Positive for now amid a plethora of risks

First things first: we’ve revised up our forecasts of economic growth. It’s not a big change – for example, our growth projection for the year to June 2019 has lifted from 2.7% to 2.9% (see Graph 1). But it’s an upward revision and so is at odds with the air of despair being generated by negative business and consumer confidence surveys.

Graph 1

Better economic growth in the near term is largely about government spending (see Graph 2).

• Government consumption over the last year has grown by 5.2% – its fastest rate since 2006. Although we continue to expect spending growth to slow over the next 18 months, our forecast is higher than we were previously predicting.
• Growth in government investment spending has accelerated from -2.9% to +4.8%pa since September last year. This momentum has led to upward revisions to our outlook for the next couple of quarters as well.

Graph 2

Aside from government spending, the other major upward revision is to our outlook for exports. According to Statistics NZ, export prices are at their highest level since 2014 in New Zealand dollar terms. ANZ’s commodity price index confirms that this strength is across the board. And with the New Zealand dollar having slipped to its lowest level in almost three years, it is logical to expect a solid response in export volume growth. Our forecasts now see export volumes growing by 3.9%, rather than 2.7%, over the year to June 2019 (see Graph 3).

Graph 3

From mid-2019 onwards, our GDP growth forecast remains marginally higher than in July, up from an average of 2.2%pa to 2.3%pa. Amid all the gloom, it feels strange to be revising up our forecasts. Although our outlook for economic growth represents our best assessment of what will happen, the risks to our forecasts are highly weighted to the downside.

Firms’ pessimism in the economy is at its worst since 2008. But over the history of ANZ’s Business Outlook survey, business confidence under a Labour-led government has been an average of 41 points lower than under a National-led government. Business confidence changes: seasonal, political, or real? takes a more in-depth look at the messages coming through from the business confidence numbers.

There appears to be less of a political bias in other indicators from ANZ’s survey, including own activity (a 13-point gap), employment intentions (seven points), and investment intentions (five points). The fact that, since August last year, each of these three indicators has dropped by about three times as much as this historic gap suggests there is something more than political posturing at play.

We would argue that the government’s policy programme has had some effect on businesses’ view of the future. Some policies have been clearly communicated by the government and have left firms feeling gloomy. Planned increases in the minimum wage have raised concerns about costs, while firms also see other proposals such as Fair Pay Agreements making it more difficult to do business. In other cases, the government’s policy direction has suffered from a lack of clarity, leaving businesses to fear the worst. And conflicting policy signals from various coalition partners, and NZ First in particular, have added to the interpretative difficulties.

But it would be petty to blame all the decline in confidence-related indicators on government policy, real or imagined. Views of the future have also been clouded by angst about the international economic outlook, arising from President Trump’s attempt at a trade war with China (for more on international events, see Trade tensions and the variability of dairy prices). Closer to home, there have also been clear signs that business profitability is being squeezed.

Firms seem to be stuck in a situation where they are unable or unwilling to lift prices, despite the cost pressures that many are experiencing. In some cases, this lack of pricing power is an obvious consequence of competition from offshore.

The retail sector is particularly exposed to these pressures, with international suppliers able to offer a much broader range of products than domestic firms, often at significantly lower costs. Larger shops within New Zealand are also using the international model of offering low-priced goods online locally, putting the squeeze on small-town retailing.

More broadly, though, the lack of price rises is perplexing. Non-tradable inflation averaged 3.8%pa over the decade to June 2011, but has averaged just 2.4%pa since then and, currently at 2.5%pa, is still well below average. The definition of “non-tradable goods and services” is that they cannot be bought from overseas, so prices shouldn’t be subject to international competitive pressures. In other words, firms in the non-tradable sector should have the ability to put up their prices if necessary.

The Reserve Bank has been theorising that firms are looking at the lack of inflation over the last six years and making pricing decisions accordingly.

But it seems odd that, if a firm’s profitability is under substantial pressure, prices are not raised to try and boost margins. It is possible that businesses are worried about losing market share if they are the first to raise prices, particularly if other firms didn’t follow suit.

And with strong economic growth over the last few years, businesses will have been able to rely on increasing sales volumes to maintain overall profits, even as per-unit margins have shrunk. However, this strategy has become less viable, with economic growth having slowed since the end of 2016.

The producers price index (PPI) shows that firms’ input prices (excluding labour costs) have risen by an average of 4.3%pa over the last two years, or 3.3%pa if we exclude dairy farming and manufacturing.

