NZ’s slide continues as global growth falters

The world economy continues to do New Zealand few favours as we grapple with our own economic slowdown. At 2.6%pa, global growth expectations for 2019 and 2020 are still marginally higher than the results in 2012 and 2016 (see Graph 1), but those forecasts have been steadily downgraded since the middle of last year.

Graph 1

Central to the global slowdown, of course, is the ongoing trade war between the US and China. Another round of tariffs was introduced by the US in September, with China retaliating promptly. A further escalation of tariffs in December on consumer goods is likely to cement US growth below 2%pa during 2020 and 2021, while China’s growth is set to slip under 6%pa for the first time since 1990.

In terms of the US economy, President Trump’s efforts to “make America great again” have primarily had a negative effect on the country’s agricultural sector, with China increasingly refusing to accept American produce. So far, household spending has been less affected by more expensive imports, because import penetration in the US is relatively low. Nevertheless, US consumer spending growth is still expected to soften noticeably by mid-2020. Previous fiscal stimulus by the Trump administration has faded, and the Federal Reserve is now cutting interest rates to mitigate the slowdown in the US economy.

The flow-on effects of reduced US demand for Chinese exports are having more obvious consequences for other parts of the global economy. European firms with Chinese operations or that supply inputs to Chinese businesses have reported softening demand. Economic growth throughout developing Asian economies is also at its weakest in a decade.

Across the Tasman, year-end growth in Australia’s export volumes is at its weakest since 2012, reflecting the fact that 34% of the country’s exports go to China. Overall economic growth has slipped below 2%pa for the first time in nine years. The squeeze on exports has been compounded by a 9.0% slump in house prices over the last 18 months, dragging household spending growth to a six-year low.

Even so, the outlook for Australia is one of the brighter spots on the global economic horizon. Substantial fiscal stimulus is expected to drive GDP growth back up to 2.5%pa next year, aided by the Reserve Bank of Australia’s moves to rapidly cut interest rates. In July, commodity prices for Australian exports also reached their highest level since 2011, despite the broader trend of weakening global demand.

New Zealand’s export prices have also shown continued strength. After adjusting for general inflation, ANZ’s commodity price index shows that NZ-dollar prices for dairy products and meat, skins, and wool have reached their highest levels in five and 17 years respectively during 2019. Seafood prices are only slightly down from last year’s nine-year high. Although horticulture and forestry prices have softened throughout the last year, they are still above their average inflation-adjusted levels of the last decade.

The terms of trade might have slipped 2.4% from its 2017 peak, but the fact that it is still above its previous all-time high recorded in 1951 highlights how much the tradable sector and export incomes are currently contributing to New Zealand’s economic performance. Slowing population growth, peaking construction activity, weak business confidence, a lack of capital investment spending, and poor labour productivity represents a potent cocktail undermining our growth prospects. But the outlook would be considerably worse without the support implied by the strong terms of trade (see Graph 2 for our terms of trade forecast).

Despite the softer global economy, we currently predict that export prices will largely hold their own throughout the forecast period. Even with slowing economic growth in China, we expect demand to increase at a sufficiently fast rate to maintain good market conditions for our meat, dairy, and forestry exports. There are obviously downside risks to this forecast in the near term, although any downward pressure on export prices is likely to be less pronounced for New Zealand’s soft agricultural-based exports than for hard commodities that feed more directly into China’s manufacturing supply chain.

Graph 2

Nevertheless, the outlook for New Zealand’s provincial economies is not entirely upbeat. As we have warned in previous forecasts, the agricultural sector is facing mounting constraints to its medium-term growth.

The government’s plans to improve water quality in rivers, lakes, and wetlands within five years are not solely targeted at agriculture. For example, local councils are likely to be required to better manage stormwater and wastewater, while sediment loss from earthworks and urban developments has also been targeted. But the proposals look set to restrict further intensification of farming and limit any further conversions of land to dairy farming. There will be stricter requirements to reduce nitrogen run-off and other farming practices that have contributed to the degradation of the country’s waterways. These proposals represent a significant change from previous growth within the agricultural sector, which was more lightly regulated than other sectors and has led to a sizable shift in land usage and stocking levels throughout the last 30 years.

