Key Macro Themes for 2007

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The National Bank outlines their thoughts on the Top Ten macro themes for the year.

Friday, January 26th 2007, 9:29AM

The National Bank outlines their thoughts on the Top Ten macro themes for the year.

1. Inflation still dominates the outlook.
Despite economic growth slowing to below 1.5%, medium-term inflation pressures, and particularly non-tradable inflation, remain persistent and elevated.

We see inflation dipping temporarily in H1 2007 courtesy of lower petrol prices but pushing back up towards 3% in late 2007, then easing slowly subsequently. Such inflation persistence and risk necessitates a period of sub-par growth, which means financial conditions need to remain tight for some time.

We expect 1.5% growth over 2007 – in effect a repeat of 2006. The Reserve Bank will not rest easy until non-tradable inflation is tamed, even if headline inflation stays within the target band.

2. Stronger productivity growth remains the missing link between improving economic prospects and receding inflation.
Labour productivity growth has been dismal over the past two years, and multifactor productivity growth has eased from 2.5% per annum over the 1992-2000 period to 1.1% over 2000-2005.

Productivity performance needs to improve if economic growth is to recover without a reacceleration in inflation. The challenge to policymakers is to deliver a policy platform that raises the supply-side capacity of the economy and shifts attention to growing as opposed to dividing the pie. Politics may deliver a new broom in this regard.

3. The RBNZ is on hold but will remain very nervous (as will we).
A more restrictive monetary policy stance may be required if the slowdown does not alleviate inflation pressure sufficiently, or the economy goes on a sustained recovery. Our core view is that interest rates will stay on hold, and we are coy about reading too much into indicators pointing towards the economy reflating. New Zealand’s economic indicators are notoriously volatile and the economy is not reflating just as it was not headed into recession in early 2006. But the risk profile for interest rates will be firmly on the upside in the near-term as the Reserve Bank looks to a potential late cycle insurance policy, which ironically would merely reinforce the need for an aggressive easing cycle at some stage down the track. With the neutral 90-day interest rate residing around 6%, even returning rates to the perceived neutral zone at some stage leaves us natural strategic receivers of the 2-5 year part of the curve. We remain equally mindful that the NZ economy does tend to turn aggressively (and the interest rate market with it).

While the 2008 Budget obviously presents a further challenge to our easing profile late in the year, a year is still a long time in monetary policy cycles and circles. Pushing the easing cycle out to 2009 – beyond the realms of the 2008 Budget – would imply a period of interest rate stability no other central bank has undertaken apart from the Bank of Japan.

4. The game of chicken between the currency and interest rates will continue for the first part of this year before we see a major currency move mid-year.
The NZD is high because the economy is perceived to be reflating, and the RBNZ has put a hike back on the table. The carry trade and yield continues to dominate. All are themes that are likely to persist for a while yet, which suggests a firm NZD. Against this backdrop, we expect the reflation theme to become a mirage (particularly given the impact the recent run-up in the currency is having).

Perception towards the carry trade will become dented as global interest rates continue to move up, and the outright yield gap closes (initially from the foreign side). The latter is likely to significantly impact on a sizeable Uridashi maturity profile in the September quarter. Any whiff of the above combination and the NZD is set for a ride and a half down in a similar fashion to early 2006.

Currencies move in cycles and we see no reason the NZD will not eventually follow its historical pattern of spending 3 years undervalued following three to four years of being exceptionally high.

5. Economic imbalances leave the economy very vulnerable, and in serious need of adjustment.
For now our forecasts are stock standard with a benign economic trough and an orderly rebalancing of growth – in effect the holy grail of economic adjustments. But if there is one thing we know from history it is that economic adjustments are anything but orderly. The economy is vulnerable to unexpected shocks that could derail the economy. The current account deficit (9% of GDP) remains precarious, the household dis-saving rate (17.5%) disconcerting, asset classes (notably property) overvalued, and household gearing is high. What these shocks might be is anyone’s guess. Yet we only need to look at geopolitical uncertainty, oil prices, and global imbalances to appreciate that significant risks are apparent.

Historically New Zealand has been knocked for six when such shocks emerge, particularly given our stage in the economic cycle. Investment quality will count at this juncture of the cycle.

6. Liquidity is aplenty, which will mitigate the downside risks.
There is an abundance of capital looking for a home. Both domestically (banking sector) and globally (excess saving from Asian and oil-exporting economies), liquidity is ample. While this presents an added complication for central banks around the world as asset and commodity prices become more volatile, it is difficult to become overly bearish on economic prospects when the liquidity tap is likely to remain firmly open.

