Struggling to match last year’s great expectations

The housing market and residential construction activity have been weaker than expected over recent months and, along with dampened export volumes in late 2016, have flowed through into softer GDP forecasts during 2017.  Economic growth is expected to ease to 2.0%pa by the end of this year, before a recovery in activity across each of these areas lifts growth back above 3.0%pa during 2018.  Over the medium term, capacity pressures in the economy will be mitigated by persistently strong net migration and a relatively high labour force participation rate.  However, growth on a per-capita basis will be weaker than its historic average, reflecting high household debt levels, a correction in property prices, and households remaining relatively cautious in their spending habits.

Having gathered some good momentum during the middle part of 2016, the New Zealand economy has lost a little bit of steam in recent months.  Economic growth in the December 2016 quarter was a disappointing 0.4% (seasonally adjusted), the weakest growth in 18 months.  The number of unemployed people jumped by 7.8% from the previous quarter (seasonally adjusted), while business confidence has been slowly softening since September last year.

Some of the slowdown in the December quarter will be a blip, with the Kaikoura earthquake having a negative short-term effect on economic activity in Wellington especially.  But there are other facets of recent data that have led us to revise down our forecasts of economic growth over the next 12 months.

The most significant of these factors is the housing market.  Three-month sales volumes have plunged 21% nationally since peaking in the June 2016 quarter, with Auckland recording a 27% drop in activity.  The Reserve Bank’s latest round of loan-to-value restrictions has played a big part in the decline but is not the only factor dragging the housing market down.

Tighter lending restrictions being put in place by the Australian Prudential Regulation Authority have affected the Australian parents of New Zealand’s four largest retail banks and flowed through into lending decisions on this side of the Tasman.

• The changes have discouraged the banks from lending to foreign buyers given the greater likelihood that these buyers could simply walk away from the property if there was a correction in house prices.
• Mounting sentiment that housing in New Zealand is overvalued has also reduced the banks’ appetites for mortgage lending, particularly in the context of Australian concern that the banks’ exposure to the New Zealand property market is one of the riskier parts of their portfolios./li>
• Banks are also increasingly wary of their exposure to denser residential property types (eg apartments), with property values in the apartment market historically having been more volatile.

The importance of these institutional factors in undermining housing market activity should not be underestimated.  Our latest forecasts allow for additional weakness in the housing market in the near-term, with annual house price inflation in negative territory in the second half of 2017, before sales activity rallies during late 2017 and the first half of 2018 as the effects of the LVR restrictions wane.  However, the risks to this near-term forecast for housing market activity are on the downside given the institutional factors outlined above combined with the clear upward trend in mortgage rates that has emerged.

At the same time, it is well established that the residential construction sector has been struggling with capacity pressures around the availability of labour.  The safety net of rising house prices encourages developers to push ahead with new projects safe in the knowledge that possible building cost overruns will be covered by higher sale prices at the end of construction.  But with the wind having been taken out of the housing market’s sails, that financial buffer looks to be less assured.  These less favourable conditions have meant that new dwelling consent numbers in the three months to February were down 3.6% from a year earlier.

Even if the real estate market could shrug off the current factors limiting activity, it is questionable how much further house prices in Auckland could rise.  House prices in Auckland are currently equal to 13.7 years’ worth of personal income, up from 8.4 years in September 2010 and a long way above the previous record high of 9.4 years in June 2007 before the Global Financial Crisis.  These figures clearly restrain the ability for owner-occupiers to bid up house prices, while LVR restrictions on investors and the unwillingness of banks to lend to foreign buyers also make it difficult for other buyer subsets to push prices up further.  With Auckland being the region most critically in need of a significant lift in construction activity, near-term prospects for growth appear limited.

Our residential construction forecasts see the annual new dwelling consent total slipping back from its current level of 30,162 in the year to February 2017 to below 29,000pa in the March 2018 year.  This moderation in activity is reflective of both the softening housing market at the moment as well as the capacity constraints that are currently present in Auckland in particular.  Consent numbers are forecast to lift by 19% over the following 15 months through to June 2019 as capacity constraints are worked around via increased numbers of people entering the industry, either via training or from overseas.  We then expect consent numbers to comfortably hold above 30,000pa throughout the rest of the forecast period, with an average build rate of 33,639 over the four years to June 2022.

