Bouncing back after Delta… but then what?

The Delta outbreak has thrown around many of our forecast numbers for the next year and underscores the continued uncertainty in our outlook. However, the economy showed outstanding resilience to bounce back after the first lockdown last year, and we expect to see a similar recovery again this time. Our central view remains for the bounce-back to continue, although we signal the risk that sustained restrictions could weigh on economic activity and fundamentally alter the outlook heading into 2022. Our central view means the stresses evident in the economy prior to lockdown, including substantial cost pressures and a very tight labour market, will continue to be present, and interest rates have started to rise as a result. The onus is now on the government to provide a clearer plan for how the New Zealand economy is reintegrated with the rest of the world throughout 2022, reducing uncertainty for businesses and those people wanting or needing to undertake international travel. These plans need to factor in the difficulties achieving the 90% vaccination rate that the government is targeting.

Lockdown 2.0 has been a rude shock for anyone hoping that 2021 was a year of improvement on the road to some kind of new post-COVID “normal”. The Delta outbreak has played havoc with many of our headline numbers, as implied by our GDP forecasts in Graph 1. We estimate that the lockdown during August and September will have knocked about 7.6 percentage points of economic activity. Supply has once again been heavily constrained by the inability of many workers to operate at Alert Level 3 or 4, and household spending has been cramped by the limited number of retail options.

Graph 1

Although lockdowns are disruptive for the economy, last year’s experience tells us that the economy should bounce back quickly from the enforced shutdown. One of the key pillars of this expectation is appropriate government support, and the government has once again come to the party with the Wage Subsidy and the Resurgence Support Payment. These measures have helped businesses to maintain their staffing levels and keep paying their workers, as well as assisting with cashflow at a time when revenue is sharply down.

Neither package is designed to completely offset the effects of lockdown on firms’ profits or balance sheets, and we also note that the wage subsidy is less generous than the 12-week lump sum that was paid during the 2020 lockdown. Nevertheless, it is also worthwhile noting that uptake of the government’s support has been lower than it was last year. This reduced uptake suggests that parts of the business community have been less affected by this year’s lockdown or are confident that they will be able to recoup any lost revenue in subsequent months.

Perhaps the most pleasing aspect of the latest lockdown has been the more limited increase in Jobseeker Support beneficiary numbers. The number of beneficiaries rose by 8,067 over the five weeks to 17 September, which is a fraction of the 45,600 increase that occurred in 11 weeks between March and June 2020. The modest increase confirms a lack of panic among businesses, a sense that any restructuring or redundancies that were planned were pushed through last year, and that letting workers go is now a last resort given the incredibly tight labour market that had developed throughout 2021 prior to lockdown.

Early indications are that households have returned to the shops, making up for lost time, as the country has moved back down the alert levels. Spending outside Auckland at Level 2 Delta and Level 2 was around 6% above pre-pandemic levels, although Auckland spending remained substantially limited. This willingness to spend is backed up by solid consumer confidence and good job security, with consumer and business confidence surveys not showing a sharp dive like in 2020.

Although most businesses have been able to successfully navigate lockdown and remain relatively upbeat about future revenue prospects, we get the sense that the distributional discrepancies are more acute than during last year’s lockdown. Hospitality businesses are clearly bearing the brunt of the latest restrictions, with Auckland recording the longest period at Alert Level 4, greater limitations on customer numbers at times in Level 2, and the popping of the Trans-Tasman bubble that had provided some boost to revenue in the June quarter. For some restaurants, cafes, event organisers, and tourism operators, this lockdown could be the straw that breaks the camel’s back. Having burned through a lot of reserves during last year’s lockdown, it is likely that some firms will not have the cash or the appetite to keep going this time around.

In terms of overall economic outcomes, we don’t expect the disappearance of these businesses to be catastrophic for the economic outlook. It is likely that the negative effects on employment will be dwarfed by the downsizing and restructuring that occurred when COVID-19 initially struck. Nevertheless, it is important to highlight these inequities to reiterate that not all industries, regions, and parts of the workforce are being equally affected by the pandemic.

Although reasonably normal life and the economy’s strong performance have been temporarily disrupted by lockdown, the same issues that were dominating our thinking previously are still likely to be present as the country moves back down the alert levels. Many of these end results of these issues are found in inflation, which we now expect to peak at a 10-year high of 4.2%pa at the end of this year (see Graph 2).

