World Trade, US Trade Balance, the dollar and stock/bond investing

The tables published by the WTO - ( http://www.wto.org ) - detail the leading exporters and importers in the world in 2004. The list is interesting and the top few nations in each category is noted below:

Exporters:

1. Germany - came in at #1 with $912 billion in exports with a growth of 20% year over year.
2. US - came in at #2 at 818 billion in exports with 13% growth year over year.
3. China at 593 billion in exports with 35% growth.

Importers:

1. United States at 1525 billion dollars registering 17% growth year over year.
2. Germany with 719 billion dollars registering 19% growth year over year.
3. China at 561 billion dollars showing 36% growth.

The U.S trade gap with the rest of the world widened to $66billion in September. Although the hurricanes are blamed for surge in imports and the reduction in exports - the trade deficit has been widening for quite some time. The trend is not showing any signs of abating any time soon. The trade balance with some key parterns can be found in the link http://www.census.gov/foreign-trade/balance/. The trade deficit with some key trading parternes looks like this.

Canada - $75 billion for the year
Mexico - $52 billion
China - $200 billion
Japan - $80 billion
India - $1o billion
France - $11 billion
United Kingdom - $10 billion
Russia - $11 billion

This year was the year the deficit was expected to stabilize and improve in the coming years. This looks unlikely given the 10-20% growth in deficit with key trading partners. The exports have also been growing at a good clip but are not keeping pace with imports. The surprise was the elevation of Germany as the top exporter in the world. China is expected to surpass both the U.S and Germany as the top trading nation in the world in the coming years.

What does this mean for the U.S dollar, the U.S economy and the world economy overall? The answers are far from clear. There are a couple of theories that predict the scenarios for the coming year.

First Scenario:

The trade deficit has to balance out or reduce over the long run. The current scenario can't continue on forever. This can happen in one of two ways - the U.S growth rate will be far lesser than the rest of the world - this will lead to more US exports and less US imports thus correcting the imbalance. The second scenario is one where the US currency gets devalued with other trading partners. This reduces the purchasing power of the dollar and increases the appeal for US made goods and services.

While it is is entirely possible for growth in the rest of the world to exceed that of the U.S - it is unlikely that the growth will come from former industrial powerhouses. The decline in population in Europe and Japan is the main reason for this - it is likely that the currently emerging countries - Chian, India, Brazil, Korea and South Africa will grow at a faster clip. Many of these countries have very low cost labor, so it is likely that they will be net exporters than importers in the near future.

The second scenario where the US currency gets devalued with the rest of the world also hasnt materialized. The interest rate differentials between Europe/Japan and US is the main reason for this. Chinese and Indian currencies cant be traded freely and aren't used as world's reserve currency. The emerging market countries cant afford to let their currencies appreciate signficantly against the dollar and risk losing jobs in their own country. For countries like China, it is ok to lose money than flame political riots at home.

Second Scenario:

The second theory says that there is a savings glut and that US is still the country of choice for foreign governments to park their trade surplus. The interest rates are good ( compared to the Euro or Yen ) and all the commodities, oil trade in dollar anyway. Given this huge stash of money chasing dollars and the reduced government deficits are causing long term treasury yields to be low. This poses the inverted yield conundrum where long term rates are the same or lower than the short term rates.

Given the non predictability of the US dollar movement, how should one be investing? How would it impact stocks and bonds? It is a difficult question to answer - in the short term it does seem as though the U.S interest rates will dictate the currency markets. With interest rates expected to reach 4.5% next year - it is likely the dollar will continue to gain against other currencies till early next year. After that, it is any ones guess on what will happen. Thus far this year, the iShares Japan Index Fund ( Ticker IWJ ) has appreciated by 10%. The German index fund EWG has gained only about 1%. In the Japanese and German case, the US dollar has appreciated. The returns would have been far greater if the dollar had declined in value. Consequently, the dollar strength has decreased the returns in other foreign investments.

Some are speculating that the dollar is headed down in FY06 - this includes the economist article http://www.economist.com/agenda/displaystory.cfm?story_id=5078354. Warren Buffett has decreased his exposure against the dollar this year given the strength of the dollar. However, the size of his bet is still substantial - to the tune of sixteen billion dollars. Next year is going to be an interesting year - if the predictions for dollar fall hold true, late this year/early next year might be a good opportunity to invest in Europe and Asia.