May Trade Deficit Lowers GDP Prospects

After markets closed for half of Wednesday and all of Thursday for Independence Day, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) had quite a bit of data to digest Friday, including Wednesday's private-payroll numbers and the Commerce Department's May's trade balance. While private-sector employment rose more than expected, adding 188,000 jobs versus a projected increase of 160,000, the trade deficit jumped 12% from April.

Pros and cons of a trade deficit
The balance of trade, calculated monthly, reflects the difference between imports and exports. If exports of goods and services exceed imports of goods and services, the country has a trade surplus. Conversely, if we spend more money on imports than we receive from our exports, we're faced with a trade deficit.

Economists had expected May's deficit to exceed April's, but they hadn't expected such a dramatic jump. Analysts called for the deficit to increase to $40.8 billion from $40.1 billion in April. Instead, the trade gap widened to $45 billion. While exports fell by $0.5 billion, the main contributor to the expanding gap was a $4.4 billion jump in imports.

Running a trade deficit isn't inherently bad, though. In fact, in every month since January 1992, the U.S. has imported more than it has exported. In every one of those months, too, the U.S. has posted a surplus in services and a deficit in goods. But those consistent deficits never got in the way of economic expansion in the '90s, and as we know. the financial collapse of 2008 and 2009 owed more to subprime lending and real-estate speculation than to a mere trade imbalance.

Trade deficits can actually be beneficial in times of rapid economic expansion, as an economy flush with imported goods creates increased price competition, limiting the prospects for inflation and providing a richer variety of products for consumers to choose from. But in times like these, when inflation is an afterthought to bringing back jobs and kick-starting the economy, you'd like to at least see exports on the rise, as it reflects increasing domestic production and therefore a heightening demand for labor.

Unfortunately, a widening trade gap negatively affects gross domestic product, one of the market's favorite economic indicators. GDP is calculated by adding up private consumption, gross domestic investment, government spending, and the trade balance. When that balance is negative, it detracts from GDP. As a result, we saw Wednesday's surprising jump in the trade deficit directly hit second-quarter GDP estimates: Goldman Sachs cut its growth projections by 0.2%, while Royal Bank of Scotland and Barclays were more bearish still, each slashing GDP estimates by 0.6%. Those may seem like modest adjustments, but with growth outlooks now ranging from 0.8% to 1.6% for the second quarter, every small tick downward has a meaningful impact.

Hinting at the future
With that said, Wednesday's report may still reflect some positive trends in the U.S. economy. Imports of industrial and consumer goods, along with automotive vehicles, parts, and engines, rose $2.8 billion in May, which shows robust demand growth from domestic industry. This particular surge in demand could indirectly give investors some clue as to the confidence blue-chip industrials like General Electric and Caterpillar have in their businesses going into the future. We already know that the Institute for Supply Management's manufacturing index showed expansion in June after contracting in May, so Wednesday's figures may serve to corroborate a secular upswing in American industry.

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