Optimism tempered by “ifs” and “buts”

Seemingly out of nowhere, an air of cautious optimism emerged across the New Zealand economy in the latter part of 2019 – or, if not optimism, at least reduced pessimism. In our view, there has been no significant shift in any of the core drivers of economic growth, but several smaller factors have come together to halt the trend of deterioration that had prevailed since early 2018.

Internationally, the US and China have been stuttering towards a trade deal, with the first phase of the deal signed on January 15. Although the agreement represents only a small reversal of the barriers put in place over the previous two years, it is nevertheless a change of direction from the continuing escalation of tariffs. The trade war between the two superpowers was having clear negative effects on economic growth around the globe, including in the US, China, Europe, and the rest of Asia.

But (and “but” will be a consistent theme as we run through the list of small positives for the economy) the Phase One trade deal is more the end of the beginning, rather than the beginning of the end. Retaliatory tariff actions have forced substantial changes to supply chains and trade operations, which cannot be quickly unwound. Nonetheless, the trade deal is undeniable progress.

The outlook for Chinese economic growth remains relatively subdued. The standard partial indicators – electricity production, freight volumes, and lending activity – have all shown a trend of softening growth throughout 2019. China’s GDP growth is expected to slip below 6%pa this year for the first time since 1990. The slowdown in China is relatively modest, but the trend is one of weakening growth nonetheless (see Graph 1).

Graph 1

Just as importantly, there’s no other economic revival emerging globally that will stoke demand. Softer growth continues to be expected in most of the key global economic powerhouses.

One of the most surprising aspects of the New Zealand economy’s performance over the last 18 months is how little our export sector has been negatively affected by the trade war and the Chinese slowdown. In fact, the terms of trade has lifted 4.4% since the end of 2018 and is now just 0.7% below the record high reached in December 2017 (see Graph 2).

Graph 2

Fonterra’s expected milk pay-out reflects the good prices being enjoyed by many of our exporters. Since our previous forecasts were published in October last year, the company has increased the midpoint of its projected pay-out for the current season by 8.1% to $7.30/kgms. ANZ’s commodity price index shows that meat prices are at record highs, while horticulture and forestry prices have also shown signs of recovery over the last few months.

In our October forecasts , we outlined the question marks hanging over the agricultural sector due to tougher freshwater standards, requirements for reduced methane and other carbon emissions, and the effects of the Reserve Bank’s tougher capital requirements on the availability and cost of credit. All these issues remain live and shape as an impediment to medium-term growth in exports.

An additional cloud hanging over provincial growth prospects over the medium-term is the potential conversion of farmland to forestry. In some cases, this change makes sense, where the returns from pastoral farming are marginal and the land is prone to erosion. But the government’s environmental policies imply that the relative returns from forestry are likely to improve significantly. This shift will potentially lead to the establishment of sizable new forestry blocks on land previously used for sheep, beef, or dairy farming.

Many communities in provincial areas have been hollowed out during the last 35 years by factors such as the aggregation of smaller farms into larger corporate stations, the centralisation of services in fewer main centres, and the general urban drift of the population. Forestry’s reduced requirements for labour and other inputs threaten to further undermine employment opportunities and, ultimately, the economic viability of some provincial communities. Over the medium-term, these negative flow-on effects could easily outweigh any positive effects that might come out of the Provincial Growth Fund.

If we delve into the September 2019 quarterly export numbers more deeply, softness is apparent in dairy products, chemical products, meat, and forestry export volumes. Notwithstanding our apprehension about medium-term prospects for agricultural export volumes, some of this recent weakness is likely to be temporary, and a rebound in growth looks likely during 2020 (see Graph 3). However, services exports present a real concern, increasing by just 0.3% over the year to September. This sluggish result compares with average growth of 3.3%pa over the last decade.

Graph 3

Since 2015, the biggest drop-off in services export growth has occurred in the “other” personal travel category, reflecting slower growth in tourist numbers. Education-related travel and insurance and pension services exports have slowed significantly as well. Weaker exports of personal, cultural, and recreational services also point towards the effects of the tourism slowdown.

One of the challenges or New Zealand’s tourism sector is the 9.3% reduction in Chinese tourist numbers over the last year. This drop is the biggest decline since the Global Financial Crisis and shows no signs of abating. In terms of overall tourist numbers, this decline has been masked by strong increases in Taiwanese and American arrivals (up 31% and 6.6% respectively), as well as solid growth in Australian arrivals (up 3.6%). However, with the global economy still slowing, conditions for the tourism sector are at their most difficult for several years.

We now expect total growth in tourist arrivals to languish below 2.0%pa between the end of 2020 and mid-2023. By early 2023, Chinese visitor numbers are forecast to be 21% below their 2018 peak (see Graph 4).

