Provinces and government are key to growth outlook

Our latest forecasts see an upward revision to our outlook for GDP growth throughout 2019. However, the picture is not all rosy, with the economy still predicted to record its slowest growth in five years. Our most recent estimates of regional GDP growth show that, for the first time since our data series began in 2001, all four of the largest urban areas are growing more slowly than the nationwide average. The Wellington, Auckland, and Canterbury regions are now the slowest-growing areas in the country (see Graph 1).

Graph 1

We are now seeing the pay-offs from the recovery in dairy prices during the second half of 2016 and the strength in most other export commodity prices coming through in the performance of provincial economies. Buoyant export incomes are boosting spending activity in the provinces, backed up by population growth that has been well above average. The growing population has been boosted by the recent international migration boom as well as an increasing outflow of people from Auckland in search of more affordable housing and a better lifestyle.

The reasons for the slowdown in the urban areas is a little hard to pin down. Construction activity, most particularly in Auckland, seems to be close to its peak, with further growth being limited by capacity constraints. Labour resourcing issues and skill shortages also appear to be restricting growth in other industries. At the same time, both business and consumer confidence have deteriorated and, without the offsetting effects of higher export incomes being enjoyed by the provinces, this pessimism has held back investment and spending decisions in urban areas. For consumers, the real estate market’s slowdown has also led to an easing in housing-related expenditure.

We see three risks hanging over the positive vibe currently prevailing in the provinces.

• It is unclear how negative the effect of Mycoplasma bovis will be on economic activity and confidence in those regions that are highly reliant on dairy or beef farming. The government’s decision to pursue eradication rather than try to manage the disease has provided some certainty to the rural community. However, the success of this programme is not guaranteed, and it is possible that Mycoplasma bovis could still spread significantly beyond the small percentage of farms currently affected. Giving eradication our best shot means supporting farmers all the way discusses Mycoplasma bovis in more detail.
• The labour supply remains a key influence on provincial growth prospects. The government has scaled back its planned clampdown on immigration, but these changes largely centre around foreign students and will have little effect on workforce needs in the provinces or their immigration flows. In fact, the absence of any recent government discussion about regionalising the skills shortage list suggests this policy has been dropped, which will do nothing to help labour shortage issues outside the main centres.
• An eye also needs to be kept on the trade ructions between the US and China . Although the tit-for-tat action on the likes of steel and soy beans has little direct effect on New Zealand, further escalation of protectionist behaviour between the two countries could result in softer economic growth internationally. More of a slowdown in China would have negative flow-on effects for New Zealand, given China’s role as our largest export market.

The current strength in provincial economies has been a contributing factor to the upward revisions to our outlook for economic growth over the next two years. We have been forecasting a delayed improvement in provincial spending since dairy prices recovered in late 2016, but confirmation that spending has now actually gained momentum provides the basis for more solid household consumption growth during 2019.

The government’s fiscal position is also better than we were envisaging in our previous forecasts. In the lead-up to May’s budget, there had been a lot of noise from the government about its tight fiscal position and the resulting need to prioritise spending decisions. As it turns out, Treasury’s projections of a surplus expanding from $3.1b in 2017/18 to $7.3b by 2021/22 show the government has ample room to pursue a wide range of policies, some of which will help stimulate economic activity.

These outcomes show through in our forecasts of both public and private consumption. We have added half a percentage point to government consumption growth in each of 2018 and 2019, with spending now forecast to increase by an average of 2.9%pa over the two years (see Graph 2). We have also revised up our outlook for private consumption growth by up to half a percentage point over the next 18 months, which is partly a reflection of more government money flowing out into the economy (see Graph 3).

Graph 2

Graph 3

The other factor feeding through into a better outlook for household spending is a pick-up in wage growth. Average hourly earnings in the Quarterly Employment Survey lifted 3.5% over the year to March, the fastest growth since early 2012. After a sustained period of very low wage inflation, we may finally be starting to see the effects of the tight labour market coming through in income growth.

Having said that, forecasting a sustained pick-up in both wage inflation and consumer price inflation remains an act of faith. Even the Reserve Bank is at somewhat of a loss to explain the persistent lack of inflationary pressures in the system, believing that the low inflation of previous years is dissuading businesses from, or limiting their ability to, raise prices now. The Bank has stated that “backward-looking pricing behaviour or other factors that have been keeping domestic inflation low may persist for longer than we anticipate, posing a downside risk” to non-tradable inflation and wage inflation.

We believe that lower net migration and slowing growth in the working-age population will keep the labour market tight and add to upward pressure on wages. Furthermore, significant public sector pay settlements will force private sector employers to pay more to compete for staff. Additionally, continued sizable increases in the minimum wage will cement faster wage growth for lower-skilled workers.

With rising wages, businesses will be encouraged to look for ways to expand while keeping their costs down. In our recent report From education to employment: Megatrends affecting NZ’s working environment , we discussed the effect that automation is likely to have on the workforce over the next 20 years. If anything, we expect the tight labour market to accelerate the automation of jobs during the forecast period.

