Looking out for potholes

In true contrarian economist fashion, just as the outlook is looking more upbeat, we’ve chosen to focus this forecast on the downside risks that threaten those continued good times.  In part, this approach is due to the fact that the broad outlook has not changed much from our previous forecasts in October.  Furthermore, there are some imbalances in the economy, the housing market being the best example, that simply become more concerning the longer that they persist.  And if there was one thing that 2016 taught us, it was to expect the unexpected, particularly in the political sphere.

But before we start focusing on the possible negatives, let’s summarise the key changes to the outlook over the last few months.

Household spending growth has accelerated to 4.0%pa in the year ended September 2016 and is expected to hit an 11-year high of 4.4%pa by March this year.  This pick-up is reflective of improved consumer confidence – households feel the most upbeat about their current financial situation since 2007.  The labour market’s rollicking performance throughout 2016 has been a key factor behind that optimism.  Growth in household spending is expected to average 3.2%pa over the four years to March 2020, up from a forecast average of 2.7%pa in our October publication.

Official figures on employment have been distorted by methodological changes made by Statistics NZ to the household labour force survey, but that effect should not distract from the fact that underlying growth in employment has still been very strong.  Allowing for the effect of the survey changes, we still estimate that job numbers will have increased 3.9% for the year ended March 2017, the fastest growth since 1996.  We are now forecasting the unemployment rate to track downwards from 4.9% to 4.5% over the next 2.5 years, accompanied by higher workforce participation than previously anticipated.

This tighter labour market shows up in two other places.  Firstly, we are expecting a slightly faster pick-up in labour costs than previously.  Secondly, we have again revised up our migration forecasts, with 47,200 more people expected to come into the country over the five years (in net terms), attracted by New Zealand’s robust economic performance and strong employment prospects.

Although the upward revision to migration might not seem that surprising at first glance, it comes in the wake of a tightening in residency requirements by the government last October (after our previous forecasts had been finalised).  We have closely studied these changes and have concluded that the relatively modest drop in residence approvals over the two years to June 2018 will be more than offset by increased numbers of temporary work visas and more positive net flows of New Zealanders.  More detail on the thinking behind our migration forecasts is contained in Arrivals still growing, but departures beginning to lift.

The election of Donald Trump as US president was another slap in the face for the status quo, coming in the wake of similar anti-establishment sentiment that led to Brexit.  However, perhaps even more surprising than Mr Trump’s victory was the positive market reaction that followed, with both share markets and bond markets rising in response to the election result.  Markets appear to have taken the view that Mr Trump’s proposed tax cuts and significant infrastructure spending will have a stimulatory effect on the US economy over the next couple of years.

Initially, the real risks posed by Donald Trump’s presidency lay in the uncertainty that he brought to policy direction.  His policy agenda has come across at various times as populist, piecemeal, inconsistent, or made up on the fly.  However, after less than weeks and more than a dozen executive orders, we are beginning to see just how different Mr Trump’s administration will be from those of his predecessors.

At the time of writing, President Trump had signed seven executive orders (which immediately become law) and 11 presidential memoranda (which are on track to become laws).  The executive orders are as follows.

• Minimizing the Economic Burden of the Patient Protection and Affordable Care Act Pending Repeal – the first stage in repealing what has become known as Obamacare
• Expediting Environmental Reviews and Approvals for High Priority Infrastructure Projects
• Border Security and Immigration Enforcement Improvements – to build the wall on the Mexican border
• Enhancing Public Safety in the Interior of the United States – cutting off funding to so-called “sanctuary cities” of illegal immigrants
• Protecting the Nation From Foreign Terrorist Entry Into The United States – the ban on entry to the US of citizens from Iran, Iraq, Libya, Somalia, Sudan, Syria and Yemen, with the exception of religious minorities
• Executive Order: Ethics Commitments by Executive Branch Employees – bans on lobbying by administration officials
• Executive Order: Reducing Regulation and Controlling Regulatory Costs – for every new regulation, government agencies will have to remove two existing regulations under their purview

As far as the memoranda go, three relate to the construction of oil pipelines (including the Keystone and Dakota Access Pipelines), one pertains to America’s withdrawal from the Trans-Pacific Partnership agreement, one is called the Mexico City policy, but is actually the reinstatement of Regan-Bush policy curbing US federal funding to providers of abortion services (both internationally and stateside, and the rest cover normal post-election restructuring of government departments, more employment in the military, and further deregulation of the manufacturing sector.