Graph 2

The shorter-term drivers of this inflation spike mostly relate to the imbalance between very strong demand conditions and the ongoing disruption to supply chains and international freight. These pressures are not limited to New Zealand. Demand conditions globally are very strong as consumers enjoy fewer restrictions and spend some of their forced savings from the last 21 months. This rebound in demand has been intensified by the massive fiscal stimulus globally, which has meant there is a lot of money flowing through the system, accompanied by very low interest rates that are also encouraging more borrowing and spending.

On the supply side, production is still being hampered by COVID-19 and shortages of some materials and componentry. These supply issues are being compounded by hugely inflated shipping costs (see Graph 3) and ongoing delays in getting product to and through ports.

Graph 3

Within New Zealand, the prolonged lockdown in Auckland has also exacerbated supply issues for some products. Manufacturing that is concentrated in Auckland was unable to operate at Level 4, but demand ratcheted back up across the rest of the country at Alert Level 3 and 2. This supply disruption has been particularly noticeable in parts of the construction industry.

The combination of rampant demand and restricted supply has led to upward pressure on prices. Conditions mean that there is less need for businesses to offer discounts because they are generally low on stock or are faced with more demand than they can meet. The widespread pressure on costs is also making businesses more comfortable with raising prices, unlike much of the previous decade, when firms were concerned that they would lose customers or market share if they tried to charge customers more.

It’s difficult to get a firm idea of when the world’s shipping woes might be rectified, but general sentiment suggests that freight costs could remain highly elevated for the next 18 months. Additional new ships are likely to become available by that point, but questions remain about port capacity and the ability to work through the freight backlog and reduce congestion. At the moment, we would be surprised to see a normalisation of shipping costs before 2023.

We currently expect inflation to slip back inside the Reserve Bank’s 1-3%pa target band in the second half of next year. However, global cost pressures could easily persist for longer, creating upside risks to the peak inflation rate and, more importantly, threatening to cause a more sustained tail of inflation within the New Zealand economy.

Although most of the price pressures discussed above appear to be relatively temporary, the ongoing tightness in the labour market looks unlikely to disappear anytime soon. The plunge in the unemployment rate from 5.3% to 4.0% since September last year has seen labour and skill shortages spread rapidly across the economy, forcing businesses to pay more to attract and retain staff. Higher wages have added to the raft of cost pressures already being faced by firms.

We have revised down our forecasts of the unemployment rate between now and mid-2023, largely on the basis of the fall in jobless numbers we have already seen. Annual growth in the labour cost index is expected to reach a 13-year high of 2.7% in early 2022.

Despite persistent labour cost pressures, we now expect the labour market to be less tight over the medium term than we were anticipating in our July forecasts. The government’s recent announcement that it will make residency available for an estimated 165,000 workers on various temporary visas will lead to a significant reduction in foreign migrant departures over the next three years and help shore up the workforce. The announcement is reflected in both our forecasts of net migration and the unemployment rate, with the latter now expected to hold in the 4.0-4.5% range between 2024 and 2026.

Graph 4

This pathway to residency provides much-needed certainty to migrant workers in New Zealand and will reduce departure numbers throughout the next three years. But it will not solve the current shortage of workers – it will only stop it from getting worse by enabling those people to stay in New Zealand. Any more genuine relief for businesses struggling to find staff is only likely to come as the borders reopen and workers from overseas become more accessible. And although the government’s immigration “reset” seems temporarily to have taken a backseat to the pragmatic realities of the 2021 Resident Visa, we remain of the view that a net migration inflow of 30,000-40,000pa looks to be a likely target over the medium term (see Graph 5). The implications of a more slowly growing workforce will be more persistent pressure on labour costs and slower growth in potential output, unless New Zealand improves its mediocre productivity performance.

Graph 5

The two monetary policy objectives of the Reserve Bank are to target price stability and maximum sustainable employment. With the outlook for both variables running hot, it is unsurprising that expectations for interest rates have also lifted significantly over the last six months. Even when we published our last forecasts in July, we were only predicting the official cash rate (OCR) to get to 0.75% by the end of 2022. But very strong inflation and labour market results, backed up by strong GDP data, have made such stimulatory monetary conditions untenable.

August’s lockdown saw the Bank defer its expected official cash rate increase, but we have since seen the tightening cycle begin in October. We now expect the OCR to be at 1.25% at the end of next year (see Graph 6), but the risks to this forecast are tilted toward the upside by as much as 50 basis points.

