We’ve dodged a bullet, but growth won’t be easy

Massive fiscal and monetary stimulus, combined with a reasoned policy approach and a dose of good luck, looks to have limited the economic fall-out from COVID-19. The unemployment rate is set to peak below 7% and annual economic activity will have surpassed its pre-pandemic levels by the middle of this year. Conditions for economic growth over the medium term still look difficult given lingering structural issues for the economy, of which housing affordability is the most critical. But there's little doubt that, compared with fears about the economic outlook nine months ago, New Zealand's current prospects are enviable, particularly in the context of the ongoing battle with COVID-19 internationally.

We’re halfway through what are normally the peak summer months for tourism, and it looks like the labour market carnage that we feared because of COVID-19 will mostly be avoided. Data up to January 22 shows an uptick in the number of people on Jobseeker Support by about 10,000 since early November, but over half of this rise is a normal seasonal increase as more people including tertiary students become available for work during summer. The remainder of the lift pales in comparison beside the jump of almost 46,000 people in the 12 weeks after the Level 4 lockdown began in March last year.

Having waited and waited for the full effects of COVID-19 to hit, we now believe that the New Zealand economy has dodged a bullet (or perhaps a missile!), taking little more than a glancing blow. Graph 1 shows that we now expect the unemployment rate to peak at 6.6% in the March 2021 quarter, rather than the 8.8% we were previously forecasting for early 2022. A total decline in employment of 50,700, as shown in Graph 2, represents a modest 1.9% drop. The few remaining job losses we’re likely to see filtering through in early 2021 will be concentrated in tourism-related businesses doing it tough over summer, and selected retailers where pre-Christmas spending failed to make up for the effects of lockdown earlier in 2020.

Graph 1

Graph 2

The retention of staff by businesses suggests that, although further increases in the unemployment rate will be limited, underutilisation in the labour market is likely to remain relatively high. The underutilisation rate has jumped from 10.1% to 13.2% since December 2019 as workers’ hours have been cut and people have scaled back from full-time to part-time work. A job is better than no job, but the pandemic has had an effect on some people’s incomes that is not fully captured by the simple rise in the unemployment rate.

We expect the unemployment rate to trend gradually downwards to below 5% by the second half of 2023, implying the labour market will have returned to “normal” by that point in time. A faster recovery will be prevented by two key factors.

• Apart from a possible Trans-Tasman bubble by the middle of this year, New Zealand’s borders look set to remain closed until early 2022. The tourism sector’s recovery will not begin until the vaccine has been rolled out and borders have reopened. Even then, the recovery will be a gradual process, constrained by reduced international air capacity, higher airfares, and some lingering reluctance to travel.
• The global economic position remains more fragile than our own. Exporters have been fortunate to get away with world export prices that are only down 3.9% from their November 2019 level, according to ANZ’s commodity price index. But more contagious strains of COVID-19 and renewed lockdowns suggest exporters should still be wary of global demand conditions throughout the next year.

Apart from the labour market, the other major positive for economic activity during the second half of 2020 has been the performance of the housing market. We recognise that the spectacular lift in demand for property and surge in house prices is not all good news, given that it has horribly compounded the housing affordability problems that were already present in New Zealand. However, one of the flow-on effects of the housing boom has been sustained demand for new housing.

In contrast to early expectations of a sharp drop in house prices and a collapse in residential construction activity, annual dwelling consent numbers have bounced past their February 2020 peak to a new 46-year high. There is a large amount of work in the pipeline waiting to be completed and capacity constraints are becoming more critical in the construction industry, particularly when disruptions to international supply chains are considered. So activity might struggle to push higher from current levels, but declines of any magnitude also appear unlikely during 2021.

The reintroduction of loan-to-value ratio (LVR) restrictions by the Reserve Bank should take some of the heat out of the housing market throughout the rest of 2021. We estimate that a record 8.5% quarterly increase in house prices during the December 2020 quarter will drive annual house price inflation up to 15%pa by the middle of this year, before price growth eases back into single digits by the end of 2021. But we are still talking about rising prices throughout this year and next year given the solid labour market, continued low mortgage rates, and the government’s explicit desire that house prices do not fall. The experience from last decade also suggests that LVR restrictions of 30% for investors might not be tight enough to have a dramatic effect on the housing market’s momentum – we see a mounting case for investors to require a 40% deposit before long.

Graph 3 shows that it is only from 2023 onwards that we see very limited scope for house prices to decline, with the big increase in the supply of new housing, gradual rises in interest rates, and below-average population growth all keeping a lid on property values.

Graph 3

The relative robustness of the labour market has important implications for household spending and overall economic growth. Much of our expectation of renewed weakness in the New Zealand economy during 2021 was based on further deterioration in the labour market. Without further significant job losses, consumer confidence and household spending look set to hold up better than we had previously anticipated (see Graph 4).

The improvement in our forecasts for household spending might seem at odds with the minimal changes to our outlook for business investment. But ANZ’s Business Outlook survey shows that investment intentions have not bounced back quite as much as employment intentions, and that they remain slightly further below their long-term average level.

Graph 4

As a result, we remain wary of firms’ willingness to commit to investment spending (see Graph 5) given that COVID-related uncertainty will hang over the economy throughout 2021. Furthermore, disruptions to international freight routes mean that sourcing plant and equipment from overseas is harder than normal. These difficulties are likely to dissuade some businesses from pushing ahead with investment plans until the logistics of getting equipment here are less problematic.