Uncertainty remains around plans to bring agriculture into the emissions trading scheme. However, with NZ First gaining a concession that the sector would only have to pay for 5% of its emissions, this element of government policy is likely to have a minimal effect on farmers. In contrast, the government’s zero carbon bill, with its plan for a 10% reduction in methane emissions by 2030 and further reductions by 2050, could significantly affect production. Without technological advancements such as a vaccine, feed additives, or breeding or genetic enhancements to animals or grass, decreased methane requirements could only be achieved through a reduction in stock numbers. Such a change would hit farmers’ revenue and profitability.

A more immediate concern for farmers is the pressure within the banking sector to reduce its exposure to agriculture. Data from the Reserve Bank shows that agricultural lending is still up 2.8% from a year ago, although that rate is lagging well behind growth in lending for housing (6.3%pa) and to businesses (7.7%pa). Banks are looking nervously at farm prices that are already declining and then overlaying the risks posed by the global economy as well as environmental policy changes being advocated by the government. Banks are also reacting to the Reserve Bank’s proposals for tougher capital requirements by demanding greater margins on their lending. The availability and cost of credit for farmers are likely to become even less favourable once the Reserve Bank settles on the new capital holding requirements and implementation timeline in November.

As a result of these factors, our outlook for growth in export volumes throughout the forecast period is relatively muted. Growth is forecast to average just 2.2%pa over the five years to June 2024 – the weakest result since 2008-13, which was affected by the Global Financial Crisis.

Alongside the shadows hanging over the agricultural sector, we also note that year-end growth in services exports turned negative in the latest GDP data, for the first time since 2013. The biggest negative contributions have come from audiovisual services, insurance and pension services, and “other” personal travel. This weakness in services exports comes despite the New Zealand dollar having slipped to a three-year low on a TWI basis. The weaker exchange rate would normally be expected to provide a boost for services exports. However, the soft global economy is clearly having a more significant effect on activity, and there are further downside risks to services exports, particularly around tourism and international education.

The Reserve Bank’s efforts to stimulate the economy have ramped up since our July forecasts, with an unexpectedly large cut to the official cash rate (OCR) of 50 basis points in August. Almost as surprising was the ability of retail banks to suddenly be able to pass on the full extent of the cut in their floating mortgage rates – something they were unwilling to do for any other rate cuts since the end of 2015.

In our view, the drop in floating mortgage rates by the banks has an element of window dressing, given the sizable profits being recorded in the banking sector. Although banks’ funding costs have probably not decreased by as much as the OCR was cut, a lack of pass-through would have raised the level of public disquiet about the sector even further. Yet the effect on bank profits of passing on the full 50-point cut will be dampened by the fact that only 16% of mortgage lending is currently on floating rates. Margins on fixed mortgage rates are far more important for bank profits. There is also evidence that banks are passing on less of the interest rate cuts to business borrowers, as they try to shore up lending margins due to concerns about the Reserve Bank’s proposed capital requirements mentioned above.

We see little that will deter the Reserve Bank from its stimulatory efforts over the next six months, and so expect the OCR to be cut to 0.5% by February next year. It is conceivable that, with risks to the economy firmly on the downside, the Reserve Bank continues to cut even more aggressively to zero or below, rather than wonder “what if?”

We have allowed for a little more stimulus in our growth numbers given that the outlook for both short-term and long-term interest rates is tracking well below what we had expected in our previous forecasts, and more of the decline in wholesale rates is also being passed through into retail rates. At the margin, there must begin to be some effect on business investment and household borrowing. The latter is also likely to be given a boost by our expectation for a further easing of the loan-to-value restrictions by the Reserve Bank at next month’s Financial Stability Report.

