Light at the end of the COVID-19 tunnel

After a year of incredible upheaval and uncertainty across the economy, preparing this latest edition of our forecasts has seemed fairly simple, with a relatively stable economic outlook. COVID-19 continues to cause major problems around the world, but the roll-out of vaccines both here and internationally raises hopes that things will have started to stabilise by early next year. New Zealand has continued to keep the virus out, the Trans-Tasman bubble with Australia is opening up, and our labour market has held together in large part thanks to the massive support provided by the government.

Against this backdrop, the sizable shifts in our headline GDP forecasts as shown in Graph 1, might seem strange at first glance. In February, we were predicting year-end growth to peak at 4.6% later this year, although that figure was artificially inflated by the effects of last year’s lockdown falling out of the annual figures. Now, we only see growth holding at about 3%pa throughout much of 2021, reaching a peak of 3.6%pa in the first quarter of 2022.

Graph 1

This change is mostly mathematically driven by the weaker-than-expected GDP result in the December 2020 quarter, when economic activity shrank by 1.0% from the previous three months. This contraction has taken a lot of the momentum out of the GDP numbers, and without an implausibly large bounce back in the March quarter, it will now be impossible to achieve the year-end growth figures we were previously expecting for 2021. In fact, March quarter GDP is likely to show another contraction and push New Zealand back into a technical recession, given the changes in Alert Levels and continued absence of international visitors over the last three months, which would normally be a peak period for the tourism sector.

The likely pick-up in year-end growth figures in coming quarters continues to mask less stellar quarterly growth results throughout most of 2021. In general, those businesses that have been able to adapt their operations to the COVID-19 environment have already done so, underpinning the strong recovery in GDP immediately after last year’s lockdown. But for businesses in the events, tourism, and hospitality sectors, there is less ability to completely pivot, and operating conditions remain far from normal. Even with the Trans-Tasman bubble alleviating some of the pressure on these businesses, border restrictions will still act as a drag on growth. These factors are the reason behind our forecast of GDP growth stalling at 1.0%pa for the June 2022 year.

Our forecasts of visitor arrival numbers reflect several factors that we expect to constrain the post-pandemic pick-up in tourism activity.

• The airline industry has gone through a massive reduction in capacity, both in terms of the number of flights taking place and the routes being serviced. Airlines’ financial positions have come under immense pressure as passenger activity has collapsed. We expect airlines will intensely scrutinise demand as they look to restart their operations, and many routes that were only marginally profitable previously are unlikely to be restored soon.
• The financial hit suffered by airlines over the last year also dictates that ticket prices will need to be higher than they were prior to the pandemic. Reduced airline capacity will also be indicative of decreased competition, with airlines focusing on consolidating their core operations and making sure they are profitable, rather than targeting growth. New operators are also unlikely to enter the market until COVID-19 is a more distant memory. Higher ticket prices will naturally reduce the amount of international travel that people are able and willing to undertake.
• Although vaccine roll-outs provide grounds for optimism about more open borders in a year’s time, the legacy of COVID-19 is likely to make international travel less straightforward for people in some countries where processes around the vaccine and associated paperwork might be less comprehensive. Additionally, apart from an initial spike due to pent-up demand from people who have been separated from their families since the pandemic struck, consumer demand for international travel is likely to remain relatively subdued for some time, with some people reluctant to travel due to lingering concerns about the risks associated with COVID-19.

Graph 2

Graph 2 shows our forecasts for tourist numbers. In the March 2023 year, which we expect to be the first 12 months after the borders are more fully open, shows projected arrival numbers of 2.27m, sitting at 58% of their pre-pandemic peak. Even more critically, if we exclude visitors from Australia and concentrate on higher-spending tourists, we expect arrivals to only be at 42% of their 2019 high.

The factors above limiting tourist numbers will apply fairly equally across both inbound and outbound tourism numbers. As our previous analysis has shown, this outcome means that New Zealand’s net tourism spending position will be less positive than it was prior to the pandemic.

Additionally, trends in regional spending data have shown that New Zealanders’ domestic holiday choices tend to be dominated by driving rather than flying. Areas within driving distance of main centres, and without a major reliance on international visitors, have performed particularly strongly – prime examples would be Northland and South Wairarapa. Although areas such as Mackenzie and Queenstown have also enjoyed a boost in domestic tourism spending, it has been nowhere near enough to make up for the absence of international visitors.