Graph 5

It’s also worthwhile noting that our estimate of a 12% drop in annual non-building investment between December 2019 and March 2021 is relatively modest compared with the 29% fall that occurred between 2008 and 2010 following the Global Financial Crisis. Even so, we recognise the risk that investment spending could bounce back more sharply during 2021 as businesses enjoy continued solid demand conditions.

These positives, in combination with the 14% surge in quarterly GDP that was recorded in September 2020, all feed through into a much stronger outlook for economic growth this year than we were previously projecting (see Graph 6). We are forecasting that year end-growth rebounds to 4.6%pa by September 2021, with annual GDP surpassing its pre-COVID peak by the middle of this year.

Graph 6

What is less evident from Graph 6 is that we do not expect quarterly growth to be roaring throughout 2021. Our projections have quarterly seasonally adjusted GDP growth averaging zero for the five quarters from March 2021 to March 2022, with several factors feeding into this period of slower economic growth.

• Export conditions will still be relatively challenging, even outside tourism.
• Imports (which are a negative for GDP) are likely to gradually overcome the constraints that have limited volumes in recent quarters.
• Household spending growth will be solid, rather than spectacular.
• Businesses will approach investment spending with caution.
• Although construction activity will remain strong, there is little capacity for further growth from current levels.
• Fiscal policy conditions will be significantly less expansionary from 2021 onwards (more on that in a moment).

This struggle for momentum in the economy over the next 12 months is forecast to see year-end growth slip below 1%pa during 2022 once the September 2020 rebound falls out of the annual numbers. Our forecast of GDP growth below 2%pa during 2024 and 2025 also reflects some of the medium-term structural issues faced by the New Zealand economy, including the likelihood that international tourism will not fully recover within the forecast period, a medium-term slowdown in residential construction as the overvalued housing market constrains activity, and the need for significant fiscal restraint following last year’s spend-up.

Despite our central view now incorporating a swifter economic recovery, we retain some caution about the ability for activity to recover to pre-pandemic levels so quickly. Our view of the economy has evolved in recent months towards a much more upbeat reading of future output, but we have lingering concerns about the sustainability of the recovery, with a chance that the pandemic has caused internal bleeding to the economy that might not be apparent immediately.

There’s little doubt that the massive monetary and fiscal stimulus implemented during 2020 has supported the New Zealand economy and locked in the rebound in activity that occurred during the second half of last year. The scale of this stimulus was unprecedented and, in tandem with New Zealand’s good public health outcomes, was far more effective than anyone dared hope back in April and May last year.

Nine months ago, we were expecting substantial spare capacity in the economy to persist for several years. That outcome will now not be the case. The economy’s performance to date means that less stimulus will be required going forward.

There is already evidence in the government accounts that some of the budgeted expenditure will not be required: better-than-expected outcomes in the labour market imply less spending on either welfare benefits or the wage subsidy. True to form, the government is also finding it difficult to progress its raft of shovel-ready projects and other construction initiatives as quickly as it had hoped, with capital investment sitting 15% below forecast for the first five months of the 2021 fiscal year. Some of this weakness is being counteracted by increased spending on the health sector but, overall, fiscal settings will be less stimulatory over the next 18 months than was previously anticipated. Additionally, the tax take has been more impressive as more people than expected are earning and spending, boosting GST, business, and personal income tax receipts.

The strength of the economy also means that there is no need for further stimulus from the Reserve Bank. The Bank looks to be scaling back its purchases of government bonds in its Large Scale Asset Purchase programme, a shift that doubly makes sense if government spending and debt levels are not going to be as high as initially thought. Take-up from the retail banks of the Funding for Lending Programme has been very limited to date, although we would expect more of these low-cost funds to be accessed as banks’ existing tranches of wholesale and retail funding come up for renewal.

Given these developments, we have removed our expectation of further cuts to the official cash rate (OCR). We now expect the OCR could be held at 0.25% until late 2024 (see Graph 7). This timeline might seem like an extremely long one, but reflects our view that inflationary pressures will be subdued for several years given the spare capacity that COVID-19 has created in the global economy. Cost pressures within the labour market domestically will also be no more than patchy, given medium-term GDP growth sitting below 2%pa. As long as the momentum in the housing market is reduced via other factors, we see little need for the Reserve Bank to act quickly to lift interest rates.

However, we do note that better trend inflation and a less battered economy could see rates rise faster than anticipated. The Reserve Bank has taken an approach of “least regret” until now, so it’s hard to see a lift in interest rates before business investment starts to get rolling again. But at the same time, pressure to address the housing crisis and higher inflation levels could bring about a change in interest rates sooner than expected.

Graph 7

The impressive recovery of the economy still leaves New Zealand with several lingering issues, including housing, poverty and inequality, and climate change. With the shift from response to recovery now primed, we note that old problems are already coming to a head again – sometimes at an even greater scale. A swift return to “normal” is not in New Zealand’s best long-term interests, and further changes will be needed to set New Zealand on a more sustainable growth path, including a focus on improving productivity and wellbeing outcomes. At a political level, the pressure is on to deliver, and not just announce, measures to enhance living standards for Kiwis and help New Zealand forge a better path ahead.