Our annual From the Beach article typically highlights the major issues or risks faced by the New Zealand economy in the coming year. But as 2014 gets underway, we have the rare situation where most economists agree about what the next 12 months holds. GDP growth is forecast to accelerate from its current rate of 2.6%pa, with interest rates also rising steadily.
So with businesses gearing up for healthy growth, we see little point in worrying too much about what’s in store during 2014. Instead, it makes sense to turn our attention to what might happen in 2015. Attendees of our presentations in late 2013 will recall that our predictions for economic growth in 2015/16 are significantly more optimistic than those of most other forecasters. If we are correct, firms should be preparing for a two-year run of improving business conditions. But what factors could disrupt the economy’s momentum, prevent the good times from stretching through into 2015 and beyond, and leave firms having overinvested in additional capital or labour resources?
Reacting to higher interest rates
Since the hawkish Monetary Policy Statement by the Reserve Bank in December and the strong September quarter GDP growth numbers, financial markets have been focused on the prospect of interest rate rises in New Zealand this year. Fixed mortgage rates have lifted to their highest levels in about two years, although the lowest rates on offer are still about 140 basis points below the average of the last decade.
The effective mortgage rate (the average interest rate faced by households across all their mortgage debt) appears to have bottomed out at 5.5% and will start rising during 2014. But with 57% of mortgage lending still on fixed rates, it will take time for interest rate rises to materially affect households’ discretionary spending. By the end of 2014, the effective mortgage rate is only likely to be about 5.8% – no higher than it was in mid-2012.
The figure of most concern is household debt levels which, at 148% of income, are higher than at any time prior to 2006. This high debt-to-income ratio suggests that households may be more sensitive to interest rate rises than in the past – particularly when the effects of the Global Financial Crisis on risk appetite and attitudes to debt are taken into account as well. We believe that, given rising employment and incomes, there is scope for consumer spending to continue growing beyond the next 12 months, but are wary of how pronounced the reaction to rising interest rates will be.
Keep an eye on electronic card and retail sales data – annual growth in core retail volumes was 4.3% over the last year and should at least maintain a similar growth rate throughout 2014.
What scope for another housing market rally?
Tied up with the prospect of rising interest rates is the housing market. However, the introduction of loan-to-value restrictions by the Reserve Bank late last year has added a further layer of complexity to housing market activity beyond the traditional drivers of population growth and mortgage rates. Early indications of the policy’s effects are that sales activity may have been knocked down by more than 10% as a chunk of first-home buyers are shut out of the market, but there is no clear sign yet of a rising stock of listings or properties spending longer on the market before selling.
Even without the LVR restrictions, it was our view that house price inflation would slow during 2014 as mortgage rates rose and affordability levels, particularly in Auckland, became more critical. The following questions are keys for the housing market outlook beyond this year.
- Does increased sensitivity to interest rate rises limit the scope for further house price growth in 2015?
- Are the effects of the LVR restrictions relatively transitory, or do they continue to affect the potential for expansion through into 2015?
- How persistent are the undersupply issues in Auckland, especially given that preliminary census data suggests population growth may not have been as fast as was previously thought?
The flow-on effects of the housing market on consumer confidence and residential construction can be significant. History suggests that it is difficult to achieve a period of strong economic growth if the housing market and building activity are heading in the other direction.
Rebuilding activity in Canterbury also cannot be ignored when thinking about prospects for the economy. Since the quakes, our predictions of the rebuild have been more gradual and prolonged than most other forecasts. This factor augurs well for economic activity in 2015, almost irrespective of what the standard cyclical drivers of the housing market may be telling us later this year.
Keep an eye on house sales, which typically turn ahead of days to sell and house price inflation. Sales are likely to be softer in the first half of 2014, but renewed growth will need to reappear in the second half of this year.
The sustainability of export incomes
The terms of trade surged 17% higher during the first three quarters of 2013 and is now just 5.7% shy of the all-time peak recorded in 1973. Export prices have been underpinned by a 36% rise in world dairy prices since the end of 2012, according to ANZ’s commodity price index, but a 14% increase in forestry prices and a 10% lift in meat prices should not be overlooked.
Nobody is expecting the terms of trade, or export prices, to stay so high. The latest range of forecasts sees the terms of trade in 2015 and 2016 between 2% and 8% below its current level. High dairy prices, in particular, will ultimately encourage increases in output from other producers across the USA, South America, and Europe. Even with demand conditions for dairy products remaining strong across China and the developing Asian economies, the pay-out for dairy farmers in the 2014/15 season is likely to dip back below $8/kgms.
Data from DairyNZ suggests that dairy farmers need a pay-out of about $5.20/kgms to break even. It’s worthwhile remembering that the 2012/13 pay-out was not much above the $6/kgms mark, so a substantial reversal in dairy prices could quickly place a squeeze on economic activity in the provinces. Big rises in input costs, such as fuel or fertiliser, could have a similar effect. And if rising input costs were symptomatic of broader import prices or global inflationary pressures, they would also potentially start to drive down the terms of trade and New Zealanders’ overall purchasing power. It is well established that rising petrol prices, in particular, have a contractionary effect on broader economic activity.
Keep an eye on commodity export prices, including Fonterra’s GlobalDairyTrade auction prices. Rising import prices, particularly for petrol, would have a similar effect to falling export prices on economic growth prospects. A moderate dip in the terms of trade is likely this year, but a decline of more than 10% risks undermining growth prospects in 2015.
Constraints in the labour market
With economic growth accelerating during 2014, the unemployment rate is forecast to dip from 6.2% to between 5.0% and 5.7% by the end of this year. Although the tightening labour market is not in question, it is unclear how significantly capacity constraints could start to restrict growth heading into 2015. Both skilled and unskilled labour are becoming more difficult to obtain, and wage costs will come under upward pressure as firms compete harder to hire and retain staff.
In particular, construction activity is set to be a significant contributor to economic growth over the next 2-3 years, but this sector also faces some of the biggest potential labour constraints. These constraints help to spread activity over a longer period of time and thereby reduce the extremes of the boom/bust cycle, but persistent and significant constraints also have the potential to undermine economic growth in 2015 and beyond.
Keep an eye on wage inflation and measures of the difficulty of finding labour. An increasingly tight labour market does not necessarily mean that economic growth will falter next year, but the longer and harder that the labour market gets stretched, the more likely that it will eventually cramp growth.
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