Finally, we note sentiment that the focus of the tourism sector’s growth must change from being purely numbers-driven to concentrating more on a higher value proposition. New Zealand’s reputation as a clean, green destination with wide open spaces was coming under considerable pressure prior to COVID-19, given the massive growth in visitor numbers throughout the last decade. We expect a change in New Zealand’s future tourism marketing will result in slower growth in international visitor numbers, even allowing for the lingering effects of the pandemic on overall activity.

Alongside a reset for the tourism sector, the government has also indicated that it is not planning to allow migration to return to pre-pandemic trends either. Immigration Minister Kris Faafoi indicated in February that industries that have previously relied heavily on foreign workers will need to “think differently about how to do that in the future”.

The Labour Party has previously made no secret of its strong preference for vacancies in the labour market to be filled by New Zealanders, and for foreign workers to be an option of last resort. However, prior to COVID-19 hitting, Labour had little success in getting migration lower. The annual net inflow had only reduced slightly, from 55,353 in October 2017 to 49,685 by March 2019, and the government had come under considerable pressure from many industries struggling with shortages of skilled and, in some cases, unskilled workers.

The labour market fall-out from COVID-19 has been relatively limited, quickly leading to labour shortages in some industries. Horticulture has demonstrated an inability to attract Kiwi workers, even with government assistance in place. Capacity pressures have become critical in the construction industry, given very strong demand conditions and a lack of access to foreign workers. More instances of labour shortages will progressively come to the fore again throughout the forecast period.

The immediate outlook for net migration is incredibly uncertain, with a range of possible post-COVID flows being very difficult to judge: New Zealanders leaving for postponed OEs, other Kiwis returning to New Zealand following the COVID-19 disaster in Europe and North America, and foreigners who got stuck in New Zealand finally heading home. Once things have settled down, we expect net migration to sit at about 30,000pa by late 2024 (see Graph 3).

Graph 3

This rate of migration will meet some, but not all, of New Zealand’s labour force needs. Employment growth will be somewhat constrained – we forecast it to average just 1.6%pa over the two years to June 2026 (see Graph 4), even as the unemployment rate declines back to 4.0% and the participation reaches uncharted territory of over 72%. The scarcity of workers will drive wages higher over the medium term, and we see the risks to our wage forecasts lying to the upside.

Graph 4

The other response we would expect to see is increased capital investment to reduce firms’ reliance on labour and improve productivity. However, New Zealand’s mediocre productivity performance means this result is one that we will believe only when we see it. Importantly, the need to source talent without enough overseas labour will require firms to plan ahead and invest more in upskilling the domestic workforce.

Financial markets have rung some alarm bells about the potential for inflation to re-emerge in coming quarters. These concerns have been driven by the combination of an improving GDP growth outlook and the massive monetary and fiscal stimulus that continues to be implemented and flow through into the economy. The optimism about growth has been underpinned by hopes that the roll-out of vaccines will allow the world to return towards normal over the coming year.

Nowhere have these inflation concerns shown through more than in bond markets. For example, New Zealand’s 10-year government bond rate jumped from 1.3% to 2.0% during a fortnight in the second half of February. Rates settled back to an average of just below 1.8% during March, but they remain volatile as financial markets try to make sense of the outlook for growth and the possible timeline for monetary policy tightening, both here and overseas.

In the near term, inflation in New Zealand is set to spike higher anyway (see Graph 5). Disruption to supply chains continues to be a hot topic among businesses. Initially, this disruption was generally limited to delays in products being received from overseas, but over the last few months it has also become evident in significant shipping cost increases being faced by many firms. Some businesses are trying to avoid passing these higher costs on to their customers, but the longer the disruption persists, the more likely it is that firms will be forced to increase their prices as well.

Graph 5

Businesses are also facing other cost pressures emanating from a mix of government regulations and necessary responses to COVID-19. The pandemic has forced extra sanitation and cleaning costs on many businesses, particularly in consumer-facing industries. The lack of access to foreign workers has also placed upward pressure on wages for some businesses.

At the same time, the government is pushing up costs for businesses by doubling the minimum amount of sick leave available to employees and introducing a new public holiday for Matariki next year. These employment changes come on top of the 27% increase in the minimum wage over the last three years, and these large increases seem likely to continue given that the living wage has increased from $20.20/hour to $22.75/hour since Labour came to power in 2017.

Without getting into the politics of these changes, we anticipate that many businesses will have little choice but to pass these cost increases on to their customers. Profit margins were already being squeezed prior to COVID-19, and with demand having quickly recovered after lockdown, firms might come to the realisation over the next 12 months that now is as good a time as any to try and restore their margins.

