Will consumers be the next pillar to fall?

The last 18 months for the economy have been characterised by very weak business confidence and a lack of business investment spending. We estimate that in the year to March 2019, private investment excluding buildings contracted 0.6%, which is a sharp contrast to the 8.3% growth recorded in March 2018. We have previously pointed the finger at an increasing squeeze on business profitability as the main culprit for this drop-off in investment, although uncertainty surrounding the government’s policy agenda continues to play a part.

Throughout this period, consumer confidence has held up relatively well – certainly in comparison to business confidence. Year-end growth in household spending has eased from 5.8% in March 2017 to 3.2%pa in March 2019, but some of that softening can be put down to slowing population growth (even though volatile migration estimates, and the lack of any census data, mean we can’t be sure of the population’s effect). At its current rate, household spending growth is still close to its average of the last decade, unlike growth in business investment.

However, it’s difficult to be overly upbeat about prospects for households. Job growth has dried up, with the Household Labour Force Survey showing a 0.2% decline in the number of people employed over the last six months. Year-end employment growth is at its weakest in three years, and we forecast that it will slip to a six-year low of 1.3%pa before the end of 2019 (see Graph 1). Not only are businesses shying away from investment, they have also become reluctant to take on more staff. The storm clouds associated with a possible global slowdown have made businesses wary of increasing their costs, including for labour.

Graph 1

This weaker job growth is reflected in other aspects of our labour market forecasts. The unemployment rate is forecast to stay above 4.0% throughout 2019 and 2020, while the participation rate is not expected to push past the record highs seen in 2017/18 until 2022. A lack of new job opportunities means that fewer people will continue looking for work in the face of lower prospects of success.

Growth in labour costs will also fail to accelerate as rapidly as we had previously expected. The government’s programme of minimum wage hikes will still push labour cost inflation to its fastest rate since 2009, but at 2.4%pa in mid-2020, pressures will be mild in comparison to the 4.0%pa growth recorded in 2008.

The other potential limitation on households’ willingness to spend is the housing market. The market outside Auckland had shown some renewed momentum in the second half of 2018, seemingly in response to the easing in loan-to-value restrictions at the start of last year. But price growth has been patchier again in the last three months.

We expect the tail end of the housing boom to continue to fade, with provincial areas going through the last phase of their “catch-up” to Auckland’s very strong price growth of previous years. Softer labour market outcomes will undermine house price growth, while easing net migration and slowing population growth will also weaken demand for housing. Perhaps most critically, residential construction activity around many parts of the country has been at very high levels, and we expect this to result in an oversupply of housing and downward pressure on house prices by the end of 2021 (see Graph 2).

Graph 2

In Auckland, house prices have already dropped 5.1% (seasonally adjusted) over the last 15 months according to the Real Estate Institute’s index. This weakness is reflected in slower spending growth in the region, negatively affecting sales of hardware, furniture, and appliances. Spending growth around the rest of the country will be similarly affected as the housing market weakens, with signs of slowing price growth coming through in recent months.

Amid this negative outlook for the housing market, we see scope for patches of brightness in the near-term thanks to the effects of commodity prices on export incomes and provincial and rural economies. Retail spending and house price inflation in areas such as Hawke’s Bay or ManawatÅ«-Whanganui is likely to outperform the larger urban centres throughout 2019 and 2020, as long as the current slowdown in global growth remains relatively mild. Further relaxation of the Reserve Bank’s loan-to-value requirements could also help provincial housing markets next year, which is more than can be expected from the Bank’s moves to cut the official cash rate (see Reserve Bank lacks potency).

Having read about the labour and housing markets, one could be forgiven for assuming we have revised down our forecasts for private consumption. However, we have actually increased our predicted growth in private consumption over the five-year forecast period from 2.4%pa to 2.7%pa (see Graph 3).

Graph 3

There are two reasons for this upward shift. Firstly, our outlook for net migration and, consequently, population growth is higher. Recent migration data has been stronger than we had expected, given the government’s apparent policy efforts to pull migration lower. Although we are sceptical of the extent of the migration upturn since mid-2018 in StatsNZ’s figures, the Australian economic slowdown could be a factor keeping overall net migration at higher levels. Some of this near-term strength in net migration is expected to be sustained, leading to upward revisions in population growth throughout the forecast period.

Secondly, following May’s budget, we expect government policy to have a more stimulatory effect on household spending than we had previously allowed for. In particular, the government’s changes to the indexation of welfare benefits will boost the spending ability of lower-income households.

Anxiety about the global economic outlook is persisting and has been a major contributing factor to the Reserve Bank’s decision to cut the official cash rate (OCR) in New Zealand. The following areas are some of the key concerns.

• The effects of President Trump’s post-election fiscal stimulus have faded. US growth is also being negatively affected by the country’s trade war with China and the effects of tariffs on imports of American products into China. US GDP is expected to grow by just 1.8% in 2020, which would be the worst result since 2016.
• Chinese growth prospects are also threatened by the trade war with the US. Although consensus forecasts for GDP growth for 2020 have held steady at about 6.0% in recent months, economic data has been mixed and there are fears of a further softening in the outlook if the US increases import tariffs further, as has been threatened.
• Australia continues to grapple with plunging house prices and a domestic slowdown, which is being exacerbated by the effects of softer Chinese demand on Australian export incomes. GDP growth of just 2.0% is expected this year, which would be the slowest rate in a decade. The good news is that the government is set to run a surplus in the 2019/20 fiscal year, which has enabled it to announce a large tax-cut package. This fiscal stimulus is expected to boost economic growth to 2.5%pa next year.
• Expectations for Eurozone growth in 2019 have slipped from 1.8% to 1.1%pa since October last year, with the biggest downward revisions occurring for Italy and Germany. The US-China trade war is affecting European exports, and government debt concerns appear to be undermining growth in Italy. Outside the Eurozone, uncertainty surrounding Brexit continues to hang over the UK economy.