Graph 4

One of the shortcomings of fuelling tourism growth through increased numbers of Australian visitors is that they spend less than half the amount, on average, that Chinese or American tourists do while in New Zealand. So currently, growth in arrival numbers is not being matched by spending growth.

This dichotomy hints at a second major challenge faced by the tourism sector. Much of New Zealand’s tourism offering has been based on natural beauty, open spaces, and a lack of people. But this foundation for our tourism sector is incompatible with a model of growth simply based on ever-increasing numbers. Tourism’s focus needs to shift from merely chasing greater numbers of visitors to concentrating on higher-spending tourists and adding more value. However, given New Zealand’s export performance in areas such as dairy and forestry, with little progress being made in exporting products with higher “value-add”, we are sceptical that any significant change will take place soon.

ANZ’s business confidence and own-activity measures rebounded in the last few months of 2019. Both indicators are still below their long-term averages, but the pick-up points towards better conditions for firms than have prevailed throughout the last two years.

The boost to confidence lines up with a recent lift in Business NZ’s Performance of Manufacturing Index, suggesting that demand conditions might have improved since mid-2019. Signs of a recovery in the service sector are more mixed, which is perhaps unsurprising given the tourism slowdown, weakness in services exports, and local retailers’ ongoing struggles with demand being siphoned off by overseas competitors.

The NZIER’s Quarterly Survey of Business Opinion (QSBO) confirmed a lift in confidence, but the detailed numbers from the survey suggested the improvement was more speculative than anything. One of the most concerning aspects of the QSBO over the last 18 months has been the deterioration in firms’ reported profitability, which is now at a 10-year low. This result hints at the pressure being experienced by firms, despite reasonable economic growth, and the squeeze on profits has also been constraining business investment.

At best, the pick-up in business confidence appears to be a reassessment in responses from the pessimism of the last two years that overstated how bad things were. We remain cautious about the rebound and don’t think it signals a recovery for the economy, with New Zealand still lacking any improvement in the fundamental drivers of faster growth.

At the same time, consumers’ perceptions of current conditions have reached levels not seen since 2007. For consumers, the drivers of this improvement in sentiment are easier to pinpoint, even if current confidence levels seem improbably high. Mortgage rates have declined to 70-year lows, house price inflation is showing signs of recovery, unemployment remains close to 4%, and there are emerging hints of a pick-up in wage inflation.

Furthermore, migration has held at a net inflow of 40,000-50,000 people per annum, which has helped to underpin continued growth in aggregate household spending. Pre-election rhetoric that Labour would reduce net migration by 20,000-30,000 people per annum has failed to be enacted.

The persistence of net migration at these levels has led us to revise up our forecasts for net migration (see Graph 5) and population growth. We still expect net migration will continue to slow, but not as quickly as in our previous forecasts.

Graph 5

It’s also important to note our belief that official migration estimates were too high has been proven right. Stats NZ has recently revised down its net migration estimates for the last year by nearly 10,000 people.

Looking forward, net migration will continue to play an important role in helping to ease labour capacity constraints, particularly in provincial areas given the government’s more regionalised approach to granting work visas. However, ongoing strength in population growth implies that pressure is likely to be maintained on infrastructure and the supply of housing in certain parts of the country.

At the end of 2019, Grant Robertson bowed to immense pressure for more fiscal stimulus to mitigate the economy’s downturn, announcing an $8b boost to infrastructure spending. The need for more investment in infrastructure is clear given the country’s strong population growth of recent years and the failure of spending to keep pace with this growth. As a result, this choice of direction for more spending is preferable to many other paths the government could have gone down.

But let’s be realistic about how much it’s likely to stimulate economic growth within the next 12 months. Since being elected in 2017, the current government has shown a remarkable inability to make substantial progress on many of its big-ticket items, including KiwiBuild, light rail in Auckland, or spending (rather than just allocating) money out of the Provincial Growth Fund. To date, there is also very little detail about exactly what projects the government anticipates spending its $8b on. Given that details on these new projects aren’t yet available, it’s extremely difficult to see how new assets could be built and finished by Christmas this year.

Doubts about the government’s ability to progress its infrastructure plans in a timely manner are exacerbated by concerns about capacity within the construction industry.

Bearing these factors in mind, we don’t believe the government’s $8b plan has magically improved the near-term economic outlook. We continue to expect GDP growth of about 2.5%pa during 2020 (see Graph 6), although revisions to historical data mean that the quarterly momentum this year is likely to feel more positive than was the case during 2019.

Graph 6

Our medium-term outlook remains one of slowing economic growth. From mid-2021 to mid-2024, GDP growth is forecast to slow from 2.6% to 1.4%pa, averaging 1.7%pa over this three-year period. This outlook is in line with our previous forecasts.