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ANZ RESEARCH

NEW ZEALAND ECONOMICS ANZ QUARTERLY ECONOMIC FORECASTS

JUNE 2013

INSIDE Key Economic Forecasts 2 NZ Economic Outlook 3 Global Outlook 7 Commodity Prices 8 Labour Market 9 Fiscal Policy 10 Inflation 11 Exchange Rate 12 Interest Rates 15 Economic Forecasts 18 Key Economic Indicators 19

NZ ECONOMICS TEAM

Cameron Bagrie Chief Economist Telephone: +64 4 802 2212 E-mail: [email protected] David Croy Head of Global Markets Research, NZ Telephone: +64 4 576 1022 E-mail: [email protected] Mark Smith Senior Economist Telephone: +64 4 802 2199 E-mail: [email protected] Sharon Zöllner Senior Economist Telephone: +64 4 576 1062 E-mail: [email protected] Carrick Lucas Strategist Telephone: +64 4 802 2357 E-mail: [email protected] Steve Edwards Economist Telephone: +64 9 357 4065 E-mail: [email protected] Con Williams Rural Economist Telephone: +64 4 802 2361 E-mail: [email protected]

GREASING THE WHEELS NEW ZEALAND ECONOMIC OUTLOOK The economic outlook has a reasonably solid look to it, though there is likely to be ongoing quarterly volatility and disparate rates of sector performance as significant structural forces continue to collide. We’ve pencilled in 2.4 percent growth this year and 3 percent the year after. Microeconomic forces will play a key role over the coming years, greasing the economy’s wheels. A key judgement we are making is that the current rundown in household saving will prove temporary, necessary to rebuild the economy’s resilience.

GLOBAL OUTLOOK Central bank actions continue to underpin asset values and risk appetites. Against a backdrop of improvement, necessary ingredients to a sustained improvement in solvency across key nations remain absent. Trading partner growth is expected to remain respectable, though we’re cautious. Poor fundamentals continue to clash with liquidity: it’s a recipe for continued volatility.

COMMODITY PRICES Just about all NZ’s main soft commodities are set to show some improvement at the farm-gate in 2013/14. Often the main driver is supply reductions from weather-related events domestically or abroad. But equally important are changing trade patterns. However, a supply response from Northern Hemisphere competitors later in the year will place some downward pressure on international prices. We expect a 2013-14 milk price of $6.80 per MS.

LABOUR MARKET The labour market is improving, though it’s far from across the board. General economic frictions imply the same for the labour market. We expect the unemployment rate to gradually gravitate lower over the coming two years. Modest employment and wage growth beckon.

FISCAL POLICY The fiscal accounts are on an improving trajectory and we expect a return to surplus by 2015. Fiscal retrenchment will be a material headwind to growth, but that’s a necessary side-effect. A small collection of microeconomic initiatives aimed at extracting more value deserves more positive attention than is being given.

INFLATION Inflation is expected to remain low over 2013, capped by contained domestic drivers and the high NZD, before moving gradually higher and settling above the target midpoint as suppressants subside. The strengthening domestic expansion is the dominating driver of inflation over the second half of the projection period.

EXCHANGE RATE The NZD remains overvalued and we expect it to remain so through the coming two years. We expect the NZD/USD to end 2013 towards 0.80/0.81 and slowly subside thereafter. It’s a similar story against the other crosses, bar the AUD, where the NZD has been re-rated into a higher zone.

INTEREST RATES

We’re picking the first half of 2014 to be the start of a slow and steady normalisation of monetary policy. Tensions from conflicting economic forces (housing stronger, a high NZD) mean macroprudential tools as an ancillary policy weapon are a reality: this will support but not replace monetary policy and the OCR. We expect local bond yields to rise gradually in coming years, with global yields set to rise from late 2013.

