When capacity becomes a problem

Expectations of monetary conditions, both here and overseas, have tracked in a looser direction since our previous forecasts were published in July.  Interest rate cuts in the UK can be directly attributed to the medium-term uncertainty hanging over British economic growth thanks to Brexit, while Japan and Europe are showing little success in warding off deflation.  Only the US Federal Reserve has surprised us with some relatively hawkish comments, and expectations are now firmly in place for an interest rate rise to take place in December.  Financial markets remain unsure how well the economy will cope with another lift in interest rates, given that America’s economic growth has been relatively patchy throughout much of this year.

One facet of the global economy that hasn’t changed has been the persistent lack of inflation worldwide.  The Reserve Banks of New Zealand and Australia are both in cutting mode, despite relatively good economic growth results, as they try to prevent inflation from slowing and expectations of price growth being dragged lower.  Our Reserve Bank has all but committed itself to another reduction in the official cash rate to 1.75% at its next Monetary Policy Statement in November.  Another cut to 1.5% in the first half of 2017 is a possibility, but we expect stronger economic growth outcomes and a lift in inflation to forestall any need for a further cut next year.

The Reserve Bank’s thinking will also be influenced by its perception of how much spare capacity remains in the New Zealand economy.  The Bank’s own forecasts predict that the economy will be producing above its long-term sustainable level in the March 2017 year and that the unemployment rate will have eased from its current level of 5.1% to 4.8% by March next year.  But due to the concentration of strong growth in a few selected industries, capacity pressures are becoming just as critical in some areas as when persistently strong economic growth drove the unemployment rate down to 3.3% in 2007.

The most obvious of these capacity-constrained industries is construction.  Residential investment has expanded by 71% over the last five years, with total growth expected to reach 89% by the time activity peaks in late 2018.  Non-residential investment has lifted 23% since December 2013 and activity is expected to continue growing until the second half of next year.  Although infrastructure activity is not at an all-time high, strong population growth and a number of large projects underway (or waiting in the wings) will drive an increase throughout the next two years.

Feedback from throughout the construction industry about current labour capacity pressures has led us to scale back our forecasts of growth in residential activity over the next 18-24 months.  Demand pressures necessitate further significant growth in activity, particularly in Auckland, but our forecast peak in consents is lower (by about 4,500 dwellings) than we were predicting in our July publication.  We are also forecasting that the high point in consents will not be reached until the end of 2018, delaying the peak for six months compared with our previous thinking.

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This change in forecast has flowed through into a less pronounced acceleration in economic growth over the next 18 months.  We now expect economic growth to peak at 3.3%pa in March 2017, rather than the 3.9%pa peak we were previously predicting.  Over the two years to December 2018, growth is forecast to average 2.7%pa, significantly below the 3.6%pa predicted in our July forecasts.

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The other major area where capacity pressures are showing is the tourism sector.  Visitor numbers have surged 26% over the last three years, with roughly one quarter of that growth coming from each of Australia and China, and another 11% from the American market.  The strongest growth over that three-year period has been in January and February (32% and 33% growth respectively) and, along with March, these months are experiencing a real squeeze in terms of accommodation and other tourism-related infrastructure.

Bearing these constraints in mind, our forecasts of further growth in tourist numbers remain relatively modest.  Year-end growth is expected to slow from its current rate of 11%pa to 7.1%pa by the end of 2017 and 3.3% by March 2019 – well below the 25-year average of 5.4%pa.  Even with this slower growth, cost pressures are likely to remain evident for accommodation and other tourist services over the next few years.

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Although strong net migration has had the finger pointed at it for contributing to Auckland’s housing crisis, the inflow of migrants has boosted growth in the working-age population and thereby helped to prevent capacity pressures in the labour market from becoming more widespread.  The working-age population grew by 2.7% over the last 12 months – the fastest growth since the mid-1970s.  Assuming that the 9.5% lift in employment since 2013 had been met by New Zealand-based workers rather than drawing on people from overseas, and  assuming a sufficient skill base and willingness to work of those domestically sourced staff, New Zealand would now have an unemployment rate of 2.8% and a participation rate of 73%.

Changes to the points-based approvals system last decade and better skills targeting have arguably improved the integration of new immigrants into the economy.  The current system is an improvement on the framework that was in place during the 2002/03 migration boom, reducing the amount of time before new migrants start adding to productive capacity and decreasing the likelihood that their skills will be underutilised.  The relatively rapid integration of foreign workers into the workforce has helped keep generalised inflationary pressures lower than might otherwise have been expected over recent quarters.

Net migration is now on the verge of peaking – the annual net flow actually eased in July before popping back up again in August.  Even with the peak finally arriving, we have revised up our migration outlook throughout the forecast period due to a weaker outlook for departures of New Zealanders heading overseas.  New Zealand’s economic growth outlook and labour market conditions will remain relatively favourable compared with much of the rest of the world, and we now expect net migration to still be over 30,000pa by mid-2021.  Over the five years to June 2021, our total net migration inflow is 42,700 people higher than predicted in our July forecasts.

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The Reserve Bank’s efforts to slow the existing housing market have intensified over the last few months.  Our analysis suggests that sales volumes could be knocked back by 22% due to this month’s tightening in loan-to-value restrictions.  Although the effects are not immediately obvious in our forecasts of house sales, the outlook is significantly weaker than in our previous forecasts, when we had predicted that activity would peak next year at over 116,000 sales per annum.  This downward revision reflects the fact that the latest round of restrictions is tougher, particularly for regions outside Auckland, than we were expecting.

The Reserve Bank looks likely to follow up the LVR changes with debt-to-income restrictions in the first half of next year.  Survey work by Horizon Research shows that a ceiling for debt levels at five times household income could knock about 25% of buyers out of the market (although given that the survey was done prior to the implementation of the latest LVR restrictions, some of those buyers might have already been constrained by the latest changes).  In Auckland alone, where housing is at its most expensive compared with incomes, the proportion of serious buyers potentially knocked out of the market rises to about 50%.

Given the likelihood of these restrictions being introduced, we are predicting a significant decline in house sales to play out subsequently.  Over the two years to March 2019, we expect a 25% drop in the annual total of house sales, taking activity to its lowest level since 2012.  This downturn will coincide with slowing population growth, although mortgage rates will remain close to or at 60-year lows.

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Although we have moderated our economic growth forecasts over the next couple of years due to capacity constraints, the dairy sector is one area where we have been able to adopt a more upbeat view.  The speed and extent of the rebound in prices at the GlobalDairyTrade auctions since July has caught us by surprise – the index has risen a massive 28% since the end of July, reaching its highest level in 18 months.  Fonterra’s forecast payout has lifted by $1/kgms to around $5.80 once returns on share capital are taken into account.  As a result, dairy farmers are expected, on average, to be profitable this season.

The improvement augurs well for dairy production and dairy exports over the coming year, and we have revised up total export volume growth for the March 2017 year from 1.6% to 3.2%pa.  The recovery in dairy incomes will also help boost growth prospects for provincial regions that have been significantly affected by the collapse in prices during 2014 and 2015, such as Southland, West Coast, and Waikato.

This earlier recovery in dairy prices and production volumes has brought forward our predicted rebound in exports, leaving slower export growth forecast between mid-2018 and mid-2020.  This softer medium-term outlook for exports is also symptomatic of concerns we have about global growth further out in the forecast period, particularly given the lingering malaise afflicting the European and Japanese economies.

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