Housing to decide our fate

- Westpac Economics Department


Some of the key outcomes were:

• consumer confidence recorded its biggest quarterly gain in six years, rising to a 12-month high;
  
• house prices jumped 5% in two months, lifting the annual pace of growth back above 10%;
  
• net migration is at its highest level since November 2005;
  
• business confidence is positive for the first time in four years, lifting business investment and employment intentions;
  
• business lending growth is accelerating;
  
• marked drops in petrol prices; and,
  
• commodity prices in November reached their highest level on record.

With such a wide range of indicators all pointing one way it is hard to deny that economic activity finished 2006 on a high note. Moreover, the broad based nature of the pick up, and particularly the stronger terms of trade and migration, suggests that the momentum is likely to be sustained, at least into the first quarter of 2007.

That said, we need to keep this 'resurgence' in activity in perspective. One of the key factors feeding activity and confidence has been the dramatic fall in petrol prices - the impact of which is not expected to last.

A fuel-injected stimulus

After a sharp increase in petrol prices through most of 2006, it is not surprising that the 40c/litre fall in prices since mid-August has induced a sense of euphoria amongst business and consumers. The steep drop in prices has not only freed up cash for consumers to spend on other goods (as reflected in the lift in retail sales to date), it has also brought some greatly needed cost relief to businesses. The latter has been reflected in business surveys where profit expectations have improved noticeably, along with employment and investment intentions.

However, in order for petrol to continue providing an impetus to spending growth we would need to see further dramatic falls in oil prices, which seems unlikely. Oil prices, at just over $50/barrel at the time of writing, are already at 12 month lows. This has resulted in increased speculation that OPEC will cut production in order to lift prices, with talk of a target of $60/barrel. Moreover, with the NZ dollar expected to fall over the coming year, downward pressure on petrol prices is likely fade through 2007.

Outside of petrol, there are other favourable factors that will continue to support economic activity. These include a solid fiscal position with the government expected to continue adding to demand via increased transfers and higher infrastructure spend, strong business balance sheets, and a buoyant labour market. All of these factors will help to ensure that domestic spending growth remains positive. However, the key determining factor going forward will be the housing market.

Housing to decide our fate

Of all the indicators released at the end of last year, it is those relating to the housing market that have generated the most discussion. For some time we have been calling for a correction in the housing market, but this continues to elude us. In fact, prices have experienced another leg up, and the recent upward trend in sales looks to be becoming more entrenched. Days to sell remain low at just 29 days.

Some of this more recent upturn appears to be related to fundamentals - in particular migration. Net migration continued to surprise on the upside through 2006, and in November leapt to its highest level in two years, with a net 14,757 people entering the country. The increase is coming both from strong growth in arrivals of non-NZ nationals and strong growth in the arrival of NZ nationals. The flows are well above Westpac and the RBNZ's expectations and at current levels are having a material impact on the demand for housing.

Net migration is likely to continue to rise in the near term, with residency approvals suggesting the arrival of non-NZ nationals will continue at a healthy pace over the next six months.

But, even taking into account the stronger migrant flows, the imbalances in the housing market have reached a point where a correction is a case of when, not if.¹ In particular, household debt and debt servicing costs have increased dramatically and rental yields are low. Moreover, measures of housing affordability reveal that the New Zealand housing market is more stretched than in the US, Australia or the UK when they entered their correction phases.

However, with a large part of the recent strength seemingly related to sentiment rather than fundamentals, we remain unsure as to the timing of the correction. What we are sure of, though, is that when the housing market does correct, the New Zealand economy is in for a significant rebalancing.

With house prices expected to go sideways for several years, households will cease withdrawing equity from their homes in order to finance their spending outside of income growth. This implies a much more conservative consumer and a prolonged period of slow economic growth.

Export outlook

Thus once again, the onus is on the export sector to come to the economy's rescue. And, despite the renewed strength in the currency, export volume growth has been pulling its weight in recent times. Export volumes lifted 3.3% in the September 2006 quarter - almost matching the 3.9% increase recorded in the June quarter, and more than outpacing the strength in imports. But it would be a brave call to say that this is the start of the rebalancing of growth in the economy. Looking into the detail reveals that much of the recent export growth has been confined to pastoral exports, particularly dairy and meat. Moreover, the export growth has largely come from inventories, which in itself suggests that the recovery experienced to date is unlikely to be sustained.

In fact, the renewed strength in the currency has seen us push out our anticipated export recovery into 2008 given that the exchange rate impacts on the real economy about five quarters down the track.

But there is a bright side in the current export outlook, and that is commodity prices and the terms of trade. Prices are at record highs in global terms and have provided substantial offset to the strong currency for many - about 50% of NZ merchandise exports are commodity based. At the same time, cheaper imports - particularly oil - mean that the terms of trade is set for a substantial boost. Thus, while export volume growth may be weak, income growth for our exporters will be substantially stronger.

By 2008 H2, we expect the combination of a lower NZ dollar and solid global growth to boost export volumes. Meanwhile, moderate domestic spending growth will see the demand for imports moderate, with the lower NZ dollar also assisting by increasing the cost of imported goods in local currency terms.

¹ Note that by correction we are not talking about falling house prices. Rather we expect the market to enter a prolonged period of flat prices.

* This article is abridged from the original. For a full copy contact NZIJ on 0800 90 60 90 or email invest@nzij.co.nz.