ANZ Quarterly Economic Forecasts / June 2013 / 2 of 21

KEY ECONOMIC FORECASTS

Calendar Years 2010 2011 2012 2013(f) 2014(f) 2015(f) 2016(f)

NZ Economy (annual average % change)

Real GDP 1.8 1.4 2.5 2.6 3.1 2.5 2.2

Employment 0.7 1.6 0.0 0.8 1.4 1.2 1.1

Unemployment Rate (Dec qtr) 6.7 6.3 6.8 5.9 5.5 5.5 5.6

Terms of trade (SNA basis) 9.1 3.0 -4.3 2.1 3.7 1.2 0.8

Global Growth (annual average % change)

US -3.1 2.4 1.8 2.2 2.3 2.9 3.0

Eurozone -4.3 1.9 1.5 -0.5 -0.4 0.7 1.5

Australia 1.4 2.6 2.4 3.6 2.6 3.1 3.2

Japan -5.5 4.7 -0.5 2.0 1.9 1.0 0.9

China 8.7 10.4 9.3 7.8 7.8 8.0 7.8

Trading Partners -0.6 4.8 3.4 3.5 3.4 3.8 3.9

NZ Inflation (annual % change)

CPI Inflation 4.0 1.8 0.9 1.2 1.9 2.6 2.3

Non-tradable Inflation 4.6 2.5 2.5 2.7 3.3 3.7 3.2

Tradable Inflation 3.3 1.1 -1.0 -0.7 0.2 0.9 1.4

NZ Financial Markets (end of December quarter)

TWI 69.2 69.3 74.4 74.4 70.3 70.3

NZD/USD 0.78 0.78 0.83 0.79 0.75 0.75

NZD/AUD 0.76 0.76 0.80 0.86 0.87 0.87

Official Cash Rate 3.0 2.5 2.5 2.5 3.25 4.0 4.5

90-day bank bill rate 3.2 2.7 2.7 2.8 3.7 4.3 4.8

10-year bond rate 5.9 3.8 3.5 3.4 4.4 5.3 5.6

Fiscal and External Balance

Current Account Balance ($bn) -9.3 -11.1 -10.4 -11.7 -13.7 -13.8 -12.8

as % of GDP -3.2 -4.1 -5.0 -5.1 -5.3 -5.5 -5.4 Government OBEGAL ($bn)* -6.3 -18.4 -9.2 -6.4 -2.1 0.1 0.4

as % of GDP -3.3 -9.2 -4.4 -3.0 -0.9 0.0 0.2

* Operating balance excluding gains and losses, June years. Forecasts and text finalised 31 May 2013.

KEY FORECAST ASSUMPTIONS:

The value of earthquake reconstruction work is equivalent to $40bn in 2013 dollars. This will be spread across residential ($20bn), commercial and social assets ($15bn) and infrastructure ($5bn). About $15bn of this work is assumed to have taken place by the end of 2016. The net impetus over the next few years will be partly diluted by contractionary fiscal policy, equivalent to 3¼ percent of GDP over the next four years.

The NZD is assumed to average around 80 US cents over 2013 and then gradually decline, ending 2015 at 75 US cents. NZD is assumed to strengthen to 86 Australian cents by the end of 2013, ending 2015 at 87. The NZD TWI is projected to fall from 76.5 at present to 70.3 by late 2015.

Dubai oil prices are assumed to trade within a US$90 to US$110 per barrel range over the forecast period.

Net annual permanent and long-term (PLT) migration inflows are assumed to strengthen to around 15,000 persons over 2013. Net PLT inflows are expected to peak at 18,000 persons over 2014 and will start to taper off as departures lift, with a net PLT inflow of 16,000 persons over 2015, and 14,000 over 2016.

The medium-term potential growth rate is expected to remain in a 2 to 2½ percent range.

Bank funding costs are assumed to continue to gradually decline from current levels. This will push the neutral OCR from around 3¾ percent at present towards 4½ percent by the end of the projection period.


NEW ZEALAND ECONOMIC OUTLOOK

SUMMARY

The economic outlook has a reasonably solid look to it, though there is likely to be ongoing quarterly volatility and disparate rates of sector performance. Significant structural forces continue to collide, which means bumpy, jumpy and grumpy growth. We’ve pencilled in 2.4 percent growth this year and 3 percent the year after, which is reasonable, structural forces considered. Microeconomic forces will play a key role over the coming years, in effect helping to dampen extremes caused by individual structural forces. A key judgement we are making is that the current rundown in household saving will prove temporary. Such restraint is a necessary ingredient of the penance process for rebuilding the economy’s resilience.

