Dairy and drought dominate in the near-term, but it’s not all bad news

Table 1.1

New Zealand’s economic growth is set to dip below 2.0%pa within the next year, as low dairy prices, dry weather conditions this summer, and uncertainty about growth prospects in China take their toll.  Business confidence remains subdued, and firms will have little appetite for new investment during 2016, especially given the lift in plant and machinery costs due to the lower exchange rate.  Nevertheless, this substantial drop in the New Zealand dollar is now helping exporters and firms competing with imported product, and service exports will perform particularly well over the next couple of years.  Construction work will also be a bright spot for the economy, with growth in activity in Auckland more than making up for the wind-down of residential rebuilding activity in Canterbury.  Growth is forecast to rebound to 3.3%pa by the second half of 2017 as global demand conditions improve and the lower New Zealand dollar helps the agricultural sector recover from this summer’s drought.

New Zealand’s economic growth so far throughout 2015 has been disappointing compared with earlier expectations.  The economy grew by just 0.7% over the first half of the year as the highly publicised plunge in dairy prices took its toll on confidence and negatively affected businesses’ investment and hiring decisions.  Uncertainty emanating from parts of the global economy, most particularly China, has also had a negative effect on activity.  More tangible negative influences have come from an earlier-than-expected slowdown in residential rebuilding activity in Christchurch, while the quick rebound in oil prices from early 2015 meant that the boost to consumers’ discretionary spending thanks to cheaper fuel bills has not been that great.

Back in August, when prices at GlobalDairyTrade’s auction were 65% below their 2014 peak and at their lowest level since 2002, a dairy payout well below $4/kgms was a real possibility.  A payout at that level would have been the lowest in at least 30 years in real terms, and well below the payouts in the years we have data for between 1951 and 1986.  The subsequent 63% rebound in auction prices has meant that we have held our forecast payout at the same level as in our July publication, at $4.80/kgms.  The very low auction prices have occurred early in the season when production levels are still low, and will have little bearing on the final payout achieved.

The other bad news for the agricultural sector is the very high likelihood of El Niño conditions prevailing this summer.  NIWA currently estimates a 99% chance of El Niño persisting throughout the next three months, with its intensity looking very similar to the 1997/98 event (the strongest since 1950).  We have factored drought conditions for eastern parts of the country into our forecast, contributing to the slowdown in economic growth persisting through until mid-2016.

Although traditional dairy-producing regions will not be heavily affected by El Niño, the weather conditions will add to the pressure from low dairy prices to not bother trying to boost production at the margin.  Newer dairy areas where production has expanded significantly over recent years, such as parts of Canterbury, are likely to suffer more heavily from the dry conditions and could record a significant drop in production.  We forecast total dairy exports to decline 7.2% for the year to June 2016.

Meat production and exports are likely to grow strongly this summer as farmers are forced to reduce stock numbers in response to dry weather.  The flow-on effects of this stock run-down will show up in growth the following year, and we expect a 2.5% fall in meat exports in the June 2017 year.

Other primary exports will still grow by 4.8% in the current June year.  This growth would be weaker were it not for the resurgence in kiwifruit exports as the industry recovers from the PSA virus, along with continued improvements in the wine industry’s performance.

The biggest saving grace for exporters is the spectacular depreciation of the New Zealand dollar since April.  The quarterly average for the TWI fell by 8.2% between June and September, the biggest quarterly decline since 2008 at the height of the Global Financial Crisis.  Of course, this drop is relatively small compared to the fall in dairy prices, but has helped push meat export prices in New Zealand dollar terms to record highs, and New Zealand horticulture export prices to their highest levels since 2009.  Manufacturing exporters are also enjoying more favourable exchange rate conditions, even if the 8.6% drop against the Australian dollar since April looks modest compared to the TWI’s movement.

Perhaps the biggest beneficiary of the shift in the exchange rate has been the services sector.  Tourism has recorded total growth of 14% in visitor numbers over the last two years, while foreign education receipts are also up strongly thanks to the lower exchange rate and relaxed work restrictions for international students.  The annual volume of services export has grown by 13% over the last year, and we are forecasting further growth of 28% over the three years to March 2018.

Graph 1.1

The big movement in the exchange rate coincided with a change in stance by the Reserve Bank from stable or rising interest rates to interest rate cuts.  In terms of monetary settings, actions speak a lot louder than words, and the Bank’s complaints about the dollar being too high over the previous 1-2 years meant little when interest rates were rising.  We see some additional downside for the dollar as the official cash rate drops to 2.5% and economic growth weakens further.

One corollary of the lower New Zealand dollar is that it will push up the price of imported goods and services.  This effect will become evident as tradable inflation pushes up to a five-year high of 3.3%pa by the end of 2016.  Households’ appetite for imports will soften in the face of these price pressures, and the effect on plant and machinery costs will further add to businesses’ reluctance to invest.  Import volume growth will slow from 6.6%pa in mid-2015 to 0.8%pa by December 2016.

Although imports in New Zealand dollar terms will get more expensive in coming quarters, the underlying trend in world prices is set to be weaker than we had previously anticipated.  This outcome partly reflects a lack of economic growth in Europe and America’s moderate recovery to date, but has mostly been caused by uncertainty about growth prospects in China.  Chinese growth looks set to fall short of the government’s 7.0%pa target for this year – we have pencilled in growth of 6.5%.  This gap between the government’s target and the actual growth outcome may not sound like much, but it represents a significant underperformance by the Chinese economy.