Pricing intentions are at their highest in over 20 years. After holding prices down throughout the last decade, firms have more cover than ever from other factors to justify higher prices.

In setting monetary policy, the Reserve Bank will look past the initial effects of most of these factors on inflation, adjudging them to be temporary or outside the Banks’ ability to change. Despite a brief spike in inflation to 2.2%pa this year, we expect underlying inflation to still be sitting at a more comfortable level of around 1.5%pa in the near term.

We forecast that inflation will gradually accelerate towards 2.0%pa during 2022 and 2023. This pick-up could lead to an increase in the official cash rate as soon as early 2023, but our expectation of subsequent rate rises is slow and limited. We continue to expect the Reserve Bank to err on the side of overstimulating the economy, given the uncertainty posed by the pandemic, and the fact that inflation has mostly surprised on the downside throughout the last decade. Nevertheless, the tightening labour market and associated wage cost pressures suggest there are upside risks to both our inflation and official cash rate forecasts.

There have been potentially significant shifts in the housing market landscape since our previous forecasts were published in early February. Firstly, the Reserve Bank announced that its loan-to-value ratio requirements for investors would be set at 40% from May, exceeding expectations that the minimum deposit would be reinstated at the 30% level in place prior to the pandemic.

Even more importantly, the government announced substantial changes for property investors in late March, with the bright-line test being extended from five to ten years, and mortgage interest expenses no longer able to be offset against income for tax purposes. The latter measure is being phased in over four years for properties already owned by investors, while the government has proposed that newly built homes will be exempt from both changes.

The fact that the change to interest deductibility is being introduced when mortgage rates are at record lows, and is being gradually phased in over four years, should prevent any completely forced sales or rushed panic selling. Nevertheless, there is already anecdotal evidence that investor demand has softened and that they are being more cautious when considering their potential purchases. We expect the fear of missing out that had gripped the market over the last six months will now quickly dissipate. There could be small quarterly price falls throughout the middle part of this year, reversing some of the rise that has occurred in recent months.

Ultimately, the government’s measures to try and improve the supply of housing will be more critical to preventing housing unaffordability becoming worse. The $3.8b Housing Acceleration Fund, intended to help provide infrastructure and open up new subdivisions, should assist residential development over the next few years. Other moves to replace the Resource Management Act and reduce planning and zoning restrictions should also start to pay dividends by the end of our five-year forecast period.

We also expect that the differential treatment of new and existing homes for property investors, alongside more relaxed LVR restrictions for new homes, will swing the pendulum further towards new construction taking place. The risk is that the other changes implemented by the government undermine the existing property market to the point that developers are reluctant to undertake new projects for fear of falling property prices.

However, this outcome is not our central forecast at the moment: we don’t see house prices falling, or becoming much more affordable, in the short term because of the recent housing announcements. Graph 6 shows that we expect house prices to track sideways throughout the next five years and be little changed between now and 2026. In inflation-adjusted terms, this outcome would represent an 8.3% drop in real house prices from March 2021 levels, providing a limited amount of relief for people who have been priced out of the market currently.

Graph 6

It is worth highlighting that the current lack of speed in New Zealand’s vaccine roll-out is beginning to sound alarm bells for our economic recovery. New Zealand is now behind most other developed countries for getting jabs out into the population. News in recent weeks around underutilised vaccination centres, IT systems, and unvaccinated border workers is concerning. A slow roll-out could hamper just how quickly New Zealand is able to reopen up to the world, thereby slowing the economy’s recovery during 2022 and beyond.

With the country’s path out the other side of the COVID-19 pandemic starting to become clearer, attention is starting to return to issues that New Zealand had been grappling with previously. Arguably the two highest-profile issues are the housing crisis (including its interrelated effects on poverty) and climate change. Apart from the government’s housing package, we have also seen the Climate Change Commission release its draft report in early March.

Unfortunately, we have extremely little evidence from the last 3½ years of the current government’s ability to deliver major programmes or policy changes. KiwiBuild, light rail in Auckland, “shovel-ready” projects, and even the length of time it has taken to get a Trans-Tasman travel bubble in place exemplify the wide gap between intentions and actions.

With a clear majority in parliament, Labour must now make use of its political numbers and capital to start delivering change around these critical long-standing issues. The government must now realise that there is broad consensus about the need to address these problems and, by taking bold action, there is much less political risk than before of alienating the electorate. As we have seen over the last 10-15 years, a lack of clear direction and leadership means that the problems will simply continue to get worse while the talkfest continues.