equities to 20-25%, overseas bonds to 15-20% and foreign equities to 15-20%.
- New council on economic and fiscal policy With respect to the GPIF reform, a new management council will be appointed that will replace the president with a new CIO and full-time members for the Investment Advisory Committee.
VAT damage already priced in Our research friends at TIS Group believe that the damage done to the Japanese economy from the ill-advised VAT tax hike may already be passing. Consumer confidence, employment and wages are starting to rise again. Japan hit its 2% inflation target over the last two months and the NIKKEI Index has already declined by 15% over the first five months of this year, fully discounting, in our view, the second-quarter’s economic dislocation. In fact, Japanese stocks have rallied about 12% over the past two months, a trend we expect to continue as investors have begun to shift their focus. We believe that they are now starting to price in the subsequent economic bounce we expect later this year, once businesses and consumers have gotten used to the new VAT tax and they have depleted their inventory of pre-bought supplies. At that point, U.S. export volumes to Japan will likely increase, perhaps sharply, which will be a net-trade boon to second-half U.S. GDP growth.
Research support provided by Federated summer intern Grace Chmiel.