Delaying the inevitable slowdown

The New Zealand economy has continued to slow since our previous forecasts were published at the start of February. Most of the challenges faced by the economy, including the softer global outlook, overvalued housing market, and constrained supply of labour remain the same as three months ago.

Our biggest concern is about the economy’s ability to achieve reasonable growth results over the medium term. Businesses’ investment intentions remain weak, and growth in capital spending in the second half of 2018 was low to negative. With a broad thrust towards increased automation, a lack of labour productivity growth, and higher minimum wage increases, these investment figures do not fill us with confidence about New Zealand’s growth prospects in 3-5 years’ time. Our forecast of GDP growth averaging just 1.5%pa over the three years to March 2024 reflects these concerns. In short, the economy is lacking the investment needed to drive innovation and continued strong GDP growth.

In the near-term, though, economic growth looks likely to be buoyed by strength in residential building activity. After declining between June and November 2018, residential consent numbers in the three months to February 2019 were up 23% from a year earlier, boosted by a 55% surge in attached dwelling numbers. Even if there is limited capacity for further growth in residential construction, consent numbers holding around current levels for the next few months could be sufficient to underpin GDP growth of about 3.0%pa until the middle of 2020 (see Graph 1).

Graph 1

Graph 2 shows the upward revision to our residential investment forecasts over the next three years, highlighting the role that more persistent strength in new dwelling construction could play in buoying overall economic growth in the near term.

Graph 2

Although economic growth expectations for China and, to a lesser extent, the US have stabilised over the last few months, the outlook for Australia has deteriorated markedly. In March, Consensus forecasts for Australia’s economic growth this year were revised down from 2.6% to 2.3%. House sales and house prices across the Tasman are plunging, dragging residential construction activity lower, weighing down consumer confidence, and undermining the outlook for household spending. Australia’s export sector is also struggling, with the potential for even worse future outcomes as the flow-on effects of China’s economic slowdown hit export incomes further.

Australia – an economy on edge? provides a broad overview of the problems being experienced by the Australian economy and touches on some of the possible implications for New Zealand. Australia’s woes add to the air of vulnerability hanging over New Zealand’s economic outlook that has been created by the slowdown occurring in the US, China, and Europe.

Arguably the most surprising occurrence in the last few months was the Reserve Bank’s strong signal that it is set to cut the official cash rate (OCR). The Bank appears to have been spooked by the softening global economy even though, in our view, the international outlook has generally been more stable over the last couple of months.

Messaging from overseas central banks now points towards an absence of any further interest rate rises and conversely, in some countries such as Australia, possible rate cuts. That shift was placing some upward pressure on the New Zealand dollar, an unwelcome outcome given the slowdown occurring in the general economy.

Although we’re doubtful about the need for the Reserve Bank to lower interest rates, we’ve now factored two 25-point cuts into our OCR track over the next few months. Given the significant shift in tone, we view a cut in May as highly likely. But if the Bank is going to cut, one won’t be enough to shift sentiment or stimulate activity, so we expect a second cut later in 2019.

In one sense, the Bank has little to lose by cutting interest rates. Price pressures remain benign and inflation is not expected to surge past the midpoint of the Bank’s 1-3%pa target band. Most drivers of economic growth are slowing, with cautious consumers reining in spending growth, businesses very reluctant to invest, and the potential for export growth being undermined by the slowing global economy. Furthermore, the existing housing market (putting aside new residential construction) has lost a lot of its momentum over the last 18 months and is unlikely to roar back into life with a couple of interest rate cuts.

Nevertheless, the Reserve Bank’s change of stance raises some questions for us. Firstly, why now, and not six months ago? As we noted earlier, sentiment about the global economy has mostly been stable over the last couple of months, in contrast to the mounting concerns between August 2018 and February this year.

Secondly, are the global risks currently big enough to justify cutting interest rates? The important context for this question is that the OCR is already at a record low. By cutting rates now in the face of a modest slowdown, the Reserve Bank is leaving itself very little ammunition if a more significant downturn was to occur.

Thirdly, will cuts to the OCR flow through into retail rates and spur investment anyway? During 2016, when the OCR was cut from 2.5% to 1.75%, floating mortgage rates barely moved over the course of the year – dipping from 5.8% to 5.6% during 2016 before pushing back up to 5.8% in early 2017. We have previously expressed our scepticism that retail rates will drop in tandem with any further OCR reductions and see no reason to change that view. We acknowledge that fixed mortgage rates are easing, but we believe this decline reflects the global economic environment and falling longer-term wholesale rates, and it would have occurred irrespective of the Bank’s OCR stance. Even then, current low interest rates haven’t made any difference to the slowdown in investment spending growth, making the case for expecting more investment as a result of an interest rate cut questionable.

In March, at the monthly review of our interest and exchange rate forecasts, we had already pushed out our timing of any expected interest rate rises until the second half of 2020, in line with the Reserve Bank’s rhetoric. We have now further delayed our expectation of the first rate rise until early 2021. This lower starting point for the OCR, delayed start to rate rises, and the fact that bond rates have continued to decline, all mean that our outlook for wholesale interest rates is lower throughout the next five years than in previous forecasts (see Graph 3).

Graph 3

The current scope for the Reserve Bank to cut interest rates partly reflects the continued absence of significant inflationary pressures in the economy. Surprisingly subdued inflation has been a persistent theme of the economy throughout the last seven years.