In broader terms, these executive orders and memoranda indicate significant deregulatory changes to the US economy, as well as key changes affecting the social fabric and stability of the country.  Some policies have already been met with widespread (even global) protests.  Nobel prizewinning economist Robert Schiller says that the nation is at risk of a 1920s Gatsby-like boom based on Donald Trump’s rhetoric, but with the speculative economy racing ahead of fundamentals, the US could subsequently be in for an almighty crash.

For New Zealand, the biggest risks stemming from Donald Trump’s presidency are via the trade channel.  Mr Trump’s rhetoric about imposing a tariff of as much as 45% on Chinese and Mexican imports would have serious repercussions for the global economy.  Although a drop-off in demand for Mexican products would matter little in the grand scheme of things, the same cannot be said about Chinese products.  China’s economic growth is already in a long-term slowing trend, having eased from 11%pa in 2010 to 6.7%pa last year and is set to slip below 6.0%pa by 2019.  A drop in exports from China to the US would see Chinese economic growth slow more sharply and, in turn, lead to weaker Chinese demand for imports.  The drop-off in Chinese demand would be realised in terms of both inputs into the production process, as well as other imports such as food, with weaker growth in Chinese incomes undermining broader spending power across the economy.

Mr Trump’s election has also created greater-than-usual uncertainty around the future path for interest rates.  The Federal Reserve has already adopted a relatively hawkish outlook for 2017, suggesting that it could lift the Fed funds rate a further three times this year – we don’t see any more than two rate rises on the cards.  But Mr Trump has been critical of the Fed for keeping interest rates too low for too long, and there have been suggestions that, by stacking the Board with his appointees as positions become vacant, he could dilute its independence and force a faster rise in interest rates.

As mentioned above, bond rates rose significantly in the wake of Donald Trump’s election, with US government 10-year rates surging almost 80 basis points by mid-December.  New Zealand 10-year rates rose nearly as far, climbing about 70 points.  Fixed mortgage rates have been trending upwards in response to higher wholesale rates, with the average five-year rate around 30 basis points higher than in late October.

Our analysis suggests that the effective mortgage rate, which is the average interest rate paid across all mortgage debt at any point in time, will decline further throughout 2017, even as interest rates for 3-5 year terms come under upward pressure.  At the end of this year, three and five-year fixed rates up for renewal will be rolling off 6.5%, while four-year rates will be rolling off 6.8%.  The mortgage rates on offer for these terms in late 2017 are likely to be below 6.5%, while one and two-year rates will still be comparable to the rates that mortgage holders had previously enjoyed.

 

Putting aside the next 18 months, New Zealand’s housing market looks to be particularly vulnerable to the effects of rising interest rates.  House prices have risen to the point where they represent 13.3 years of personal income in Auckland and 12.5 years in Central Otago-Lakes.   In Auckland, even with mortgage rates down at 60-year lows, debt-servicing costs now take up a greater proportion of income than at the previous peak in 2007, when mortgage rates sat at about 8.7%.  A modest rise of 1.5-2.0 percentage points in mortgage rates would clearly stretch many borrowers in Auckland, as well as squeezing potential buyers out of the market.  A rise in forced sales could lead to a significant medium-term drop in house prices.

We are predicting a 12% fall in average house prices between the end of 2017 and September 2020.   However, as we have indicated in previous forecasts, the timing of this correction is difficult to judge given the massive undersupply of housing in Auckland and persistently strong net migration, which suggest that house prices should continue to rise rapidly, even though affordability ratios are already very ugly.  In our view, there is little scope for house prices in Auckland to be bid up further, and the likely introduction of debt-to-income ratios this year will be too great an obstacle for the Auckland market to navigate and keep house prices rising.

New Zealand’s two-year stint of inflation running below the bottom of the Reserve Bank’s 1-3%pa target band has come to an end.  Inflation reached a two-year high of 1.3%pa in the December quarter, and pricing intentions in both the NZIER’s and ANZ’s surveys have risen in the latter part of 2016.

Capacity pressures have been an increasingly critical feature of parts of the labour market over the last year, particularly for construction and in some service sectors.  But with these pressures becoming more widespread, we expect inflation to push up to 1.5%pa by the end of this year and 2.0%pa by 2019.

Adding to inflationary pressures is the jump in oil prices from US$42/bl to US$56/bl since early November.  As a result, petrol prices in New Zealand have reached their highest level since July 2015.  Higher fuel prices generally act as a dampener on consumer spending growth and, by extension, underlying inflation pressures by limiting discretionary spending.  But the current rise in petrol prices comes at a time when consumer confidence is high, the labour market is tight, and spending is growing rapidly.  Domestic demand conditions are likely to remain relatively strong, even with the recent rise in oil prices meaning that it costs more to fill up the car than we’d previously been anticipating.

