Despite Trump’s promises, the US trade deficit hit record highs last year. But it’s set to shrink in 2021 – and that’s good news for the economy.

us trade american flag
An American flag flies nearby with shipping containers stacked at the Port of Los Angeles in the background, which is the nation’s busiest container port, on November 7, 2019 in San Pedro, California.

  • The US trade deficit blew out to record levels in 2020 due to the pandemic.
  • But that should turn around in 2021, as the US starts exporting more goods.
  • The will help boost the US economy and weaken the US dollar.
  • Neil Dutta is head of economics at Renaissance Macro Research.
  • This is an opinion column. The thoughts expressed are those of the author.
  • Visit the Business section of Insider for more stories.

For years, the Trump administration drew attention to what the former president called the US’s “unacceptable” trading relationship with the rest of the world. 

Ironically, by the time President Trump’s time in office was up, the real trade deficit widened to a record. The widening of the trade deficit was a meaningful drag on growth over the second half of 2020, a time when the broader economy was in recovery. 

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But this year, trade is likely to provide a lift to US growth, and the narrowing of the trade deficit may also push up the value of the US dollar against the currencies of its major trading partners.

Why the trade deficit grew in 2020

To understand why the trade deficit will narrow this year, let’s first look to why it widened so sharply in the first place. 

Despite a pandemic, US consumption of goods was relatively buoyant. Indeed, real goods consumption is running about 1.0% above its pre-pandemic trend. This is remarkable given the scope of the job loss in the US and elevated levels of uncertainty in the economic outlook. Purchasing decisions behind big-ticket items tend to be hard to undo. Moreover, many big-ticket goods could be purchased without making physical trips to the store. 

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While the US is a relatively closed economy, goods represent the main source of imports. In 2020, goods accounted for 83% of US imports, broadly in-line with the average over the last three decades. 

But while American households were buying goods from abroad, the same cannot be said of other countries buying our goods. About two-thirds of US exports are goods. These exports dropped more sharply during the depths of the pandemic and have recovered more slowly, leading to the wider overall trade deficit. But there is reason to expect goods exports  to pick-up in the year ahead. 

Why the trade deficit will shrink in 2021

Much of the trends that helped drive the record trade deficit in 2020 are about to see a turnaround, which in turn is good news for US economic growth.

Global manufacturing has picked up, and most of what is manufactured in the US is tradable goods. For example, the ISM new export orders index is consistent with solid growth in goods exports over the next few quarters. So American exports should pick up as well, helping narrow that side of the deficit.

In the year ahead, as the economy reopens, the amount of goods purchased by Americans will level off because they are already running so close to the pre-pandemic trend. Also as vaccines are distributed and people emerge from pandemic restrictions they will be much more likely to spend on services – dining out, going to the movies, amusement parks, etc. 

As it stands, services consumption is currently 9% below its pre-pandemic trend. Service-sector consumption, by its nature, tends to require close physical proximity to consumers. This is one reason why they aren’t really tradeable and why they disproportionately suffered during the pandemic. 

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The composition of consumption in the US this year lends itself to a narrowing of the trade deficit as consumers rotate into services, which are not really imported, relative to goods, which are.

All that adds up to a stronger dollar and growth

The narrowing of the trade deficit will likely have interesting implications for the US dollar exchange rate and our trading partners. 

As a rough rule of thumb, a wider trade deficit tends to weaken the exchange rate. If the trade deficit narrows, the opposite is true. Advanced economies represent the major trading partner for the US. OECD countries account for 60% of US imported goods. Thus, if US import growth slows, it will tend to come at the expense of these economies. As a result, we could see currencies like the euro, pound and yen weaken relative to the US dollar. 

Moreover, there is substantially more upside to growth in emerging economies than there is in our major advanced economy trading partners. 

For example, according to data from the IMF, in Asia’s emerging markets excluding China, the 2022 GDP level is roughly 8% lower relative to its pre-COVID trend. For Latin America and the Caribbean, the GDP level is about 7% lower than its pre-COVID trend. By contrast, advanced economies are off just over 2% relative to the pre-pandemic peak. That there is significant room for EM to strengthen bodes well for EM currencies. 

In short, there is more upside to EM and if goods imports to the US moderate that will tend to hurt advanced economies, at least relative to most emerging market economies. 

There are compelling investment implications. If EM begins to catch up to its pre-crisis trend, that will lift EM currencies, loosen financial conditions across the region, and provide a lift to EM stocks. In developed markets, there is reason to see the US outperforming Europe in the year ahead. Thus, we’d expect the euro and pound sterling to weaken this year.

Read the original article on Business Insider