OVERVIEW

Our big picture overview remains on track, with the economic outlook influenced by a series of offsetting structural influences:

A soggy national balance sheet. Total net external debt stands at 68 percent of GDP. The household savings rate is zero and the current account deficit is 5 percent of GDP. Nationwide saving remains low in relation to our investment needs. Whilst the Government is striving to balance their books, households are once again showing signs of consuming more than they are earning. Borrowing to fund productive investment that generates an income is one thing, but borrowing to fund consumption is quite another. Ultimately the piper must be paid. The sacrificial pawn is growth.

An uncertain global scene. We’re seeing improvement – though indicators have waned of late – but we suspect we’ll remain prone to wobbles (refer page 7). The spotlight is now turning on Australia, our largest trading partner.

An inappropriate mix of monetary conditions, given the need to rebalance the economy. Mortgage interest rates are at 50 year lows providing considerable impetus to consumer spending and the housing market. While the NZD has lost 5 US cents in slightly more than a month, on a TWI basis the NZD is well above where it ended 2012 and approximately 15 percent overvalued. Long-term correction catalysts don’t look imminent (refer page 12). The NZD has gained 40 percent against the yen over the last year. The NZD/AUD has risen from an exporter-friendly 0.75-0.80 range towards the top of the more neutral 0.80-0.85 zone. An unfriendly mix of monetary conditions means an unfriendly mix of growth, despite balance sheet considerations requiring otherwise. We expect the monetary mix

to slowly start to shift in a direction less obstructive to the required economic rebalancing, but this will be a gradual process.

Rising connectivity to the fast-growing Asia region. This connectivity is helping to underpin strong commodity prices (further boosted by concerns about supply), a rising share of exports heading towards Asia, and more inbound tourists from the region. Our goods terms of trade is lifting and is on track to hit its highest level since the early 1970s: that’s a windfall – we need to sell less to get the same income. But sell more and get a better price and it’s a double-dip quinella.

Steps to unlock New Zealand’s natural resource endowment. New Zealand is estimated by the World Bank (Wealth of Nations) to be the 8th wealthiest country around the globe in terms of natural capital (per capita figures), and the richest when it comes to renewable resources. These represent unique points of difference to drive growth. This doesn’t mean New Zealand should slavishly seek growth at all costs. There are negative externalities to worry about, and growth needs to be sustainable, which means taking heed of environmental aspects. However, there is also a basic reality. New Zealand’s balance sheet is weak. It’s always more palatable to address balance sheet weakness from the income-generating side.

Addressing housing shortages in New Zealand’s largest city. Loan-to-value ratio restrictions to curb housing excesses are pending, but Auckland’s issue is simply too few houses. A supply-side response is in train: 13,000 houses per year to be built. Given population growth of 20,000+ per year in Auckland (more than half New Zealand’s population growth), improving migration trends, and a starting point shortage of 30,000 units, we’re talking at least a decade before the shortfall will be eliminated. Residential-related activity will support growth, but it’ll come with some possible inflation side-effects, which will have the Reserve Bank on tenterhooks. Auckland needs more houses, and the rest of New Zealand can ill-afford to see Auckland’s housing issues drive an asset bubble.

The rebuild of New Zealand’s second-largest city. With estimates of the rebuild revised up to $40bn, an event bigger than Ben Hur has gotten bigger. A glass half full interpretation focuses on the impetus to economic activity: that’s a lot of growth and jobs in the pipeline for years to come. Alas, it comes with hooks: the $15 billion of Government spending supporting Christchurch can’t be spent twice. Higher rebuild costs mean



higher insurance premiums. Auckland and Christchurch’s rebuild needs will place huge pressure on construction sector capacity, which risks forcing the RBNZ’s hand if inflation pressures mount.

Tight fiscal policy. The Government wants to return to surplus by 2014/15. That means taking more money out of our pockets than we get back. The economic headwind is 3¼ percent of GDP over the next four years. Wellington as a region will be a laggard.

Mother Nature. The drought has broken but the damage will take two years to work through the system.