Although firms’ output prices have also risen, the PPI suggests that there has been significant margin compression for several industries, including manufacturing; electricity, gas, water, and waste services; transport, postal, and warehousing; and financial and insurance services.

These margin pressures are at their most acute in six years and suggest that inflation will push closer to the midpoint of the Reserve Bank’s 1-3%pa target band by mid-2019 (see Graph 4). The alternative is that more firms go out of business because they are unable to maintain their profitability in a slower-growth environment.

Graph 4

Trade tensions between the US and China have continued to escalate. US tariffs on Chinese products will increase again at the start of January 2019, and the antagonism between the two countries suggests that no resolution is in sight. We see potential for New Zealand exporters to benefit in the short-term, as China actively looks to source products from countries other than the US. However, the medium-term repercussions of the US-China trade war on global growth are unequivocally negative.

At this stage, Consensus forecasts for 2019 Chinese economic growth are 6.4%pa, having held at around that level since the start of this year. US growth projections have also been stable, implying that an economic slowdown is more risk than reality at the moment, or that any slowdown won’t start to hit until 2020.

Exporters will be keen to make the most of solid demand conditions and high commodity prices in the near term given the risks to medium-term growth.

With the GlobalDairyTrade index having fallen 16% since May to its lowest level since October 2016, Fonterra has been forced to reduce its forecast milk price for this season to $6.25-6.50/kgms. DairyNZ estimates that the average farmer’s breakeven point is about $5.45/kgms, so at this level, most dairy farmers will still be making a profit. However, profits are likely to be only about half what might have been hoped had the milk price held up at around $7/kgms.

We’ve discussed the reasons we think are behind low business confidence, but consumers have also lost their cheer. The most obvious candidate is petrol prices, which have climbed 18% over the last year to a new record high. Current expectations are for the surge in petrol prices to taper out by the end of this year. But we still predict that prices will remain above previous record highs throughout 2019 and 2020. This situation will maintain the squeeze on household budgets and cramp consumers’ discretionary spending.

At the same time, the housing market remains relatively subdued. Annual sales volumes have tracked sideways this year, having previously fallen 20% between June 2016 and December 2017 in response to the Reserve Bank’s tightening of loan-to-value ratio (LVR) requirements. At a nationwide level, house price inflation of 4.3%pa might seem to be enough to stave off the blues. But house price growth rates of 0.9% and 0.3%pa in Auckland and Canterbury respectively will be undermining consumers’ feeling of wellbeing.

The labour market is the biggest positive for households, with Westpac’s measure of employment confidence hitting a 10-year high in the June quarter before pulling back in September. Slowing employment growth and a slight uptick in unemployment in the near-term should not unnerve consumers – particularly if wage inflation continues to pick up during 2019 and 2020.

Quarterly GDP growth of 1.0% in the June quarter was well above the Reserve Bank’s expectation of 0.5% and should have put paid to speculation of an interest rate cut by the Bank any time soon. However, the multitude of downside risks to economic growth over the next couple of years means the possible need for more stimulatory policy can’t be completely ruled out.

In its August Monetary Policy Statement, the Reserve Bank argued that any further cuts in the official cash rate (OCR) would result in lower retail interest rates in New Zealand as well. However, our examination of the data suggests that any pass-through from a lower OCR into retail rates would be negligible.

The only other levers available for the Reserve Bank are an easing of its macroprudential requirements for trading banks, or a reduction in its LVR restriction for mortgage borrowers. The after-effects of the Global Financial Crisis imply the Bank would be hesitant to make much of an adjustment to the macroprudential rules, leaving the LVR restrictions as its only tool of any real effect.

The ability for the Reserve Bank to take actions that directly shore up the housing market is reassuring, given that housing remains significantly overvalued. Furthermore, high house prices are likely to be linked with the very high labour force participation rate – particularly in Auckland, where multiple incomes are necessary to service the massive mortgages required to purchase property. Although we are not currently forecasting a labour market downturn, a rise in unemployment of a percentage point risks undermining the ability of households to meet their mortgage obligations. In this situation, the lift in forced sales could easily swamp any stimulatory effects of slashing LVR restrictions that the Reserve Bank could implement.

Similar questions must be asked about the scope for effective changes in fiscal policy. The government’s $5.5b surplus for 2017/18 was unexpectedly high, but will not last as the Labour government’s new spending initiatives are fully implemented. And even though The Treasury’s forecasts show the government surplus expanding to $7.3bn by 2022, these projections are predicated on strong economic growth and a substantial upward revision in expected tax receipts. As a result, the government’s fiscal headroom appears to be vulnerable to more negative outcomes in terms of both economic growth and tax revenue.