Uncertain world undermines NZ's momentum

Uncertainty about much of the world economy has shown up in significant drops in oil prices and long-term interest rates, and has also negatively affected the outlook for New Zealand’s growth over the next couple of years.  Dairy prices have recently stabilised, but fell much faster and further than anticipated during 2014, and will dampen spending growth over the next couple of years compared to what we would otherwise have expected.  Broader international demand conditions also remain shakier than might have previously been anticipated.  There is a lack of inflationary pressures both domestically and internationally, and any further rises in interest rates by the Reserve Bank are a long way off – despite evidence that the Auckland housing market is reigniting.  Amid this backdrop GDP growth is forecast to hold above 3.0%pa this year before slowing to 2.1% in the 2016 calendar year.

If we look at production GDP, the New Zealand economy has just managed its fastest year of economic growth since the Global Financial Crisis, expanding by 2.8% over the year to September 2014.  Yet much of last year’s economic commentary was spent obsessing about how far dairy prices would fall and how big the knock-on effect for future growth would be.  This year, we’re about to find out.

But our attention over the last few months has been distracted by massive price falls for a more fundamental commodity for the world economy: oil.  Since peaking at US$115/bl in June 2014, Brent oil prices have collapsed, getting as low as US$45/bl in January this year.

Trying to understand the relative importance of supply influences versus demand factors in driving the oil price drop is an important issue that we have explored in Where has the floor on oil prices gone?.  And although increases in the supply of oil have played a definite role in capping oil prices, soft demand conditions are also causing some concerns.

To be fair, some of the lack of demand growth represents a step change in demand growth following the massive ramp up in oil prices between 2000 and 2008.  This lift in prices provided a significant incentive for more efficient use of energy.  Furthermore, the slower global economic growth since the GFC has also meant that demand growth has been below expectations over recent years.

But other indicators hint at a cyclical lull in demand as well.  Fears that global economic growth will remain subdued have seen investors take refuge in government bonds, which has put downward pressure on yields.  Ten-year government bond rates for the US, UK, and New Zealand have fallen to their lowest levels since April or May 2013, while bond rates for Japan, Germany, and Australia are at record lows.  Consensus forecasts for global growth this year have also been easing back since August 2014.

At first glance, the most obvious factor behind the softening outlook for global growth is Europe.  Deflationary concerns across the Eurozone, a lack of economic momentum in Germany, and the uncertainty caused by the Greek political situation have all undermined GDP growth prospects in Europe.  But even bigger downward revisions to consensus growth forecasts for 2015 have been made for Eastern Europe (from 2.5% to 1.2% since August), Latin America (2.6% down to 1.6%), and other countries[1] (4.6% down to 3.6%).

Arguably the most obvious omission from the list of areas with softening growth prospects is the Asia-Pacific region.  China has been causing concerns given a range of weak indicators, including contracting manufacturing activity, falling house prices, and slowing growth in export volumes.  China’s year-end GDP growth of 7.4% in 2014 was the country’s weakest performance since 1990, although a trend of slowing growth had not been completely unexpected.  A further slowdown is anticipated this year, with growth easing to 7.0%pa for 2015.  But at this growth rate, China will still be a significant contributor to world growth and continues to provide good trade prospects for New Zealand.

The other major positive for the world economy is the performance of the US.  The American economy is expected to grow by over 3.0% this year for the first time since 2005.  Household spending has been growing strongly, and will continue to be boosted by lower oil prices (the percentage fall in US fuel prices will be greater than for most other countries given the relatively low portion that taxes contribute to the price at the pump).  The tightening labour market is also boosting optimism about prospects for growth, thereby feeding expectations that interest rates in the US will start to increase from the middle of this year.

The upshot is that, although the outlook for the world economy is looking a bit shakier around the edges than it was 6-12 months ago, the two main engines of growth remain in relatively good health.  As a result our forecasts of trading partner growth still look pretty robust, reaching 3.5%pa this year and holding above 3.0%pa for consecutive years for the first time since 2007.

We see three key downside risks to our view of global growth.