7. A helping hand from abroad.
There are three global themes we believe are specific to NZ at present.
- First, strong global growth, particularly in China, will sustain commodity prices at high levels. This dampens some of the economic risk facing the New Zealand economy, and suggests the overshoot in the currency detailed in point 4 will be mild by historical standards. The first derivative of China’s growth boom has been surging hard commodity prices and we expect the second derivative (through rising incomes as opposed to industrial production) to be positive New Zealand’s soft basket.
- Second, we are siding with the Fed over its view for the US economy. We are reminded of the bearish economic sentiment that engulfed New Zealand in early 2006, inversion in the yield curve, weak currency and subsequent recoveries in all. The key lessons from New Zealand’s experience are that economies do not keel over when liquidity is ample and the labour market remains strong. The housing market quickly reflates when the yield curve inverts. This more bullish view of the US, and hence global economy, leaves us with a more bearish bias towards US and global interest rate settings (once again following the NZ monetary policy experience) and reinforces our bearish view of the NZD.
- Thirdly, given the risk profile for global interest rates is to the upside, we expect New Zealand’s yield curve to progressively normalise, and the RBNZ to gain additional policy traction through this avenue.

8. Corporate sector focus: costs, costs, costs.
Slowing economic growth and more recently the high NZD has hit the revenue line and rising costs (especially wages) are inflating the expenditure side. A tight labour market environment and poor labour productivity performance over the past two years has hampered the corporate sector’s ability to contain rising wage costs. As an indicator of corporate profits we note that the corporate tax take is 3.0 % down on a year ago, while business investment is 5.2% below last year’s levels. Expect the corporate sector’s focus this year to be on cost containment. Precisely when this flows-through to the workforce remains the million dollar question.

9. Households to start sharing the economic burden as the year progresses.
The slow-down that manifested over 2006 was largely borne by businesses with households being insulated via a strong labour market. Labour’s share of income has rocketed to a 15 year high. The corporate sector’s focus on costs will see less demand for labour, leading to gradually higher unemployment. This turn in the labour market is the missing ingredient transferring the economic slowdown from the corporate sector to households and delivering the sustained slow-down the Reserve Bank is seeking. While we expect the unemployment rate to remain low, the household sector still looks vulnerable to even a mild turn in job prospects given the stretched nature of the household balance sheet, and notably high debt servicing ratio.

10. Let’s not forget the positives.
New Zealand’s major commodity prices have moved to a higher structural plane. China and India will become of increasing importance to New Zealand over the coming years. New Zealand’s macro framework is working a treat. We are starting to see smarter investment offshore. Signs of stronger growth are met by higher interest rates and currency. The reverse also applies and such movements iron out the peaks and troughs, leading to more stable outcomes. Significant investment in infrastructure and exploration is being made. New Zealand has some pockets of mineral wealth. Of course there are numerous judgments that underpin these views. Current imbalances are unsustainable and need to adjust. We expect these imbalances to weigh heavily. The neutral 90-day interest rate is around 6%. Fair value for the NZD/USD resides between 0.62-0.64. As imbalances are purged the economy could be expected to revert to its potential growth rate, thought to be around 3%. Economies and financial markets tend to mean-revert to such anchors.

But what if our judgements of these anchors prove to be wrong? There are certainly some anchors such as the economy’s potential growth rate and the neutral interest rate level that we are becoming increasingly queasy about. For instance, if the economy’s potential growth rate is now lower at 2.5%, growth could be weaker for longer and the Reserve Bank would have to keep rates higher for longer to purge excess demand. Equally, if the neutral 90-day interest rate is above 6.0%, interest rates are likely to stay higher for longer.

A lower potential growth rate would have material implications for asset valuations all-round. Increasingly, central bank officials in the US, Australia and Canada are debating whether the potential growth rate in their respective economies are in fact lower than originally thought.

Such debate is largely absent in New Zealand at the moment, but may generate increasing policy attention this year. With regards to economic adjustments, our judgement is that it will be an orderly rebalancing process. But what if it is more abrupt, as history and the Iceland experience last year show is a real possibility? Or what if the current imbalance does prove to be sustainable in a world awash with capital?

Ultimately it is the qualitative risk profile that accompanies the quantitative assessment that matters, and how the risk profile changes as the year progresses.

Source: The National Bank, Market Focus Newsletter

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