However, we also remain unconvinced that the Bank’s actions will do much to boost economic growth. As we have noted in previous forecasts, uncertainty about government policy and the global economy is undermining firms’ willingness to commit to new capital investment or hiring staff. Consumer confidence is being weakened by slowing employment growth, while high house prices and massive deposit requirements for first-home buyers work against any sustained pick-up in household borrowing. Neither businesses nor households would currently point to financing costs as a major factor limiting their appetite to borrow.

Our modest outlook for economic growth over the medium term raises questions about whether, in the foreseeable future, conditions will ever be sufficiently upbeat for the Reserve Bank to start raising interest rates again. Further declines in the unemployment rate and increased labour cost pressures shape as the most likely catalyst for the Bank to start withdrawing some of its monetary stimulus from 2021 onwards. Financial markets are also doggedly sticking to their view that longer-term interest rates will start to shift back upwards sooner, rather than later, despite being proved wrong throughout the last three years. We concede the risks to our interest rate forecasts must lie on the downside, and we can easily envisage a scenario where New Zealand slips into a trajectory of sustained slow economic growth and low inflation.

From the point of view of consumers, it’s also worth highlighting the unsettling effect of recent disruption to oil supplies in the Middle East and the resulting lift in petrol prices in New Zealand. We have a higher outlook than previously for fuel prices throughout the next year as markets factor in greater risks around the security of supply following the drone attacks in Saudi Arabia.

Futures markets have a weaker outlook for oil prices over the medium term, undoubtedly a reflection of soft prospects for the global economy. Based on current futures pricing, domestic petrol prices retreat towards $2/l during 2021. However, it is possible that this outlook is too relaxed given events of the last few months and the potential for more frequent disruption to oil supplies looking forward.

Consumer confidence is at a four-year low according to the latest ANZ Roy Morgan survey, and elevated fuel prices will add to the pressure on spending growth coming from the labour and housing markets. If petrol prices remain at higher levels over the medium term, they will further weigh on economic growth later in the forecast period.

Alongside its own efforts to boost economic growth, the Reserve Bank has also become increasingly vocal about the need for the government to step in with fiscal stimulus. This call from the Reserve Bank for a mate is a new and significant development that highlights the diminishing ability for monetary policy to save the day. May’s Budget and Economic Fiscal Update showed that the government’s fiscal impulse was expected to be flat in the June 2020 year and turn negative (ie dampen economic growth) from 2021 onwards. Furthermore, those numbers were based on the government successfully progressing its major policy initiatives such as KiwiBuild, rail infrastructure projects, and the Provincial Growth Fund. Instead, all three policy areas are proving much slower to get spending.

Weaker economic growth than was projected by Treasury will naturally feed into more fiscal “stimulus” via a lower tax take and increased welfare payments. However, we believe that the prospect of a slowing economy in the lead-up to next year’s election, along with pressure to make up for some of its “unused” spending to date, will encourage the government to announce new spending initiatives in the Half Year Economic and Fiscal Update in December. The recent $7.5b surplus has made public pressure on more government action even more intense.

Combined with the effect of revisions to historical data by Statistics NZ, additional government spending will drive faster near-term growth in government consumption than we had previously allowed for. However, we have again scaled back our forecasts of government investment spending during 2020 and 2021 given the continued slow progress on capital projects, and the net effect on our forecasts is less growth in total government consumption and investment spending during the next two years (see Graph 3).

Graph 3

The government is likely to reuse this template for more pre-election spending more successfully in 2022-23 as the economy continues to muddle along over the medium-term. And with delays to government capital spending in the near-term, there is an increased likelihood of more progress later in the forecast period. Graph 4 shows the effect of this fiscal activity as an upward revision to our GDP growth forecasts in 2022-23.

Graph 4

Readers will also note that, despite near-term efforts at stimulating the economy by both the Reserve Bank and the government, our growth forecasts are lower over the next 1-2 years. This outlook reflects our view that the weakening global economy, in particular, will outweigh the effects of any policy steps taken to try and buoy growth domestically.