• There is a chance that the ongoing slowdown and rebalancing of economic activity in China will be sharper than we are allowing for.  The indicators mentioned above have seen the People’s Bank of China cut its benchmark interest rate in November and reduced its reserve ratio in early February.  However, significant fiscal stimulus is unlikely given that local governments are heavily indebted and central government is keen to encourage a change in the mix of economic activity – a shift that would be undermined by a raft of additional new infrastructure projects.
• The big drop in oil prices is having a serious effect on the growth prospects and financial positions of those countries heavily reliant on oil exports.  The likes of the Middle East, Russia, Nigeria, Venezuela, and Norway face a significant tightening in credit conditions and much slower growth in household, business, and government spending.  At its worst, the sharp drop in oil-related revenue could see a substantial rise in bad debt and lead to financial “crisis” conditions developing in some of these nations – an outcome that would have negative repercussions for broader global growth as well.
• The election of a new government in Greece has increased uncertainty about the stability of the EU and the region’s financial stability.  Although a Greek withdrawal from the monetary union would have little direct effect on New Zealand, there is a potential that the uncertainty created in financial markets would lead to a tightening in global credit conditions and a flight to safety among international investors.

One of the other countries where falling commodity prices have had a profound effect is Australia.  Since peaking in February 2011, world spot prices for Australia’s bulk commodity exports have dropped by 59%.  The decline makes the 20% fall in New Zealand’s export prices since February last year pale by comparison, as Graph 1.1 shows.

Graph 1.1

The effects of the drop in commodity prices are evident across various facets of the Australian economy.  Business investment has shrunk by 6.5% since peaking in June 2013 and is forecast to continue contracting during 2015 and 2016 – which would be the longest uninterrupted contraction in investment spending since at least the 1950s.  The unemployment rate has risen from 5.0% in April 2012 to a 12-year high of 6.4% in January 2015.  With inflation dipping below the Reserve Bank of Australia’s 2-3%pa target range, the Bank has cut its cash rate target to 2.25%.  The federal government is also maintaining a relatively tight fiscal approach as it struggles to turnaround its continued budget deficits.

Given all the negative economic news coming out of Australia, it’s slightly surprising that the country hasn’t had a quarter of negative growth since the flood-induced contraction in March 2011, and still hasn’t experienced a technical recession since 1991!  We are forecasting GDP growth this year of 2.7%pa – weaker than New Zealand’s growth, but still a perfectly respectable performance.  By the second half of 2015, we expect the unemployment rate to start trending down again.

From New Zealand’s point of view, the combination of modest economic growth prospects and the relatively weak Australian dollar will limit the near-term potential for expansion of our exports heading across the Tasman.  Nevertheless, the fact that we are still talking about 2.5-3.0%pa growth for Australia indicates that a significant contraction in the size of this export market is unlikely.

Relatively favourable labour market conditions in New Zealand, compared with the softening occurring in Australia, have been a key factor driving up net migration into New Zealand over the last couple of years.  We expect net migration to peak at almost 55,000pa in the first half of this year, with a gradual improvement in the Australian labour market thereafter one of the contributors to the subsequent easing in net migration.  However, continued underperformance by the Australian economy and labour market present an upside risk to our migration forecasts.

One of the major changes in this set of forecasts, both domestically and internationally, is the outlook for inflation.  We have lopped 0.8 percentage points off our projection for global inflation this year, which is expected to be at its weakest since 2009.

The biggest reason for this change in view is the decline in oil prices that has occurred and, presuming that much of the drop persists, will make a significant negative contribution to CPI movements around the globe.  Although cheaper fuel prices may also flow through into some cost reductions in the transport and travel areas, many businesses are likely to take the opportunity to boost their margins.

It is important not to view any price falls that occur as deflation; rather, the dip in the CPI reflects a “one-off”[2] relative price shift for oil that will temporarily lower inflation.  This understanding of the CPI enables central banks, including our own Reserve Bank, to look past the immediate effects of lower oil prices when setting monetary policy and concentrate on the underlying inflationary picture.  In New Zealand’s case, the fact that inflation is slowing to well below the Reserve Bank’s
1-3%pa target band in the short-term does not justify interest rate cuts at the moment.  The key for the Bank is how significant the flow-on effects from lower fuel prices and softer inflation expectations are on underlying inflation over the next couple of years, and weighing those effects up against the boost to aggregate demand caused by households having more money freed up for discretionary spending.

The distinction between the oil-induced relative price shift and outright deflationary pressures is much more difficult to make in Europe and Japan.  The latter has a long history of struggling with deflation, and last April’s increase in consumption tax from 5% to 8% has had a significant negative effect on aggregate demand.  In Europe, the risk of a shrinking economy combined with falling prices is a more recent phenomenon, brought about by restrictive fiscal conditions since the region’s debt crisis, a lack of sufficient and timely monetary policy support by the European Central Bank, and consumer fatigue from the lack of any noticeable improvement in broader economic conditions.  In other words, any further easing in monetary policy in either Europe or Japan is not necessarily indicative of the monetary settings that should be pursued in other parts of the world.