The softening global economy has meant the outlook for monetary settings internationally has become more dovish. For example, any further interest rate rises are off the table in the US and a cut is now expected before the end of the year, Australia has lowered its cash rate target in both June and July and could cut further, and expectations of any rate hikes in Europe have been pushed back. This shift in international sentiment has been a key contributor to the Reserve Bank’s decision to cut interest rates in New Zealand, given that the exchange rate had been coming under more upward pressure.

Except for recent declines in dairy prices, international commodity prices for New Zealand’s agricultural exports have held at relatively high levels in the face of the global slowdown. Nevertheless, our discussion above highlights that there are still clear downside risks to global demand, which could have negative effects on export prices over the next 18 months.

One export area that is coming under substantial pressure is the tourism sector. Year-end growth in arrival numbers slipped to a six-year low of 1.4%pa in March, largely thanks to a drop-off in Chinese tourists. China was the second-biggest contributor to growth in tourist numbers over the previous five years behind Australia. But slowing Chinese economic growth, diplomatic tensions, capacity pressures, and rising prices within New Zealand are seeing this country fall from favour as a holiday destination. Slowing economic growth is also starting to hit arrival numbers from the likes of the UK, France, South Korea, and Japan.

Tourism and dairy are the two biggest components of New Zealand’s exports and are also the key factors behind the downward revision to our export forecasts. We now predict that export volumes will grow just 2.0% during 2020, compared with 2.9% in our previous forecasts.

Graph 4

Despite the Reserve Bank’s interest rate cuts, we see little prospect that monetary policy will stimulate the economy during 2019 or 2020. Firstly, only about half of the Bank’s reduction in the OCR in May flowed through into floating mortgage rates. There is the likelihood that even less is passed through in any further cuts as the OCR gets closer to zero.

Secondly, interest rates are not the primary factor limiting the housing market or growth in business investment and consumer spending. Interest rates are already at such low levels compared to the last 50 years that they are not holding people back from borrowing. As we have outlined above, there are far more critical factors affecting spending, including the squeeze on business profitability and lack of income growth for households.

Thirdly, concerns about the Reserve Bank’s proposed increases to capital requirements to banks are hanging over the financial system. As it stands, the proposed changes would restrict the availability of credit compared with current conditions, making it more difficult and costlier for businesses and farmers to borrow. Previous episodes where there has been a tightening in the availability of credit, such as the Global Financial Crisis, have limited economic activity and restricted GDP growth.

Perhaps the most effective stimulus the Reserve Bank can offer at the moment is a further relaxation of its loan-to-value ratio (LVR) restrictions. In a recent speech, Deputy Governor Geoff Bascand stated that the Bank is “comfortable with further easing in the LVR policy over time”. Continued softness in the housing market this year suggests the Bank will relax the LVRs again at the start of 2020. We believe that the deposit requirements in place are the biggest factor constraining buyer demand, particularly for first-home buyers. Although we have outlined the factors behind our weak outlook for the housing market over the medium-term, we see scope for more relaxed LVRs to temporarily buoy parts of the housing market over the next 24 months.

The Treasury’s most recent forecasts, published with the Budget in May, showed much stronger growth in government consumption spending in the near term. Despite Treasury’s upward revision of spending growth in the June 2020 year from 1.5% to 4.2%pa, we are cautious about how successful the government will be in boosting growth that quickly. Several of the government’s major policy initiatives, including the Provincial Growth Fund, KiwiBuild, and its infrastructure agenda, have shown that it can take considerable time for planned spending to actually take place.

Bearing this outcome in mind, we have pushed out our expectations for fiscal stimulus to account for the longer lead time in getting projects spend-ready. Our forecasts for government consumption and investment spending growth have been revised down in the near term, with upward revisions later in 2020 and 2021 as some of the government’s ideas finally start to come to fruition (see Graph 5). The net effect is that fiscal stimulus will buoy up economic growth during 2021 – we have revised up our forecast of GDP growth for that year from 1.7% to 2.4%pa. Even so, further delays are a key risk around the government’s major areas of planned investment spending.

Graph 5

Our forecasts show a steady tailing off in economic growth throughout the forecast period (see Graph 6). GDP growth is forecast to remain below 3.0%pa during the next five years and, after a wave of fiscal stimulus in 2021, it is expected to slip below 2.0% during 2022.

Graph 6

This mediocre medium-term outlook is a consequence of the current lack of business investment and a persistent shortage of productive workers. Businesses will struggle to increase their output without more investment in plant and machinery, and a lack of capital investment will limit improvements in labour productivity. Even with employment growth slower than it has been over the last five years, good workers will stay in relatively short supply. Growth in the working-age population will slow, in line with easing net migration, and much of the pool of unemployed will consist of people without the necessary skills or aptitude to contribute in the workplace.

Aside from the effects of the Reserve Bank’s proposed capital requirements for banks, the government’s environmental agenda and more expansive focus on wellbeing are also likely to contribute to weaker economic growth outcomes. Environmental policy effects will be felt most heavily in the agricultural industry and export sectors, while the emphasis on wellbeing suggests that the government is willing to trade off more potential economic growth in return for improvements in other aspects of New Zealand’s broader social and economic outcomes.

We recognise that GDP growth has often been overplayed as the most important single focus of government policy or society’s advancement. However, a lack of evaluation of government wellbeing spending being linked to actual advancement in outcomes could undermine actual progress, as could an inability to actual spend the funds needed to change lives. Just as importantly, we also note that achieving growth in output and incomes is also often a key element in facilitating improvements in other, broader socioeconomic outcomes.