A spot of stagnation in 2018

Economic growth in the December 2017 quarter was only slightly below expectations. But the mix of that growth, in combination with revisions to previous data, has led us to revise down our GDP forecasts again for 2018. We now expect GDP growth to ease to 2.4%pa by December and slip below 2.0%pa during 2019.

Graph 1

There are several contributors to the deterioration in growth prospects. None of these factors represents a major shift in our thinking, with many of the issues covered in our previous forecasts published in February. However, the sum of the changes in the individual components has combined to knock almost a percentage point off our GDP growth forecast for the year to June 2019.

Let’s start with the stuff we already knew about. Capacity constraints remain problematic in the construction industry, especially in the residential subindustry, and particularly in Auckland. We were previously forecasting relatively growth in residential investment over the 18 months to June 2019, averaging 2.9%pa. But even this sort of expansion might be difficult achieve, and we now expect activity to contract at a rate of 1.3%pa over the same period.

Although our non-residential construction forecasts are little changed in the near-term, we recognise that there are also capacity pressures evident in this subindustry. The decision of Fletcher Building to cease “all bidding on vertical construction projects in New Zealand” risks exacerbating resourcing problems in non-residential construction in the near term. It is not immediately obvious that other firms such as Hawkins, Arrow, and Naylor Love have the ability or appetite to fully make up for the loss of resources represented by Fletcher Building’s decision. Over the medium term, the decision potentially opens the door for a greater presence of Australian or Chinese firms in the industry in New Zealand.

The release of further information about KiwiBuild has also confirmed our suspicion that the programme will make little difference to residential construction outcomes over the next few years. Figures from The Treasury suggest that KiwiBuild will take even longer to ramp up than was previously thought, and it could add as little as 9,200 more houses to the total of new dwellings over the four years to June 2022. In other words, almost 70% of the policy’s construction could be taken up by the government’s pre-existing building programme and the purchase of dwellings that would probably have been built anyway. Add in the potential for other private sector work to be crowded out by the construction of KiwiBuild dwellings, and we are comfortable that the stimulatory effect on residential activity will be modest.

Outside the construction industry, there is evidence that capacity constraints and high prices are starting to negatively affect growth in tourism. Year-end growth in tourist arrivals slipped to a three-year low of 5.5% in January and will slow further in coming months as the World Masters Games and Lions tour drop out of the numbers. Substantially higher costs for accommodation will be deterring some visitors, and the less clean, green, and isolated experience being offered during the peak season is also likely to undermine growth. Furthermore, future growth in Chinese visitor arrivals is expected to be more in line with growth in the total number of international tourists from China. The increase in international travellers from China during 2017 was about 7.0%, well short of the 22%pa average growth in Chinese arrival numbers into New Zealand between 2009 and 2016.

Capacity pressures in other parts of the economy appear to be less critical at this stage, despite businesses reporting that both skilled and unskilled labour are increasingly difficult to obtain. We continue to expect these pressures to show through in faster wage growth – a trend that will be reinforced by this month’s lift in the minimum wage, as well as increases in future years.

In this environment, though, we believe that bigger minimum wage increases might not be as big a problem for businesses as initially thought. It is likely that the tight labour market will force firms to pay more to attract and retain staff anyway, and the government’s push to increase the minimum wage to $20/hr could simply end up being in line with market movements over the next few years.

We note that ANZ’s measure of own activity from its Business Outlook survey has lifted 13 percentage points (seasonally adjusted) since November last year. Although this recovery is welcome, it only represents about one third of the total drop that occurred in the indicator between August and November 2017. Businesses remain unconvinced that trading conditions will be as positive as they were hoping eight months ago (see Graph 2).

Graph 2

We had also previously signalled that growth in government investment spending was going to be harder to achieve in the short term given the shift away from roading to other projects such as rail, which would need significantly more planning and design work before proceeding. We have seen nothing over the last 2-3 months that has changed that view.

Highlighting the slow wheels of government is Shane Jones’ $3b Provincial Growth Fund. Less than $50m of the first year’s portion has currently been allocated, although we expect the announcements to gather momentum as the year rolls on, with the government’s annual budget in May likely to contain a big whack of spending. The early signs are that the Fund will be directed towards favoured areas such as rail and forestry. However, we also expect spending on tourism-related infrastructure and capital grants to local councils for essential infrastructure upgrades and expansions to feature in future announcements as well.

We now expect a 2.9% contraction in government investment spending over the 18 months to September 2019, implying a total drop of 5.9% in spending since September 2015. As recently as October last year, we had been forecasting a 13% expansion in government investment over the same four-year period (see Graph 3).

Graph 3

The corollary of weaker investment spending in the near-term is that we predict a catch-up, by way of faster growth, in the later years of our forecast. Even then, growth of 3.0%pa over the four years to June 2023 is hardly exceptional, and it will be the second half of 2021 before government investment spending surpasses its previous peak in 2015.

