Trade Problems Ending?

The stock market risks pulling back this week, in part because it may have overreacted to some of the positive US/China trade headlines last week.  The most important headline was China's purported offer to buy $1 Tn in US exports over the next 6 years.  While this proposal would be positive for the economy and stock market when it begins, it would likely lead to problems later.

The Chinese proposal to buy more than $1 Tn in US exports over the next 6 years would provide a significant boost to US economic growth.   Adding about $200 Bn to GDP per year,  it would lift US Real GDP by roughly 1% per year, with the boost about half in 2019 if it begins in H219.   Everything else unchanged, the Fed's Central Tendency forecast for GDP would be above-trend for the next 3 years at least:

                                               Fed's  Central Tendency for Real GDP Growth
                                                            (Q4/Q4 percent change)
                                                       2019              2020                 2021
As of December:                          2.3-2.5            1.8-2.0              1.5-2.0
With Chinese Purchases             2.8-3.0             2.8-3.0              2.5-3.0
(everything else unchanged)

Not everything else would be unchanged, however.  Market forces and the Fed would move to offset at lease some of the Chinese spending boost.   Higher market interest rates and dollar would crowd out domestic spending.  And, the Fed would likely have to tighten, as well -- probably by 75-100 BPs.  After all is said and done, it is conceivable GDP Growth would be the same as it would have been without the Chinese purchases, but with interest rates and dollar higher the composition would be different.  This outcome would be a negative for stocks.

The markets and Fed would have to tighten even more if inflation picks up.  The impact on US inflation will likely be the net effect of stronger domestic wage pressures and higher export prices versus softer import prices.  Stronger GDP Growth would lower the Unemployment Rate further and put upward pressure on wages.  If China boosts purchases of food products, their prices should rise independently of wages.  If needed migrant farm workers are not available because of border clampdowns, higher labor costs could boost food prices, too.  In contrast, besides the tempering effect of a stronger dollar, foreign price pressures from outside of China could ease if Chinese demand shifts away from them to the US.  Moreover, tighter Fed policy would likely put downward pressure on commodity prices.

Elimination of the US/Chinese trade deficit would end the macroeconomic need for deficit spending in the US.  When China was grabbing market share of manufacturing by keeping its currency low, some sector of the US economy had to spend more than its income to offset the drag.  Moreover, the amount of deficit spending had to expand over time to match the widening trade deficit.  The US initially relied on the household sector to do so through the housing market.  This channel was not sustainable.  Rising Federal deficits took its place.   These would no longer be needed.  Fiscal initiatives, such as infrastructure/border wall projects, regardless of whether financed by the government or private industry, would just crowd out other spending.  In other words, financial market conditions would become even more restrictive.