The need for capital investment and the push towards automation needs to be balanced against the fact that business confidence is at a 10-year seasonally adjusted low, according to ANZ’s latest Business Outlook survey. Weak confidence levels will play a dampening role on private non-building investment, with growth forecast to ease from 9.4%pa in the September 2017 year to 2.6%pa by the end of 2019 (see Graph 4). Nevertheless, we have moderated the slowdown in our investment growth forecasts throughout the next year, with many businesses left with little choice but to invest given rising wage costs and ongoing labour capacity constraints. We do not believe current confidence levels signal a major contraction in business investment as we saw in 1997-98, 2001-03, or 2008-10, but recognise that the risks to our near-term forecast probably lie on the downside.

Graph 4

We have also incorporated the effects of increasing automation in our medium-term unemployment forecasts. Between 2020 and 2022, the unemployment rate is forecast to trend upwards from 4.3% to 4.9% (see Graph 5). This lift is not a large one by historic standards, but reflects an increase in unemployment as more workers lose their jobs to automation and are not able to immediately regain work due to a lack of required skills, the need to retain or change industries, or a lack of new job opportunities in specific regions. Despite expectations that the overall labour market will remain relatively tight over the long-term, we expect some lift in transitory unemployment as the economy and workforce go through this period of relatively rapid technological change.

Graph 5

Apart from the broad effects of stimulatory fiscal policy on government and household spending outlined above, government policy continues to have an important effect on the outlook for the economy across a range of areas.

It is somewhat ironic that spending from the government’s Provincial Growth Fund is ramping up at a time when economic growth is stronger outside the main urban centres. The following points are key aspects of the $126m of funding awarded by the government to date.

• Infrastructure projects account for approximately 30% of funding, although some of this funding relates to business case development and investigation rather than spending on physical infrastructure.
• Government departments and other central government agencies have been allocated 14% of the funding, with another 5% going to local councils.
• Northland has received a massive 44% of funding to date, with Taranaki and ManawatÅ«-Whanganui receiving 14% and 12% respectively.

With the government looking to spend $1b per year, these indications of where and how the funding is being used could change significantly in coming months. In any case, the Provincial Growth Fund is likely to help maintain the outperformance of provincial economies over the next 1-2 years.

Global fuel prices have been on the rise due to a range of international market concerns, including US sanctions on Iran as well as jitters about the trade tensions between the US and China. If anything, the latter factor risks pushing down demand for oil over the medium term if global economic growth is undermined. But for now, risk aversion is seeing more stockpiling take place.

Financial markets expect oil prices to ease back below US$60/bl over the medium term on the back of increased production from OPEC, Russia, and the US. This reversal in oil prices will help bring domestic fuel prices back from their current highs, outweighing the effects of any depreciation in the New Zealand dollar.

Of course, regional fuel taxes and the government’s annual increases in fuel excise are also pushing up retail petrol prices. Neither of these factors are surprises to us, but they do seem to have had a negative effect on consumer confidence in recent months. Their effects on households’ discretionary spending will be felt more keenly if international fuel prices hold up at current levels. As a result, petrol prices represent a downside risk to our forecasts for private consumption and economic growth over the next two years.

The government’s softer stance on immigration means that population growth during 2019 and 2020 will be faster than we were previously expecting (see Graph 6). Net migration will still ease from its current level of 66,243 to 33,200pa by March 2021, dragged down by the combined effects of:

• falling foreign student numbers
• a levelling off in work visa numbers, due to changes by the previous National government
• an increasing net outflow of New Zealanders as our economy’s outperformance of the Australian and global economies comes to an end.

Graph 6

Even with the drop-off in migration, this forecast level represents a significant upward revision from our previous forecast of a net inflow 16,800pa by early 2021. We anticipate that skill shortages will keep demand for migrant workers relatively high, limiting the government’s ability to reduce immigration further or faster. The construction industry is a prime example of these shortages, particularly given the government’s ambitious KiwiBuild targets, but there are plenty of other industries where labour market conditions are tight.

The upward revisions to our outlook for population growth suggest the potential for slightly faster average economic growth throughout the forecast period. They also imply greater persistence of demand pressures in the housing market.

KiwiBuild continues to be a key area of government policy where there is a lot of noise, but not much else. We remain sceptical of the government’s claims that KiwiBuild will significantly add to the residential build rate, particularly given that announcements to date have mostly seen the KiwiBuild label slapped on projects that were already going ahead anyway. Increases to the price bracket for dwellings in Auckland, high income limits for applicants, and Phil Twyford’s description of KiwiBuild as a “middle-class aspirational home-ownership policy” all suggest that it will do little to improve housing affordability on a widespread or sustained basis.

If there is one aspect where we see KiwiBuild having a significant effect, it is acting as a catalyst for the expansion of prefabrication in residential construction in New Zealand. Phil Twyford’s keenness for prefabrication as part of the solution suggests that the government will make sure that building standards and the consenting process will be changed to remove any regulatory impediments. The implicit guarantees of government demand for prefabricated components and dwellings will also encourage businesses to invest in boosting their production capacity.

For now, residential construction continues to be restrained by a mix of constraints across labour capacity, the availability of land, and access to credit for developers. The slowdown in the housing market throughout 2017 would normally suggest an easing in residential building activity. Auckland’s undersupply of housing and government efforts to stimulate more construction are likely to mitigate the extent of the downturn in residential construction. Nevertheless, we are still forecasting an 11% drop in residential investment between December 2018 and March 2022.