Accompanying the weaker near-term outlook for government investment is a slowdown in government consumption spending. The growth during 2017 was never going to be sustained, but it appears to have started to turn more quickly than we had anticipated. Growth in spending will gradually accelerate again between mid-2019 and early 2021 but, in the meantime, government consumption will be less of a positive contributor to economic growth than had previously been hoped (see Graph 4).

Graph 4

Given recent government announcements about the fiscal pressures it sees in areas such as education and health, we see upside risks to our spending forecasts during 2019 and 2020. However, the current indication is that the government will look to pare back other initiatives it might have introduced to cover the apparent funding holes that it is facing, rather than drastically lifting its overall spending plan.

The other major contributor to our softer outlook for growth during 2018 is a bigger lift in imports. Import volumes grew by 6.4% (seasonally adjusted) over the second half of last year, which was the strongest six-month performance since 2010. The biggest surge came from a lift in capital equipment imports, suggesting near-term strength in business investment. Both intermediate and consumption goods imports also recorded solid growth.

New Zealand’s terms of trade is at an all-time record high, indicating that the low relative price of imports is facilitating growth in import volumes. Even so, slowing growth across the board in domestic economic activity will naturally lead to softening demand for imports over the next couple of years. Import growth is predicted to ease from 6.6%pa at the end of 2017 to 4.1%pa by the end of 2018 and 3.4%pa by the end of next year. We note that the 2018 forecast is an upward revision from the 2.9%pa growth we were previously predicting.

We have also revised up our forecasts for the terms of trade over the medium term, even though the index is already at a historically high level, having passed its 1951 peak. This change in our forecasts reflects our view that there will be a continued divergence between international prices of softer food-based commodities and prices for hard commodities and manufactured goods. Even with global economic growth in 2018 expected to be at its fastest rate since 2010, persistent overcapacity in the manufacturing industry internationally is likely to maintain downward pressure on import prices over the medium term. After tracking sideways during 2018 and 2019, we expect the terms of trade to rise another 9.7% over the three years to March 2023 (see Graph 5).

Graph 5

The spotlight has been turned on international financial markets over the last couple of months as volatility ramped up, especially in early February. Markets remain highly sensitive to the prospect of rising interest rates, given the massive volumes of cash that have been sloshing around the financial system in the wake of the Global Financial Crisis.

The US Federal Reserve is expected to be the most active in terms of lifting its cash rate over the next year, with another two or three interest rate rises likely by mid-2019. But interest rates at the long end of the yield curve are arguably more important to keep an eye on, particularly as quantitative easing measures in the UK and Europe are wound back. Ten-year bond rates are expected to rise by up to 60 basis points over the next 12 months, suggesting an end to the very cheap credit conditions that have fuelled borrowing and investment spending and contributed to a substantial rise in asset prices across the board.

The US ten-year bond rate is expected to climb to 3.2% by the end of 2018, which would represent its highest level in over seven years (see Graph 6). Markets seem to have built up 3.0% as a psychological ceiling for US bond rates, and there is potential for uncertainty to reappear in financial markets over coming months as interest rates remain under upward pressure. Although we don’t expect this uncertainty to have a discernible effect on global or New Zealand’s growth prospects, the associated risks are worth keeping an eye on.

Graph 6

Although we have revised down our GDP forecasts during 2018 and 2019, the prospects for economic growth in the second half of our forecast period are more positive than previously. At 2.1%pa over the three years to June 2023, the rate of growth could hardly be described as “rip-roaring”, but it is still an improvement from our previous outlook, which saw growth tailing off to be as low as 1.2%pa in late 2021.

The stronger outlook is primarily a function of government policy. The timing of these changes to our outlook reflect delays in implementing significant changes in spending priorities, as well as a desire by the government to boost growth outcomes close to the 2020 election. We have also assumed that a Labour-led government retains power and continues down a similar policy path in the 2020-23 period.

• Government consumption between June 2020 and June 2022 is predicted to grow by an average of 2.9%pa, up from a forecast of 2.4%pa previously.
• Government investment will expand by 3.1%pa over the same 2020-22 period, compared with our prior forecast of 1.2%pa. As previously mentioned, this shift reflects a lack of progress on the government’s flagship infrastructure projects in the near-term.
• Private consumption growth will also benefit from tax and welfare policies targeted towards lower-income households. Although the upward forecast revision over the two-year period is reasonably modest (from 2.1% to 2.3%pa), private consumption is the largest component of GDP, and so the contribution from the change should not be overlooked.

These changes to our growth outlook are consistent with the view that fiscal policy will be more stimulatory with the Labour-led government. Furthermore, the government’s fiscal position is likely to be less positive than previously projected, although there is enough room for the crown accounts to remain in surplus territory.