Being upbeat about growth is becoming harder

Anxiety about a deterioration in the global economy has been at the forefront of our thinking when preparing our latest economic forecasts. From the beach 2019 details a range of concerns about the possibility of slowing growth during 2019 and 2020. Our worries include those emanating from the US-China trade war, more cautious Chinese consumers, and the flow-on effects from Australia’s struggling housing market.

Prospects are for New Zealand’s GDP growth to hold close to 3.0%pa throughout 2019. That expansion will be hard-fought, given domestic factors that include slowing growth in business investment, non-existent labour productivity growth, falling net migration, and consumers that are less willing to spend. New Zealand’s economy is forecast to slow during 2020, with GDP growth easing to 1.9%pa by mid-2021 (see Graph 1). This slowdown reflects the confluence of tougher economic conditions both internationally and domestically.

The remainder of our Forecast Story concentrates on the key factors affecting our expectations for domestic growth.

Graph 1

The slowdown in business investment spending during 2018 was disconcerting, even if it was consistent with business confidence surveys. We estimate that annual growth in private sector non-building investment slipped from 10% to -1.0% between September 2017 and September 2018. Although it’s only been two years since we saw slower growth in private-sector investment, it’s also worth remembering that the 2015 and 2016 results were dragged down by the flow-on effects of plunging dairy prices.

The reluctance of businesses to invest is at odds with the incentive for more spending on capital equipment due to the tight labour market and the threat of rising labour costs. The unemployment rate is at a 10-year low of 3.9%, implying that firms will struggle to grow if they simply rely on hiring more staff. And with automation widely expected to have a major effect on the workplace during the next 10-20 years, the continued introduction of new technology and investment in more capital equipment would seem to be a given. Low interest rates at the moment also add weight to the argument that more investment should be undertaken now.

However, for now, the decision-making of most businesses seems to be dominated by fears that the near-term returns on any capital spending could be undermined by a weak economic environment. A year ago, we would have seen those concerns as little more than potentially self-fulfilling pessimism. But with mounting anxiety about global growth, some caution now appears to be warranted.

In our view, worries about the global economy will persist throughout 2019 and, by the end of this year, drag year-end growth in investment spending to a nine-year low. More spending is likely to take place from late 2020 onwards, with growth in private sector non-building investment forecast to average 4.4%pa between June 2020 and June 2023 (see Graph 2).

Graph 2

Graph 3 reveals how reliant the New Zealand economy has been on more labour to achieve its growth in recent years. Although GDP growth over the last five years has averaged 3.4%pa, this expansion has coincided with rapid increases in the working-age population thanks to the net migration boom. With total hours worked across the economy increasing rapidly as well, labour productivity has increased by just 0.1%pa since 2013 – the worst five-year performance since at least the early 1990s.

Graph 3

It’s difficult to comprehend why New Zealand’s productivity growth has been so poor. The lacklustre performance could partly be a result of the fastest employment growth being concentrated in lower-skilled industries such as tourism-related services and construction, thereby dragging down productivity at an economy-wide level.

The shrinking pool of available labour in recent quarters might also have undermined productivity growth. As was the case when the unemployment rate dipped below 4% between 2004 and 2008, there is an increasing number of anecdotal reports from businesses that finding new staff is hard, and that the output of those being hired is relatively poor. These complaints are backed up by the NZIER’s Quarterly Survey of Business Opinion, which shows that finding both skilled and unskilled labour is now at its most difficult since 2005 (see Graph 4).

Graph 4

If the marginal productivity of people entering the workforce is low, it will naturally have a depressing effect on economy-wide productivity.

Given the unequivocal tightness of the labour market, we continue to be surprised by the lack of wage inflation. The labour cost index has risen just 1.8% over the last year – the same as the average rate of increase over the last decade, and well below the 3.3%pa average increase between September 2004 and September 2008.

We remain convinced that something must give, especially given that the outlook is for the labour market to be tighter than was previously expected. We have revised down our forecasts for the unemployment rate between now and mid-2021 by as much as half a percentage point. We expect faster increases in the labour cost index throughout the forecast period, with growth peaking at 2.7%pa in mid-2021 (see Graph 5). We expect the tight labour market will force firms to pay workers more, not only to attract talent, but also to retain the staff they currently have.

Graph 5

Adding to the upward pressure on labour costs are the government’s planned increases in the minimum wage. This year’s $1.20/hr increase in the minimum wage (up 7.3%) will be the biggest lift since 2008.

This combination of rising wage costs, questionable labour productivity, and lacklustre business investment is likely to be a drag on economic growth. We expect GDP growth to trend lower throughout the next two years, slipping below 2.0%pa by mid-2021.