On top of this we have the usual array of cyclical forces. Residential and business investment is recovering from cyclical lows. The lowest mortgage interest rates in 50 years are kick-starting interest rate sensitive pockets, with a turnaround in net migration inflows adding to the demand for housing. This is most evident in Auckland and Canterbury, with house prices 17 and 13 percent above their mid-2007 peaks respectively, while house prices elsewhere are still below or just above their pre-GFC peaks. While the demand for labour is picking up, benign wage growth and regional and sector differences in employment gains suggest a strong and steady nationwide labour market recovery is not yet assured. The return to sub-5 percent unemployment rates remains some way off.

This combination of structural and cyclical forces is resulting in ongoing volatility. Financial conditions and confidence measures are flagging strong growth; the national balance sheet is not.

How New Zealand navigates this concoction will increasingly come down to microeconomics: the small things that can help grease the wheels of an economy. This means keeping an eye on initiatives to expand the pool of construction labour, steps to mitigate Auckland’s housing pressures across multiple facets, how the tradable sector is lifting productivity, steps aimed at lifting public sector performance, how New Zealand is wrapping an innovation strategy around its unique resource mix, what is happening in regard to water, oil exploration and mining, whether New Zealand exporters are evolving from Asia’s opportunities and outright execution of those opportunities… to name but a few. Small things done well add up to macroeconomic muscle. They’ll also help ensure one individual structural force does not dominate the outlook. Auckland’s housing woes are the classic example. If we don’t get the response at the microeconomic level, New Zealand will suffer at the macroeconomic one.

Behind the scenes, we think New Zealand is in a far better space at the microeconomic level than is generally recognised. The past few years have seen considerable change, and getting the basics done well is an ongoing process. Businesses have lifted their game: change has become the new certainty. Grumpy growth has forced businesses to get fighting fit: that’s a precursor to stronger productivity growth. We’ve seen solid progress in the government sector and small changes in economic incentives are starting to bear fruit. But it all takes time to accrue into sustained macroeconomic performance.

2013: DROUGHT / NZD VS DOMESTIC DEMAND

The economy has a solid feel about it in early 2013. Improvements in business confidence from the end of last year have been matched by an increasingly positive consumer. Signs of a housing-centric lift in activity are percolating through the economy, and are more evident in domestic-centric sectors, including retail and services. Residential building consents are lifting, migration trends are rising, the tax take is solid, and traffic volumes are rising. It’s not completely across the board, but ticks now considerably outnumber crosses.

Despite this, the quarterly volatility that has characterised the last few years is likely to persist. We expect a slower pace of quarterly growth in the first half of this year. This largely reflects an element of recoil from the strong end to 2012, and the impact of the early 2013 drought on primary production, which is expected to shave 0.5 percentage points off 2013 H1 activity. The impacts of drought tend to be persistent, and we do not expect agricultural production levels to fully recover until 2015. While climbing export commodity prices will provide an income offset, this is fairly narrowly based, being concentrated in the dairy sector.

Housing Balances by Region

-30

-20

-10

0

10

20

30

1997 1999 2001 2003 2005 2007 2009 2011

(000)

Sources: ANZ, Statistics NZ

Auckland

Canterbury

Rest of NZ

Excess Demand

Excess Supply



Lifting residential investment will dominate the investment recovery. The cost of the Canterbury rebuild is now closer to 20 percent of GDP than 15, but we are likely to see a more drawn-out construction sector lift, given resource constraints in the sector. Also competing for resources will be the extra 39,000 dwellings flagged for Auckland over the next three years, and a projected extra 400,000 dwellings over the next 30 years. We expect the next few years to show a stepping-up of construction sector activity, with the level of work expected to peak in 2016. Residential sector activity will be above historical averages as a proportion of GDP over the remainder of the projection period. A more rapid turnaround in net migration than expected is a key upside risk.

The overall impact of more construction sector activity will not be a case of simply adding this activity to the baseline, as there will be some displacement impacts on other sectors and regions. At a regional level, building more houses in Auckland and Canterbury reconstruction will take up resources that could have been used elsewhere.

We see Christchurch’s city rebuild and tighter fiscal policy as being broadly offsetting. On the face of it a $40bn rebuild dwarfs a 3¼ percent of GDP structural fiscal tightening. However, over the projection horizon, the discrepancy narrows considerably, with less than 40 percent of the rebuild likely to occur before 2017. Taking into account the dislocation impacts of the reconstruction, the gulf narrows further, even if a lower government share of income could potentially “crowd-in” more activity from the private sector. There will be regional and sector winners and losers, with Christchurch and Wellington marking the two extremes.

