Barclays projects that consumers will continue to drive U.S. economy. S&P targets high-yielding dividend funds. BlackRock forecasts slower, but steady growth in China. 

Dean Maki, Barclays Capital

Rebalancing is hard to do.

-- Soft consumer spending growth and a large boost from trade in Q2 11 may raise hopes that the long-anticipated rebalancing of the US economy is beginning.

-- We do not think this is the case because the trade boost was largely due to depressed real import growth that owed to an import price surge.

-- If import price growth moderates, domestic demand and real import growth will likely pick up and the trade boost will fade.

For years, many analysts have been calling for a fundamental rebalancing of the US economy, in which consumption would play a lesser role and net exports would contribute more. So far, this has not happened. Consumer spending increased to 71.1% of the GDP in Q1 11; this was the second-highest reading in the six decades that quarterly GDP data have been kept. In addition, the trade deficit has been widening, not narrowing, since the recession ended. Thus, the data indicate that the long-awaited rebalancing had not yet started. At first glance, however, data for Q2 11 seem consistent with the rebalancing thesis. We estimate that real consumer spending rose only an annualized 0.5%, but that trade contributed 1.0pp to growth, helping lead overall real GDP growth to rise a modest 2.0%.

We are skeptical that the Q2 11 real GDP data represent the start of a sustained rebalancing. One reason is that, as shown in Figure 1, while the real trade deficit has narrowed modestly through May, the nominal trade deficit has continued to widen. This is largely because real import growth has stalled, even as nominal import growth has been robust. Import prices have surged, in large part in the food and energy categories, and this has helped caused real import and real consumer spending growth to slow sharply. Energy prices have now dropped notably from their peak, and if that helps lead real consumer spending and overall domestic demand growth to pick up in Q3 11, as we expect, then real import growth is likely to firm as well. Thus, we expect the real trade deficit to widen modestly again in Q3, which would confirm the Q2 narrowing was not the start of a sustained trend..

The dollar by itself will not be enough Since the US started running large trade deficits in the 1970s, moves toward a narrower deficit have generally been achieved through recessions that generated weakness in domestic demand and caused imports to plunge and the trade deficit to narrow. That is unlikely to be the scenario that anyone would advocate as the way to rebalance. Instead, some may advocate a weaker dollar as the answer. However, as shown in Figure 3, the significant fall in the trade-weighted dollar early in the last decade led to only a modest narrowing in the deficit; most of the recent narrowing occurred during the recession. Since the recovery began, the trade deficit has been on a widening trend. There is only one example of a substantial narrowing in the trade deficit that did not occur through a recession during the past forty years: the sharp fall in the trade-weighted dollar that occurred in 1985-88, which helped lead to a narrowing trade deficit starting in 1988. However, one outcome of this drop in the dollar was a substantial rise in import prices, which contributed to a rise in consumer inflation. The PCE price index rose above 4% in 1988 (Figure 4), helping lead the Federal Reserve to increase rates significantly in 1988-89; the lagged effect of this tightening was likely one of the factors contributing to the recession of 1990-91.

Thus, there are no examples of pain-free rebalancing in the US since it started running large trade deficits; significant reductions in the trade deficit have occurred in recessions or been accompanied by rising inflationary pressures. The size of the drop in the dollar needed to substantially narrow the deficit by itself now is unlikely to occur without generating strong inflationary pressure. It also is unclear whether foreign growth is going to accelerate sharply in coming quarters from the pace so far in the recovery, which has not been fast enough to narrow the deficit greatly. One avenue that may help lead to a narrower trade deficit over time is fiscal adjustment, in which spending cuts may lead to slower import growth and help narrow the deficit. However, with the labor market weak, sharp near-term fiscal contraction does not look appealing. The bottom line is that a sustained narrowing of the trade deficit is likely to be painful, and the policy actions that would lead to that outcome are unlikely until the growth backdrop is much stronger.