The immediate outlook for inflation has softened over the last few months because of slowing global growth. Tradable price pressures had ratcheted up since 2016, but the softer international outlook is leading to the development of overcapacity in Asian economies again, which has deflationary implications.

The labour market remains the biggest enigma in the inflation puzzle. Despite an unemployment rate of 4.3% and surveys showing that firms are finding it very hard to find staff, labour cost inflation remains very muted. This month’s 7.3% increase in the minimum wage will show through in the official labour market data published in August by Statistics NZ, but there is little sign of broader labour cost pressures to date.

Our recent discussions with other businesses suggest that firms are finding it more expensive to attract and retain staff in the competitive labour market, and they are having to pay more accordingly. We continue to expect an acceleration in labour cost inflation during the next three years. In our view, this factor presents the biggest risk to the Reserve Bank’s current dovish outlook for monetary setting.

One of the other concerns expressed by businesses is the effect of tightening `gration policy on the labour supply. Prior to the 2017 election, both Labour and NZ First were vocal in their desire to bring migration down from its record high levels. However, the policy changes made so far by the current government have been relatively minor, possibly due to an increasing realisation that firms have a significant reliance on staff sourced from overseas to fill gaps in the workforce.

The other complicating factor surrounding migration is the massive uncertainty about the actual level of migration, given Statistics NZ’s measurement and modelling changes. The estimated trend in annual net migration, as published by Statistics NZ, swung from a decline of about 770 people per month in November to an increase of about 1,710 people per month by February. Combined with the unavailability of 2018 census data, we arguably have less idea about New Zealand’s population than ever before.

Our best guess is that net migration will continue to track downwards throughout the next 3-4 years (see Graph 4). The effects of National’s changes to work visa rules in August 2017 will continue to play out during the next 18 months. Labour’s rule changes for international students wanting to stay in New Zealand following completion of their study are likely to drag net migration down further throughout the 2019-2021 period. Regionalisation of the skills shortage list has yet to be completed, while the government has quietly reduced Immigration NZ’s residence approvals target from an average of 45,000pa over the two years to June 2018 to an annualised rate of 40,000pa.

Graph 4

Our outlook is at odds with the “official” estimates of net migration, which in January and February showed a strong resurgence. However, visa approvals and the large number of unclassified travel movements makes us deeply sceptical of the estimates as they stand.

Outside Auckland, the housing market has looked to be in a standard late-cycle position, with slowing population growth and an increasing supply of new dwellings set to quell house price growth in coming quarters. Until recently, the next shift in interest rates was expected to be upwards, while any moves by the Reserve Bank to ease its loan-to-value ratio (LVR) restrictions would simply mitigate the market’s slowdown rather than stoking a resurgence.

We see little reason to significantly change our overall outlook for the housing market, despite the prospect of OCR cuts and the additional uncertainty caused by the ambiguity surrounding migration. Indeed, with residential consent numbers having recovered momentum over the last few months, it seems even more likely that an excess supply of new dwellings is developing around much of the country and will act as a drag on house prices.

Auckland remains a special case, with its curious mix of apparent undersupply, rising occupancy rates, chronic affordability issues, and significant investor presence. In our view, an inability for people to pay any more for property is preventing house prices from being bid up further. At the same time, investor demand has been progressively undermined by the extension of the bright-line test on capital gains to five years, the ban on foreign buyers, uncertainty about the introduction of a broader capital gains tax, and the additional costs set to be imposed on landlords by the government’s Healthy Homes Standards. With 39% of residential property in Auckland owned by investors (as opposed to 34% around the rest of New Zealand), it makes sense that changes affecting investors have a bigger influence in Auckland than elsewhere.

Several people have expressed reservations to us about whether Auckland really has an undersupply of housing, given that neither rents nor house prices are being driven up rapidly by a shortage of available housing. But in our view, it is impossible to compare the growth in Auckland’s population and growth in the housing stock since 2006 and conclude that there is not an undersupply of some magnitude. Nevertheless, there are some factors that mean the undersupply might not be great as the data initially suggests.

• Statistics NZ’s new migration picture implies that New Zealand’s population might not be as large as we previously thought. Although this population discrepancy would probably lead to reduced regional population estimates across the country, the concentration of new migrants settling in Auckland means that the effect on the city’s population could be greater than for other parts of New Zealand.
• The lack of any data from the 2018 census to date also adds to the uncertainty about Auckland’s population, and the net outflow of people from Auckland to other regions could be larger than estimated.
• The increasingly multicultural population of Auckland means that our assumptions about what constitutes a “typical” household could be less accurate than in the past. For example, households in many Asian cultures include extended or multigenerational families, rather than the “mum, dad, and two kids” model that has generally prevailed in New Zealand in the past. This shift would help to drive up the number of people per household compared with what we would otherwise expect.

Even allowing for these factors that mean the undersupply might not be as large as previously thought, overall demand for housing in Auckland is likely to remain subdued while the house-price-to-income ratio remains so high. We are not forecasting a dramatic correction in house prices, so we expect people in Auckland to continue crowding together more than would otherwise be the case to save on housing costs. The relative affordability of housing in other parts of the country will also ensure that a steady net outflow of people from Auckland into other regions continues throughout the next five years.