The Chinese government has been heavily involved in trying to stem the share market’s falls and trying to mitigate the risks of a financial sector meltdown via other measures as well.  One of the most obvious policy shifts was a 3.0% depreciation of the yuan in August which took the Chinese currency to its lowest level in four years.  The shift may not sound like much, but signals a definite pullback from the policy of allowing the exchange rate to appreciate and encourage more domestically driven economic growth.  Concerns about the robustness of household demand have seen the Chinese government return to its familiar growth levers of effective export subsidisation through a low exchange rate, as well as boosting spending on infrastructure.

Neither of these methods will be particularly effective at accelerating growth in China, and we expect economic growth to ease further towards 6.0%pa over the next few years.  Demand for Chinese exports will remain relatively constrained by modest global demand conditions, particularly given Europe’s ongoing economic difficulties.

China’s difficulties have led us to lop almost half a percentage point off economic growth throughout the developing Asian economies for both 2015 and 2016.  Many of these countries are heavily reliant on Chinese demand for their exports and are feeling the flow-on effects of the Chinese slowdown.

Reflecting the persistence of productive overcapacity internationally, moderate demand conditions, and China’s quest for more export-driven growth, we are predicting that global inflation will average just 1.8%pa between 2015 and 2018.  This rate of price growth is well below the 2.5%pa average of the last decade.  The low-inflation environment will also show up in New Zealand’s data, with our CPI rising by an average of 1.7%pa in the four years to 2018, compared to 2.5%pa over the last ten years.

The US remains the brightest light on the international scene, although even American growth is only set to reach 2.5%pa for 2015, rather than the 3.0%pa we had previously hoped for.  Current momentum in the US economy is not as robust as we’d expected, with the manufacturing sector coming under some pressure from the rising greenback, while the US economy is also feeling some effects of the uncertainty that has been emanating from China and Europe.  The Federal Reserve remains on track to lift the Fed Funds rate within the next six months, but the rate of further increases during 2016 and 2017 may yet be slower than we are currently forecasting.

Growth in private non-building investment has averaged 9.5%pa over the last five years, with activity lifting from 7.7% to 11% of GDP and surpassing its pre-GFC share of the economy.  The ANZ’s Business Outlook survey shows that investment intentions slipped to a six-year low in August as confidence has eased in response to falling dairy prices and international economic uncertainty.

Dry weather conditions will further undermine firms’ willingness to invest in coming quarters, and we are forecasting a 3.3% contraction in annual private non-building investment between September 2015 and March 2017.  This decline is a very modest one compared to the 28% contraction that occurred between mid-2008 and the end of 2009, but still represents a significant change from the strong growth recorded since the start of this decade.

Even with global overcapacity keeping the international cost of plant and equipment down, the lower exchange rate will mean that the capital prices faced by New Zealand firms will push upwards, reducing the appetite for purchasing new machinery.  Furthermore, the high investment volumes of recent years mean that New Zealand’s capital stock is generally in good shape, and there is now less need for additional new investment.  These negative influences will show up in trends across a wide range of capital items including vehicles, computers, and manufacturing equipment.

Our predicted growth for total investment spending across the economy in the two years to March 2017 is 1.3%pa, down from 2.3%pa in our July forecasts.  The downward revision would be larger if it wasn’t for three mitigating factors.

• Government investment spending is set to grow faster in the near-term, with the government looking to accelerate some of its infrastructure spending in response to the economic slowdown.  The fact that the fiscal position to date has also been better than expected has made the government more confident about its ability to provide some economic stimulus.

• Non-residential building consents have remained stronger than expected this year, and construction is forecast to grow by 15% in the year to September 2016.  Prospects for non-residential construction in Auckland have improved further, while the non-residential rebuild in Canterbury continues to gain momentum.  The biggest risk surrounding the latter tranche of activity is capacity constraints, which could lead to projects taking longer than normal to move from consent through to completion. 

• Residential building activity has held up better than we anticipated in 2015, and there will be further growth in activity between now and mid-2017.  Although residential rebuilding work in Canterbury appears to be winding down sooner than we had expected, this slowdown will be more than offset by continued strong growth in residential activity in Auckland in response to the region’s rampant real estate market, an undersupply of housing, and the stimulatory effects of the Auckland Housing Accord.

Graph 1.2

New Zealand’s economic growth is set to slow to 1.9%pa over the coming year, which would be the slowest growth since 2011.  Although exports and investment spending will be the initial drivers of the slowdown, household spending growth will also soften as the labour market weakens and unemployment pushes back above 6.0%.

Graph 1.3

Net migration is set to peak at over 60,000pa before the end of this year, and slowing economic growth will see the net inflow start to ease gradually during 2016.  Australia’s economic struggles mean that the turnaround in migration flows will not be a rapid one, and with population growth still running at 1.8%pa by September next year, per-capita growth will threaten to turn negative for the first time since 2010.  Strong population growth will partially mask a relatively weak performance by the New Zealand economy over the next year.

The effect of the falling exchange rate on imports will also prevent a starker economic downturn from eventuating.  Import volume growth was running at 6.6%pa in the year to June 2015, but is expected to be barely positive by the second half of 2016 as the lower dollar sees demand switch towards domestic firms.

By the second half of 2017, economic growth is forecast to recover to 3.3%pa.  Improved export volumes on the back of the low currency, more favourable weather conditions, and some recovery in international demand and commodity prices, will drive export growth back above 5.0%pa.  Business investment spending is likely to recover from its lull in 2015/16, while growth in disposable income will also shore up growth in household spending, even as population growth eases back to 1.1%pa by early 2018 – in line with its average of the last 20 years.