Graph 6

We continue to take the view that households will be sensitive, but not susceptible, to interest rate increases of this magnitude. The lowest available mortgage rates have already risen from 2.2% to about 2.7% since June, and we expect further increases to at least 3.3% by the end of next year. As existing mortgages are refixed, these higher rates will reduce households’ funds for discretionary spending and start to limit growth in private consumption. Graph 7 shows that we expect growth in household spending to slip below 2%pa by 2024.

Graph 7

Higher mortgage rates are also likely to stunt future house price growth. Our analysis suggests that one of the reasons buyers have been able to bid up prices so far is because the servicing costs on larger mortgages have shrunk so much as interest rates have fallen. Although house-price-to-income ratios are eyewatering, servicing costs as a percentage of incomes look reasonably normal by historical standards. However, as interest rates track back upwards, potential property buyers will be less willing to take on such hefty debts.

Although household spending (outside Auckland) has bounced back strongly from the recent lockdown, we have added an element of caution into our projections for business investment. The ongoing threat of possible restrictions on trading activity, the spectre of interest rates rising considerably sooner than had previously been expected, and the costs and delays of imported plant and equipment due to international shipping disruption will all give businesses pause for thought before committing to new investment. Graph 8 shows that, overall, we still expect business investment to track upwards from mid-2022 onwards. However, it might be a couple of years before the hole in investment caused by this lockdown is caught up.

Graph 8

The Delta outbreak and lockdown have increased the pressure on the government to provide a roadmap for New Zealand’s future. Some details have started to emerge, including the assertion that a vaccination rate of 90% of the eligible population (or 76% of the total population) should be sufficient to avoid future lockdowns and widespread restrictions on people’s movements and business activity. Yet international data shows many other countries COVID-19 vaccination rates plateauing in the 65-70% range for the total population. Child vaccination rates in New Zealand for the year to June 2021 sat between 73% and 92%, suggesting that a 90% rate will be difficult to achieve. And after a boom in vaccination numbers during August and September when the Delta outbreak hit, first vaccination numbers have slowed despite about 20% of the eligible population still not having booked or had their first shot.

Against this backdrop, it remains unclear what the government will do if the vaccination targets outlined above are not reached, or if there remain significant vaccination shortfalls for specific ethnic groups or in particular geographic areas. Recent moves to increase alert levels in some parts of the country, based partly on low vaccination rates, underscores the difficulty in predicting the economic outlook until the health and vaccine outcomes are clearer. There is also ongoing uncertainty about what restrictions might be retained over the medium term, such as limitations on numbers at venues that could continue to affect the hospitality and events sectors, for example. However, the likelihood of such limitations persisting appears to have reduced with the announcement of the government’s mandated vaccine certificate system.

The other major area of uncertainty is centred around the border reopening and reintegration of New Zealand with the rest of the world. The government has started to provide a little clarity in this regard, stating that only vaccinated foreigners will be eligible to enter New Zealand. And the broader migration picture has been partially resolved by the announcement of the 2021 Resident Visa.

Nevertheless, it is still very difficult to predict the timing and scale of cross-border movements resuming in terms of either migration or tourism. There is immense pressure coming on the government from the limited MIQ capacity, and it seems the government is pinning most of its hopes to resolve this bottleneck on vaccination both here and overseas.

One of the biggest risks for New Zealand is that any ongoing significant restrictions on people, either domestically or in terms of international travel, could lead to widespread dissatisfaction or disconnection if the rest of the world is opening up. At the moment, countries such as Singapore, Denmark, and Portugal are guinea pigs for how a post-COVID world might operate. But increasing freedoms across a broader range of countries will inevitably turn the focus back on New Zealand’s transition from COVID-19 elimination to how we live with the virus. Failure by the government to get the timing and scale of that transition right could have negative long-term consequences for the tourism sector and other business linkages with overseas. General dissatisfaction among the population could also result in lower net migration, with fewer foreigners willing or able to come here, and more New Zealanders likely to leave if conditions overseas have stabilised.

Our latest forecasts show an economy with strong foundations that is still resilient. The bounce-back in economic activity since COVID-19 hit last year has been far better than originally anticipated, which provides confidence that the economy can withstand the latest setback caused by the Delta outbreak. There are risks that it will take longer to bounce back, given that restrictions in Auckland are more extended this time around. Regardless, economic pressures are building, presenting other challenges for policymakers, businesses, and households.

Uncertainty still reigns, with the domestic and global picture subject to substantial change, as vaccinations roll out, reopenings are attempted, and virus variants emerge. The rollercoaster ride of this global pandemic is not over yet.