U.S. trade gap hits a decade low. The U.S. trade figures released last week showed that the trade gap continues to narrow to $26B, a level not seen since late 1999. The trend of a correcting U.S. trade deficit has been underway for almost a year now but the fact it is hitting new medium term lows does not bode well for America’s trade partners. It is not a particularly strong sign for the U.S. economy either. You want trade gaps to narrow because of a pickup in exports, not a further decline in imports. Think of it as the right thing for the wrong reason.

The trade gap is composed of two major components, a surplus in services ($11.4B in May) that the U.S. runs with the rest of the world and a deficit in manufactured goods (negative $37.3B). Both are persistent but the recent movement has been in goods trade over the past year. The surplus in services has declined 8% from its peak in July ’08 while the deficit in manufactured goods has declined by just over half over the same period.

Imports are down despite rising oil prices. The surprise is not so much that the trade gap narrowed suddenly at the end of last year but that there has been no momentum whatsoever in the first five months for this deficit to widen back out. The low point in goods trade was back in February when the average price of oil imported to the country was $39.22. In May, that price (as reported by the BEA) was 31% higher at $51.21. Total imports declined even after absorbing the $3.4B higher bill for oil.

Borrowing to trade deficit dramatically reduced. The net result is $40 billion less is required each month to fund this trade deficit. This is a positive development for the dollar. Conventional wisdom has the dollar resuming a downward slide as the economy recovers. True, the U.S. government deficits risk the stability of the dollar but much of the resulting spending is transfer payments to its citizens in the form of tax credits and unemployment benefits.

I do not mean to say the U.S. is in a healthy fiscal situation. However, with narrowing trade deficits and rising domestic savings rates the need to borrow in foreign markets is dramatically reduced. This alone should cause us to question the conventional wisdom of a weak dollar, particularly when there is no consensus on what will strengthen.

The smaller trade gap equals higher GDP growth. The trade deficit for 2007 and 2008 was about $700 billion. The present trend (even allowing for a gradual widening of the deficit back to $30B for the rest of the year) would suggest a 2009 figure that is closer to $350B. That $350B improvement would add 2.5% to U.S. economic growth.

One major component of GDP growth for all countries is the change in the net contribution of exports. This change in net exports will make U.S. GDP growth for 2009 2.5% greater than it otherwise would have been.

While it is easy to dismiss this nothing more than a mathematical artifact, it is real none the less. This factor was apparent in the first quarter numbers as the only strongly positive component of GDP growth. The trade gap has narrowed further since Q1 but even allowing for the deficit to widen back out some, it is reasonable to think of the net exports contribution to GDP growth in Q1’09 to be a precursor of the full year.

For every action, there is an equal and opposite reaction... For this we can borrow loosely from Newton’s Third Law of Motion. Unlike other components of GDP growth, net exports is a zero sum statistic at the global level. Thus as a $350B improvement in net exports boosts the U.S. economic growth data, there must be some collection of countries whose economic growth are hindered by that amount.

North American and Middle Eastern trade partners most impacted. After analyzing the changing trade patterns between the U.S. and its partners, I did some calculations to quantify the impact. The results are not so different from the conclusions when I first wrote on the narrowing trade deficit. It is the members of NAFTA and the Middle East that will see the greatest impact as their economies are most dependant on running surpluses with the U.S.

Take Mexico, a major source for automotive, electronics, and energy imports, for example. Its trade gap with the U.S. is on track to decline 47% for the year. All other things being equal, if this were to play out for full year 2009, the Mexico GDP growth would be reduced by 2.6% due simply to this decline in surplus with the U.S. There may be factors in the Mexican economy that offset this somewhat but trade creates a real headwind for many of America’s trading partners.

The U.S. is now outsourcing unemployment and negative growth. After decades of exporting manufacturing jobs, the U.S. has become a services dominated economy. While the service sector has declined single digit amounts, it has been the manufacturing portion of the globally that has taken the greatest hit, seen by industrial production declines that regularly exceed 30% in many economies. The U.S. has arguably the most fluid and dynamic labor force (i.e. American companies are very quick to layoff employees). The present 9.5% unemployment rate is alarming but it likely would have been much higher by now if manufacturing jobs had been kept in the U.S.

Now many indicators in the U.S. point to stabilization but not necessarily a robust recovery. Without the resumption of a growing U.S. trade deficit, it is likely there will be continued stress on foreign labor markets for quarters to come, even after unemployment peaks in the U.S.

The point is not to paint a rosy picture of the U.S. or that this issue makes for a strong dollar. Rather, it is to question the thinking that markets outside the U.S. are fundamentally sounder and have better growth prospects. Globalization cuts both ways. The boost to non-U.S. economies that growing trade surpluses represented from 2004 to 2007 is now working in reverse.

With five months of trade data behind us, a picture of U.S. trade deficit being cut in half has emerged. Most countries including the U.S. face many headwinds to economic growth. There is one factor, net exports, that provides the U.S. a tailwind to the tune of 2.5% growth for the full year of 2009. Unfortunately, it is an equal and opposite headwind for many of its major trading partners.

Disclosure: No positions.