U.S. budget and trade deficits have been declining as percentages of GDP. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth-management firm based in Philadelphia.

Summary Stock markets around the world rose significantly last week though they've since backed off a bit. Rising oil prices and the sub-prime mess dominate economic headlines now, but the twin deficits -- budget and trade -- and their impact on the dollar are what worry investors. As it happens, both have been shrinking as a percentage of U.S. gross domestic product (GDP) -- dramatically in the case of the budget deficit. While there are some longer term systemic issues associated particularly with Medicare and the budget deficit, it is quite possible that under a scenario of moderate growth and stable oil prices the two twins continue to shrink as a percentage of GDP. LI>

Review and outlook

The world's equity markets rebounded last week as investors shelved fears of that the sub-prime loan market's woes would prove contagious and took heart from the Federal Reserve's latest comments on the state of the economy.

This rebound was of course nice to see. It was also good see a bit more "fear" priced into things. As we have said before, a lack of fear probably set the market up for its most recent decline, and we still may need more turmoil before we return to a truly healthy balance between bullishness and bearishness.

Worry about the sub-prime market has entered the mainstream. But there is one fear pre-dates it and still worries our clients: the dollar. I speak with a lot of our clients about our market overview and their questions and feedback indicate that the dollar is their main concern. In particular, people will point to the size of the "twin deficits" -- the budget and trade deficits -- as sources of instability. But in fact these two figures have, to an extent, improved in the last few months.

As measured by the S&P 500, the stock market rose by 3.6% last week, led by the performance of energy and telecom stocks. Small-capitalization stocks, as measured by the Russell 2000, bulked up by 4.0%. International equities added 4.2% based almost entirely on local-market returns -- in a bit of a change, a depreciating dollar has played a very small role in their performance. Though international equities markets, on their own, have performed better than the U.S. equity market over the past five years, it has been the decline in the value of the US dollar that has really put some distance between U.S. and international stocks.

Is the dollar likely to stay weak well into the future? This, as I might have said back in my days as an undergraduate student, is a truly cosmic question. There are an awful lot of forces that are pushing and pulling on the value of the U.S. currency. Alas, I am no longer at college, and so lack the tools to make deep and meaningful cosmic statements. (By "tools" I mean an incense-filled dorm room complete with a faux oriental carpet, a black light, strange electronic music and cold pizza; items that, with the exception perhaps of the cold pizza, don't qualify under Glenmede's expense reimbursement policy.)

Instead let's look at the twin deficits, things frequently cited as a source of the dollar's weakness. A few years ago these numbers reached record levels. Since that time one number has got better. The other has got worse. Much worse.

Three years ago the budget deficit hit a high of $430 billion as the economy suffered from the impact of the bursting of the internet bubble. At that point the the deficit reached 3.7% of GDP. Since then the figure has steadily improved despite the unanticipated effect of Hurricane Katrina and a war that has lasted longer than most forecasters had predicted. Now the budget deficit is now 1.6% of GDP. This is big by late-1990s standards, but it's still better than the longer term average. Over the past forty years the budget deficit has averaged 2.2% of GDP.

|image1| But before we get too excited, it's worth knowing that the US still faces some real challenges with its entitlement spending, particularly with regard to Medicare. There is also the risk that too much of the revenue gains we have seen have come from the capital gains or asset-appreciation gains earned by the wealthiest Americans. As we saw with the Californian state budget a few years ago, the tax revenue gains from the paychecks and investment portfolios of "moghuls" tends to be highly cyclical. Still, the current budget deficit numbers are far better than most forecasters were anticipating. Assuming reasonable economic growth these numbers may even improve.

Tractable to intractable

Let's now turn to the trade deficit. There is very little that we can say to make this look like a reasonable number. The U.S. trade deficit now stands at -5.2% of GDP. By any historical measure this is a big number. The large trade deficit is sustained by the capital inflows from overseas countries. The fear this engenders is that, at some point down the road, overseas investors may choose not to hold dollar-based securities and instead reinvest the money back into their own market. This would potentially drive up inflation and interest rates.

|image2| We have argued that the present "imbalance" between imports and exports benefits the U.S. and overseas economies. If foreigners chose to work together to stop funding the trade deficit, the economies that now lend us money would be among those to suffer most.

Others, including David Malpass at Bear Stearns, have argued that the trade deficit represents nothing more than the normal flow of funds between aging-demographic countries -- Japan, Europe and, believe it or not, China in a few years -- and a country with a relatively young demographic, the U.S. That these economies fund our spending should be no more surprising than the fact that a lot of savings and investments probably flow out of states with aging populations like Pennsylvania into states with higher growth and "younger" populations. This is a more nuanced argument than standard text-book answers and is interesting in that it treats the global economy as one big market that is integrated in a lot of different ways.

Generally, however, a large trade deficit makes markets uneasy and a lower deficit, all other things being equal, would probably relieve some of the pressure on the dollar. The growth in the trade deficit has been fairly dramatic since the mid 1990s, contracting only briefly in the 2000 and 2001. The trade gap has, however, been shrinking since early 2000. Some of this shrinkage is not surprising. As shown in the graph below, export growth has been very good -- rising over 10% on a year-over-year basis. Oil prices, a large part of imports, have stabilized somewhat over the past year.

I find the trend in non-energy imports to be somewhat more interesting. Not only has the year-over-year growth in total imports slowed, but so too has the year-over-year growth in non-energy imports. While the deceleration in energy imports can be attributed to lower prices as well as lower shipments, the slowing growth in non-energy imports is more likely to be a function of lower demand.

There are two reasons for this trend. The dollar has become cheaper, imports have become more expensive and hence less attractive. Certainly, the largest drops in import growth have come from areas of the world where the U.S. dollar has appreciated most. But the nearly 16% drop in the trade-weighted dollar would seem to have a fairly delayed impact on buying decisions. We suspect that the more important factor behind this slowdown in import growth is simply a slowdown in overall economic growth to 2% from the 3%-to-4% level.

|image3| Is the trend our friend?

Can this trend towards lower deficits continue? This depends on the shape of growth going forward. Slower growth in the U.S. probably has the effect of continuing to lower the trade deficit as import demand slows. Even if this slower growth is passed on to overseas economies leading to lower export growth, mathematically equal percentage reductions in import and export growth lead to a lower trade deficit.

You can't have it both ways though. Slower growth may also stall improvement on the budget deficit. A more likely scenario is that growth slows for a while and then picks up later in the year or next year as the housing market starts to bottom. From that point forward the shape of the twin deficits will depend on the nature of the recovery. If the housing market takes off like it did before, leading to a whole lot of consumer-led growth, the budget deficit may continue to improve but the trade deficit will worsen. On the other hand if growth comes back in a more balanced form with more growth in capital and business spending then we might see both a better budget deficit number and, potentially, better trade figures as well.

We are inclined to believe that the sort of speculative frenzy we saw in the housing market a few years ago will not be a large component of an economic re-acceleration -- the market will find some other place to conduct a speculative frenzy. So it's possible that both deficits will continue to be significant in size, but they might also be lower as a percentage of GDP this time next year. -FWR

.