Annual growth in retail sales volumes slipped to a six-year low of 2.7% in the September 2018 quarter. More recent electronic card spending data has been even weaker, with annual growth in the value of electronic retail transactions at its lowest since 2009. Since peaking in March 2017, year-end growth in household consumption has eased from 5.8% to 3.4% (see Graph 6), and the other indicators of spending suggest that growth will slow further in coming quarters.

Graph 6

Part of the slowdown in household spending growth is due a drop-off in population growth. Since March 2017, population growth has slowed from 2.2% to 1.9%pa. So even if per-capita growth had remained steady during this period, we would have seen slightly slower growth in total household spending (and GDP).

But slower population growth only accounts for about one-eighth of the drop-off in household spending growth. The rest of the drop is reflective of falling consumer confidence, particularly during the middle part of 2018, which is symptomatic of the slowing housing market and soaring petrol prices.

The good news is that petrol prices have retreated about 18% since peaking in October last year. This reversal has provided major relief for households, whose discretionary spending was squeezed significantly by climbing fuel costs since late 2017. Volatility in international oil prices has added uncertainty to our petrol price forecasts and could see fuel costs rise again later this year. But abstracting from this uncertainty, we don’t expect petrol prices to revisit last year’s record highs in the near future, which should help to mitigate further downward pressure on growth in household spending.

If there is uncertainty about the outlook for petrol prices, there is no more clarity about the outlook for the housing market either. On the positive side, the Reserve Bank has further relaxed loan-to-value ratio (LVR) restrictions from the start of this year, which should theoretically increase the pool of potential property buyers in the market. Additionally, projections about when the Bank will start to increase the official cash rate (OCR) have continued to be pushed out. The Bank’s own forecasts now show the OCR being held at its current level of 1.75% until mid-2020.

But the latest data from the Real Estate Institute showed house sales volumes in December were at their lowest level since 2014 (seasonally adjusted), while sales in Auckland had not been lower since 2010. This weakness was backed up by Barfoot & Thompson’s listing numbers, with the company’s listings in Auckland not having been higher since the end of 2011 (seasonally adjusted).

The data points towards a lack of buyers in the Auckland market – particularly when house price growth of 8.0% across New Zealand excluding Auckland is in contrast with the 1.7% fall in Auckland prices over the last year. The irony of these house price figures is that Auckland still looks be the region when the undersupply of housing is most acute and, therefore, where upward pressure on house prices should be most intense.

We can only put the absence of buyers in Auckland down to the sheer unaffordability of housing in the region relative to incomes. Even with more relaxed LVR restrictions, prospective buyers are unwilling or unable to service the size of mortgage required to enter the Auckland market. The lack of buyers has been exacerbated by the government’s ban on foreign purchases of investment property, which was more prevalent in Auckland than in most other parts of the country.

We expect downward pressure on house prices to persist throughout 2019 and into early 2020 (see Graph 7). However, continued tightness in the labour market will limit this downward pressure, with few forced sales taking place. We are forecasting a 4.1% decline in average house prices between December 2018 and March 2020. Slowing GDP and population growth suggest that the recent rally in property prices outside Auckland is unlikely to be sustained.

Graph 7

At the beginning of 2017, we were predicting that the OCR would start to head upwards by the end of that year. Two years later, any interest rate rises seem to be as far away as ever. Consumer price inflation has continued to surprise on the downside, which has been a recurring theme since 2012. Over the last couple of years, the absence of inflation is mostly due to a lack of wage increases, despite the increasingly tight labour market as noted earlier. Furthermore, business profitability has come under increasing under pressure, but has not translated into any broad-based increase in prices across the economy.

Current market expectations for the first OCR rate increase range from late 2019 to late 2020. Our outlook for labour costs mean that we are at the early end of this range. But there are several factors that could delay rate increases even further or, at their most severe, result in the Reserve Bank needing to cut interest rates.

• Continued low wage inflation and a lack of cost pass-through by businesses would keep consumer price inflation below forecast and remove the need for the Reserve Bank to raise interest rates.
• More substantial weakness in the housing market could encourage the Reserve Bank to cut interest rates. However, we note that the most recent OCR cut in 2016 did not lead to any declines in mortgage rates. Instead, the Reserve Bank has scope to relax the LVR restrictions further, which could be a more effective tool than lowering the OCR to stabilise the housing market.
• The clouds hanging over the international economy have the potential to drag down international and domestic growth. A downturn in the global economy would almost certainly lead to lower interest rates in the US and several other key countries and would place downward pressure on rates here as well.
• We also note the Reserve Bank’s current consultation about increasing capital requirements for the retail banks. There has been speculation that the proposed changes would push up banks’ costs and lead to higher mortgage rates. However, the Bank is looking at a five-year transition period for the changes to be implemented, so they look unlikely to affect interest rate settings within the next 1-2 years.