Graph 1.2

Nevertheless, in New Zealand we have continued to be surprised by the lack of inflation in the economy.  We have taken the knife to our forecasts of non-tradable inflation, which we expect to hold below 2.5%pa until March next year and peak at the relatively slow rate of 3.2%pa in December 2016.  This change in view about medium-term inflation implies the potential for further GDP growth without generating significant pricing pressures.  Combining this implication with our downward revisions to New Zealand’s economic growth outlook has resulted in a considerable flattening of our interest rate forecasts.  We now expect the official cash rate to remain at 3.5% until early 2016, with the number of interest rate increases limited to just two in the first half of next year, taking the OCR to 4.0%.

After slowing throughout 2014, the Auckland housing market has started to regain momentum over the last couple of months.  Having maintained our view that the market would surge again in 2015, we are breathing a small sigh of relief.  All the fundamental drivers were in place for further strong price growth in the Auckland market, including strong population growth, a robust economy and an improving labour market, low interest rates, and an undersupply of housing.  However, there were some questions about whether the loan-to-value restrictions would continue to constrain buyer demand for longer and by more than we had allowed for, and whether there was any scope for house prices in Auckland to be bid up further given how high they already are compared to incomes and rents.

New dwelling consent numbers in Auckland reached an eight-year high of 7,669 in the year to November 2014.  But with population growth in the region running at 2.3%pa in the year to June 2014, we estimate that about 11,200 new houses would have been needed in the region just to cover the growing number of people, let alone allow for declines in the average number of people per dwelling or take into account any demolition of houses due to intensification.  Consequently, we continue to expect a sizable acceleration in house price inflation in Auckland this year, and it could well exceed the 16%pa peak recorded in the second half of 2013.

Faced with this kind of pick-up in house price growth, the Reserve Bank will not have scope to ease or remove its LVR restrictions this year.  In fact, the Bank is openly considering the introduction of additional lending restrictions aimed at property investors, forcing banks to keep more capital on hand and thereby increasing the cost of lending to people owning five or more properties.  We expect this change to be implemented within the next six months, and to be billed as a permanent control (as opposed to the temporary nature of the LVR restrictions).

Outside Auckland, the scope for a substantial pick-up in house price inflation is much more limited, given that there is little or no housing undersupply in most other regions.  However, above-average population growth and declines in fixed mortgage rates since September will contribute to some acceleration in house price growth this year, particularly in those areas that are not heavily exposed to dairy.

Low fuel prices, favourable interest rates, and a falling unemployment rate will all contribute to buoyant consumer confidence levels this year.  We forecast that growth in real household spending will peak at over 4.0%pa during 2015, growing at its fastest rate since 2006.  This rate of growth will occur without any significant deterioration in the household savings rate.

Offsetting the positive of upward revisions to our forecasts of household spending over the next couple of years are the following factors.

• Growth in government consumption spending over the two years to March 2017 is forecast to average 0.5%pa, down from 1.5%pa growth forecast in our November 2014 publication.  This change reflects the tighter fiscal position faced by the government due to the effects of the dairy price drop on tax revenue and broader economic growth.
• Total investment spending is forecast to average 2.3%pa over the two years to March 2017, compared with the 3.6%pa predicted in our November 2014 forecasts.  Business investment in key areas (eg dairy) will be more subdued due to lower commodity prices and revenue, while growth in public sector investment may also be limited by the government’s fiscal position.  Rebuilding work in Canterbury will also have passed its peak by this stage, and will be acting as a drag on overall investment activity as well.
• The average contribution from net exports to economic growth over the next two years is forecast to be -0.3%pa, rather than the +0.1%pa we expected in November last year.  This shift reflects a small reduction in export growth due to the economic problems in Europe and concerns about China’s growth prospects, while faster growth in household spending is reflected in slightly faster import growth.

In summary, current GDP growth looks set to be weaker than we’d previously anticipated due to softer investment spending and a bit of a hole in export growth.  Good growth in household spending is set to push GDP growth up to a peak of 3.2%pa in the year to March 2016, before tightening monetary conditions, the slowing housing market, and sluggish growth in investment spending see economic growth slip below 2.0%pa in the year to March 2017.

Graph 1.3

 

 

[1] Egypt, Israel, Nigeria, Saudi Arabia, and South Africa.

[2] The price shift is “one-off” in the sense that it is not indicative of a downward trend across a broader basket of consumer goods and services.  The downward shift could also be reversed out by a “one-off” shift upwards in oil prices if future market conditions change.