Capacity constraints were a key theme of our previous set of forecasts, and these limitations continue to play an important role in the New Zealand economy’s outlook.  Government investment spending looks to be the next subsector that will find its ability to grow restricted by capacity in the economy.

Over the last six months, government investment has been one area of the economy where we have talked up growth prospects.  The fiscal position has steadily improved and was firmly back in surplus territory.  There has been talk from the government about potentially boosting its spending on physical and social infrastructure.  Rapid population growth has been stretching infrastructure resources, particularly in Auckland.  And the Kaikoura quake has necessitated a lot of extra spending to restore the road and rail links down the east coast of the South Island.

But we have revised down our forecasts of growth in government investment, with capacity pressures in the construction industry clearly spreading beyond the residential subsector.  We now expect growth in government investment spending of 4.3% during 2017, compared with a prediction of 6.2% growth in our January forecasts.  Over the three years to June 2020, growth is forecast to average 2.9%pa rather than the 4.7%pa we had been predicting previously.

Broadening capacity pressures across the economy are also evident in our inflation forecasts.  Although an upward revision of 0.2 percentage points to inflation during 2017 might not seem like a lot, it hints at the emergence of greater price pressures both domestically and internationally.  World inflation is expected to average 2.2% this year, up from 0.8% and 1.3%pa in 2015 and 2016 respectively to its fastest rate in six years.  And despite cost pressures remaining reasonably subdued within New Zealand, there are signs of prices starting to creep up in industries beyond the construction and tourism sectors.

ANZ’s commodity price index shows that world prices for New Zealand’s exports have lifted 24% since April last year.  Out graph shows that, although the increase has been dominated by a 53% surge in dairy prices, all categories have experienced a rise in prices over the last 11 months.

The terms of trade index surged 5.7% in the December quarter to record its first annual increase since mid-2014.  The recovery has been sharper than we expected and has seen us revise up our outlook for the terms of trade throughout the next three years.  Even so, we have been cautious about the potential for further increases in the index, and our forecasts see the index hold within 1.2% of its current level between now and early 2021.

There are both upside and downside risks to this outlook for the terms of trade over the medium-term.  Improving demand conditions and the re-emergence of some inflation internationally will potentially have positive flow-on effects for our export sector, particularly if the pick-up in global growth is reflected in Chinese incomes.  On the downside, the threat of US tariffs on Chinese imports remains, although a lack of support for some of President Trump’s policies throughout the Republican Party suggests this risk is less pronounced than it was 2-3 months ago.

Although prices have been improving, goods export volumes had their worst quarterly result since 1992, contracting by 6.0% in the December quarter (seasonally adjusted).  The dairy sector’s problems with a wet spring have been well documented, with production for the first nine months of the 2016/17 season down 2.5% from a year earlier.  But the weather has hampered production in other agriculture subsectors, such as horticulture, as well.  And prolonged softness in the Australian economy, including a 20% contraction in private investment in machinery and equipment between December 2012 and June 2016, appears to be taking its toll on manufactured exports.

We expect export volumes to recover their lost ground during 2017 as weather conditions return to normal and international demand conditions, including in Australia, improve.  This recovery will not prevent year-end growth in exports from turning negative for the first time since 2009.  Growth in export volumes is forecast to rebound to 3.7%pa by September 2018 and could be even stronger if demand conditions internationally continue to be favourable.  Over the medium term, export volume growth is forecast to settle at about 2.5%pa.