-1.0%

-0.5%

0.0%

0.5%

1.0%

Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17 Jun-18 Jun-19

Canterbury Rebuild vs Fiscal Tightening Profiles (Contribution to Annual GDP)

Assumed Multipliers+0.75 Spending-0.25 Revenue

Rebuild Stimulus

Fiscal Tightening

Sources: ANZ, RBNZ, Treasury

% annualised

We’re still somewhat guarded on the question of the durability of the recent strengthening in consumption. High levels of consumer sentiment, the high NZD, rising house prices, and the strengthening

residential investment outlook are clear support factors for consumption. However, the fundamentals still look shaky. Housing affordability metrics are stretched. Debt levels are high, and the household saving rate is too low compared to the level we consider would allow a sustained pro-cyclical upswing in consumption to unfold. Hence we’re backing a sedate outlook for consumption growth. If we’re wrong, and consumption takes off, brace for policymakers to rain on that parade. Recently announced increases in bank capital requirements for high-LVR lending and the likelihood of a prudential policy response by the RBNZ suggest policymakers will not stand idly by. The possibility remains of OCR increases that are greater and more rapid than currently expected. The balance sheet and policymaker invariably win in the end.

The high NZD may have been a boon to consumers, but it remains a considerable obstacle to tradable sector activity. Rising export commodity prices have helped soften the blow for parts of the tradable sector, but the benefits appear concentrated in the dairy sector. Not only are other exporters under the gun, but firms servicing the domestic sector are also feeling the pinch, with continued job losses in the manufacturing sector. Prospects are a little brighter in the wider primary sector (particularly energy). While investment activity in this area is stepping up, it will take time to flow through into export sector activity.

NZD Real Effective Exchange Rates

-40

-30

-20

-10

0

10

20

30

40

92 94 96 98 00 02 04 06 08 10 12

% deviation from average

Restrictive

Enhancing

Sources: ANZ, Bloomberg, Statistics NZ

Dairy

Other Commodities

Manufacturing & Services

2014 AND BEYOND: LAYING THE PLATFORM

Investment will be the major growth driver over the next few years, given the Canterbury rebuild and strengthening residential investment activity in Auckland. Outside of these areas, growth will be more moderate, given the headwinds posed by fiscal restraint, a fickle global scene, and pressures on tradable sector activity from the still-high NZD.



A key assumption we are making is that private consumption spending will not markedly diverge from income growth. While the Auckland and Canterbury housing markets have captured the headlines, the labour market will be the key determinant of household spending. We are forecasting moderate growth in both employment and wages – albeit with a wider dispersion in incomes than normal, given the specific resource requirements of greater construction activity. It should be enough to allow the necessary saving plus growing consumption a little at the same time.

Total investment and consumption shares

15

20

25

30

88 90 92 94 96 98 00 02 04 06 08 10 12 14 1670

75

80

85

Percent of GDP


Percent of GDP

Investment (LHS)

Consumption (RHS)

The outlook for tradable sector activity will, as always, be dominated by four factors: the NZD, the outlook for our trading partners, implications for commodity prices, and the weather. These are largely beyond our control. The NZD has been driven primarily by overseas central bank actions. With

regards to the global outlook, while our trading partner growth projections (see page 7) are more or less in line with the market consensus, risks are not evenly distributed, with the need to address large debt overhangs in Europe and the US, and the investment-centric nature of the Chinese growth mix being sources of downside risks to the outlook. Adverse weather events are also beyond our control.

Despite our expectation of only a modest fall in the NZD over the projection period (see page 12), the current account deficit is forecast to remain capped below 6 percent of GDP. Pending rises in the goods terms of trade are expected to support the merchandise trade position. Looking through the saving and investment lens, our forecasts assume a rising investment share of income. The fact that fiscal consolidation and improving household spending are forecast to be largely funded by growing incomes will help limit the national saving shortfall, with moderate rates of credit growth expected. Nevertheless, the higher cost of the rebuild is likely to result in a greater insurance bill from the $10bn+ in claims that have yet to be settled. Not only will this have more of an impact on the net external debt profile, but it adds to the list of support factors underpinning the NZD.

