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U.S.: The Export Engine Is Shifting Into High Gear

The global economy promises to look a little less lopsided in 2006 -- much to the benefit of U.S. exporters. In the past few years, the U.S. has been the dominant force behind world growth. True, China and much of Asia have posted strong gains, but those markets are not as important to export businesses as those in the euro zone and Japan. Those two areas account for more than 20% of all U.S. shipments abroad, but they have been largely on life support in recent years.

The coming year will be a different story. While growth in the U.S. is expected to slow a notch, as higher interest rates begin to cool off housing and consumer spending, demand in both the euro zone and Japan will strengthen. Both regions are already showing signs that exceptionally low interest rates are finally shoring up labor markets and boosting domestic spending -- even in growth laggard Germany. Outlays by Japanese consumers and businesses are picking up steam now that Japan is winning its battle with deflation and stagnation.

The economies of both Canada and Mexico, which absorb more than a third of U.S. exports, are expected to show some improvement as well. Growth in China may slow a bit, but it will remain robust enough to keep Asian growth powering ahead at a solid clip.

Stronger foreign demand may not be the only plus for exporters this year. There are good reasons to believe that the dollar is ready to start declining again, especially against the euro and the yen, after the greenback's surprising strength during most of 2005.

That's because improving growth prospects abroad and rising foreign interest rates will enhance the potential return on overseas investments relative to dollar-based opportunities in the U.S. The dollar dropped sharply vs. the euro on Jan. 3-4, after the minutes of the Federal Reserve's Dec. 13 meeting suggested that the Fed's rate hiking may end soon.

THE REAL WINNER in this scenario is U.S. manufacturing. The industrial sector has shown new strength in recent months in response to resilient domestic demand by U.S. consumers and businesses.

The December purchasing managers' index of industrial activity slipped almost four points from November, to 54.2%, but that decline was from a high level exaggerated by the post-hurricane rebound, and the December reading is consistent with a strong factory sector. Although the purchasers' index of export orders also dipped in December, its average for the entire quarter increased for the second quarter in a row.

In 2006 manufacturers can expect an additional lift from overseas, especially makers of capital goods. Exports of business equipment, ranging from aircraft to high-tech gear, have accounted for more than 85% of the U.S. goods exported during the past year.

Exports in 2005 slowed from their strong performance in the previous year, as surging energy costs ate into global demand and the broad trade-weighted dollar rose. Not all the data for 2005 are in yet, but exports are on track to grow a couple of percentage points less than in 2004. In that year, foreign shipments of goods and services increased 8.4%, their best showing in four years, helped by the 16% decline in the broad trade-weighted dollar between early 2002 and late 2004.

This year, U.S. exports stand a good chance to post their strongest growth since their last double-digit performance -- in 1997. Stronger overseas demand will help, but greater competitiveness in foreign markets because of a cheaper dollar will also be a key factor in achieving that result.

That's especially true for the dollar vs. the yen and the euro, which is where the greenback gained the most ground in 2005. Using the inflation-adjusted indexes calculated by the Federal Reserve, the broadest measure of the trade-weighted dollar rose 4% last year. However, it soared more than 10% vs. major currencies, which the Fed defines as the euro, yen, British pound, Swiss franc, Swedish krona, and the Canadian and Australian dollars. In particular, the dollar gained 12.5% against the euro and 14.8% vs. the yen.

THE GOOD NEWS: Those two currencies are the ones against which the dollar will likely lose the most altitude this year. One reason is that the Federal Reserve appears very close to ending its interest-rate hiking. But at the same time, the European Central Bank has only now begun to lift rates, and the Bank of Japan is discussing when to end its four-year policy of zero rates. A narrowing in the rate differences between these two regions and the U.S. will make prospective returns on dollar-based securities relatively less attractive to investors. That's the opposite of the trend in 2005.

Another reason: Growth in the U.S. economy in 2005, which is expected to wind up at 3.6% when all the data are in, far outpaced the 1.3% and 2.2% clips expected for the euro zone and Japan, respectively. In 2006, those growth differences should narrow, another relative minus for investors' perceptions of dollar-based returns.

INTERESTINGLY, THE DOLLAR'S broad rise last year disguised one surprising trend in U.S. competitiveness that seems likely to continue this year. While the dollar was strengthening against the currencies of the U.S.'s major trading partners, it was actually slipping against those of other smaller, but important, partners.

The Fed also calculates a separate trade-weighted dollar index, made up of 19 "other important trading partners." Those 19 include China and Asian economies, key Latin American nations, and other countries that all together make up about 40% of U.S. trade volumes.

Since the middle of 2004, the dollar has declined more than 6% vs. this basket of currencies. Many of these nations keep their currencies in a tight range relative to the dollar. China's baby-step revaluation of its yuan last July, which lifted its value vs. the dollar by about 2%, was partly responsible for this trend, but the benefits to U.S. exporters have been broader. For example, overall exports to Pacific Rim countries, excluding Japan, in October were up nearly 14% from a year ago.

Following China's lead in its move toward more currency flexibility, other Asian nations have also relaxed their hold on their currencies. Plus, by the end of 2005, the Chinese yuan appears to have appreciated further, based on its movement against a basket of currencies. Economists expect to see a further rise in the coming year.

Nevertheless, while exports are set to make headway in 2006, don't expect those gains to narrow the gaping U.S. trade deficit. Even if exports grow by 10%, after adjusting for inflation, import growth would have to be limited to about 6.5% just to hold the trade deficit at its current level. Unless the slowing in U.S. demand is much greater than now expected, imports will most likely grow faster than that pace. That means trade patterns will not be universally positive for U.S. manufacturers. For exporters, however, 2006 is shaping up to be a very good year.

By James C. Cooper, with James Mehring in New York

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