Recent tourism data has also rung one or two alarm bells.  In the three months to February, Chinese visitor numbers were down 5.4% from a year earlier – the worst result since late 2013 when the banning of cheap shopping tours by the Chinese government caused a short-lived drop in arrivals.  However, on this occasion, the reason for the decline is less clear.  We note that the total number of flights arriving in New Zealand from China in February was unchanged from a year earlier – the first time since August 2015 that this measure of capacity has failed to grow.  But measures of economic activity in China, including GDP, electricity usage, and rail freight, have all recorded accelerating growth in the latter part of 2016 and would normally be expected to be driving faster growth in tourist numbers.

With China having contributed 21% of the 775,000 increase in annual visitor numbers over the last three years, the strength of the Chinese economy and the appetite of Chinese people to visit New Zealand are critical to the tourism sector’s growth prospects.  The potential for President Trump to impose tariffs on Chinese imports into the US poses the biggest threat to continued economic and income growth in China and, by extension, ongoing growth in the size of the Chinese tourist market.  But capacity pressures within our tourism sector could also limit further increases in tourist numbers.  At this stage, those pressures are most intense during the peak season from January to March, and the latest data might reflect this seasonal difficulty with achieving further growth.  Any continuation of weak results into April or beyond would imply more fundamental problems for the tourism sector, with capacity pressures leading to a deteriorating experience for visitors and undermining future growth prospects.

Although the recent slowdown in Chinese tourist numbers has raised concerns, we still expect visitor numbers to retain a general upward track throughout the five-year forecast period.  The government has paved the way for further expansion, extending the length of time that Chinese visitors can use a multiple entry visa to five years and increasing the quota for flights between China and New Zealand from 49 to 59 per week.  However, as mentioned above, this expansion of capacity to bring Chinese tourists to New Zealand lacks the accompaniment of additional capacity to accommodate or facilitate activities for more tourists, so the risks to our forecast are on the downside.

Although capacity pressures remain an important feature of the economic outlook, two aspects of the labour supply will prevent these constraints from becoming as critical as they might otherwise have done over the medium term.

Firstly, the outlook for net migration and the supply of workers from overseas continues to be upbeat.  Net migration is forecast to peak at 73,436 in September this year and, although population growth will then ease throughout the forecast period, it will remain at above-average levels during the next five years.

Secondly, our forecast incorporates a gradual easing in the participation rate from 2017 onwards.  Currently at a record high of 70.5%, the participation rate is expected to slip to about 69% by 2021/22, reflecting the aging population [1] .  The risk to this forecast is that the participation rate holds up more than we are expecting, particularly as interest rates start to rise.  People that have heavily leveraged themselves to purchase property, most particularly in Auckland, are likely to find that rising debt-servicing costs cause a significant degree of financial stress.  Re-entering the workforce or taking on additional hours to boost their income are ways that people can adapt as mortgage rates track upwards.

Finally, a word about the outlook for economic growth in general.  Our forecasts predict average GDP growth of 2.6%pa over the five years to June 2022, a result that is in line with the average recorded throughout both the last five and the last 20 years, and which compares favourably with the 1.9%pa growth achieved over the last decade.

However, our graph shows that, on a per-capita basis, the economy’s performance looks somewhat underwhelming.  Per-capita economic growth is forecast to average just 0.9% between now and 2022.  The biggest culprit behind the sluggish economic performance is household spending.

Growth in private consumption accelerated throughout the middle part of 2016 to an 11-year high – a welcome pick-up that has corresponded with a tightening labour market and improving consumer confidence.  As recently as early 2016, growth in household spending had looked surprisingly feeble given how strong population growth had been.

Surging house prices have driven household debt levels to record highs, and it seems that some of the cautionary lessons learnt during the Global Financial Crisis are already being forgotten.  The emergence of flat or falling house prices within the next few years will undermine consumers’ willingness to spend, while the discretionary portion of households’ budgets will be squeezed as interest rates gradually rise from their historic lows.  The result is persistently weak growth in household spending from 2018 through to early 2021, with per-capita growth holding below 1.0%pa throughout this period.

[1] The participation rate is the proportion of all people aged 15 and over that are in the labour force (ie either employed or looking for work), so as the baby boomers reach 65 and the number of people that are retired grows, the participation rate would be expected to decline.