Putting oil prices aside, tradable inflation will generally be kept in check by persistent strength in the New Zealand dollar.  The rapid recovery in dairy prices since July 2016 has helped boost the exchange rate.  Although we expect a gradual depreciation in the New Zealand dollar throughout the forecast period due to improving economic prospects and tightening monetary policy overseas, better export prices over the medium term will limit the extent of the dollar’s decline.

Soft results for government investment during 2016 have led us to revise down our forecasts for growth in investment spending during 2017.  This outcome seems counterintuitive given November’s Kaikoura earthquake and the resulting $2bn-3bn bill faced by the government, with the bulk of that cost centred on infrastructure repair and replacement.  But our experience from the Christchurch earthquake has led us to adopt a conservative timeline for this spending to take place, even with the concerted push to get State Highway 1 open again to both the north and south of Kaikoura.  The positive effects of the earthquake can be seen through upward revisions to our forecasts of government investment spending from 2018 onwards.

The other positive factor for government investment over the medium term is projections of increased capital spending in The Treasury’s Half Year Economic and Fiscal Update published in December.  Treasury highlighted a significant lift in capital expenditure over the next five years compared with the previous five, including increased spending on education and defence assets and infrastructure.  Indeed, with rapid population growth projected to continue over coming years, there will be considerable pressure to expand physical and social infrastructure to meet the needs of the ever-increasing number of people.

The previously mentioned lift in bond rates since November raises some risk of government capital spending being constrained as financing costs become more expensive.  Nevertheless, we note that The Treasury’s interest rate projections in the HYEFU were lower than in the forecasts that accompanied the Budget in May last year.  Consequently, we do not think that current interest rates will act as a constraint on government investment – further substantial rises would be necessary before financing costs become a problem.

John Key’s unexpected resignation as Prime Minister in December has significantly changed the political landscape ahead of this year’s election.  The race between National and the Labour-Green bloc is likely to be closer than had previously been expected and, although we still expect National to lead the government beyond 2017, the chances of NZ First having some influence on policy over the next three years have increased.  Core policy platforms for Winston Peters are likely to include keeping the age of eligibility for NZ superannuation at 65, tighter restrictions around immigration, and tougher rules for foreign investment in New Zealand.

Without John Key’s personal appeal to buoy the party’s support, and with policy progress likely to be slow under a more fragmented coalition, we now expect that National will be ousted from government at the 2020 election.  However, with a well-performing economy benefiting the incumbent government, Labour should not regard victory in three years’ time as a fait accompli.

 

Prices at GlobalDairyTrade’s online auctions surged 56% between mid-July and early December and appear to have stabilised over the last couple of months.  New Zealand’s milk production in October and November, the two peak months for the season, was down 5.0% from the same period in 2015, while production levels in Australia and Europe are well down from a year earlier as well.

Reserve Bank data shows that dairy farming debt expanded by 9.2% over the year to June 2015 (well above the 3.9% increase in other agricultural debt) and a further 6.2% over the following 12 months.  The increase in dairy-related debt over the last couple of years means that, even with Fonterra’s pay-out surging to over $6.50/kgms this season, farmers will still be cautious with their spending and concentrate on reducing their debt levels instead .  It is likely to be early 2018, once the pay-out for next season is relatively secure, that spending by dairy farmers starts to pick up more significantly.

Although the dairy sector will be in a significantly healthier state over the next couple of years thanks to improving incomes, we are not expecting a revival in the number of dairy conversions taking place .  Firstly, pay-out levels currently do not provide enough of a wedge over other farming returns to act as an incentive to switch to dairying.  Secondly, and perhaps more importantly, we see increasing environmental concerns acting as a limitation on the further expansion or intensification of dairy farming.

These concerns are becoming more broad-based, emanating not just from traditional environmentalists, but also being voiced by a wider spectrum of urban people as well as those involved in the tourism sector.  Although the dairy sector is a big contributor to New Zealand’s export receipts, there is a growing feeling that the industry’s success should not come at the expense of New Zealand’s water quality, the country’s clean and green image, or sustainable farming practices.

We do not expect a National-led government to make significant changes to environmental requirements over the next three years.  However, mounting disquiet with the effects of intensive farming operations are likely to limit the dairy sector’s growth, with a potential Labour-Greens government introducing tougher environmental standards in the first half of the next decade.