Our assessment of the current trend growth rate of the NZ economy is in the lower part of a 2 to 2½ percent range. Such is our confidence in the underlying microeconomic story we expect this to lift towards the upper part of the range towards the end of the forecast period.

NEW ZEALAND NATIONAL ACCOUNTS FORECAST

Calendar years (average annual percent change) 2010 2011 2012 2013(f) 2014(f) 2015(f) 2016(f)

Total Consumption 2.3 2.0 1.7 2.1 2.0 1.7 1.4

Private Consumption 2.6 2.0 2.1 2.7 2.5 2.0 1.7

Public Consumption 1.3 2.0 0.3 0.1 0.2 0.3 0.4

Total Investment -0.4 3.3 6.6 9.8 12.5 5.7 3.8

Residential investment 2.3 -11.2 10.6 18.3 16.9 10.6 7.4

Other investment -0.9 6.3 5.8 8.2 11.6 4.7 3.0

Stockbuilding1 2.5 -0.4 0.1 -0.3 0.1 2.1 0.0

Gross National Expenditure 2.5 2.6 2.7 3.4 4.5 2.8 2.1

Total Exports 3.6 2.7 2.1 -0.2 0.9 2.9 2.5

Goods 4.9 2.4 4.0 0.4 0.5 2.8 2.3

Services -0.6 3.6 -4.3 -2.3 2.7 3.2 3.2

Total Imports 10.7 6.7 1.5 2.1 5.0 4.1 2.2

Goods 11.6 6.5 2.5 2.3 6.2 5.1 3.8

Services 8.3 7.5 -1.3 0.9 1.2 0.8 0.8

Expenditure on GDP 0.9 1.3 3.0 2.7 3.2 2.3 2.2

GDP (production based) 1.8 1.4 2.5 2.6 3.1 2.5 2.2 1 Percentage point contribution to growth


GLOBAL OUTLOOK

SUMMARY

Central bank actions continue to underpin asset values and risk appetites. Against a backdrop of improvement, necessary ingredients to a sustained improvement in solvency across key nations remain absent. In a numerical sense, trading partner growth is expected to remain respectable, though we’re cautious in a qualitative sense. Poor fundamentals continue to clash with liquidity: it’s a recipe for continued volatility.

THE PUNCHBOWL

The G3 central bank “put” has been exercised, with the foot firmly on the accelerator. The BOJ doubled their monthly yen purchases in April, and in May the ECB cut rates to record lows and held out the possibility of further supportive policy actions. The US Federal Reserve’s $85bn of monthly asset purchases under QE3 look set to continue.

The provision of abundant liquidity has helped shore up financial market sentiment. Long-term interest rates are low and equities have fared well. Proxies for financial dislocation remain benign, though some are starting to wonder whether new bubbles in the credit space are forming. Financial conditions remain highly accommodative, consistent with strong growth across the OECD. Global inflation remains low.

Such has been the success that attention is turning to when the QE punchbowl is likely to be withdrawn, with speculation over the degree and timing of tapering in the US. Markets have suffered gyrations at the very mention of the prospect: a sign that deep-rooted problems remain.

Central bank support will be required for some time yet. Economic growth across the OECD ranges from modest (US) to poor (Europe). Unemployment rates are not coming down; nor is inflation trending higher. Profligate money printing will not cease until global growth becomes self-sustaining. That’s a way off. In the meantime, central banks continue to deliver liquidity-driven support to assets.

Critically, the nucleus of a full-blown solution for many OCED economies, namely credible paths to fiscal sustainability and pro-active micro-

economic reform agendas, are still lacking. Our sovereign risk framework, which combines debt and growth (read: flexibility) proxies, remains European-centric in terms of where the largest problems reside. Indeed, we expect attention to return to some European heavyweights over the coming year. Real GDP growth sits below real 10-year borrowing costs: fiscal sustainability is deteriorating before an additional dollar is borrowed.

Across the key regions we expect:

The US economy to perform solidly. The Fed is underwriting momentum. Businesses remain awash with cash, and household balance sheets have improved markedly. Housing activity is picking up. Even the US fiscal position is improving. However, the latter is a very, very long journey.

European activity to remain weak. Debt levels are high, economic flexibility is low, and political fragmentation is rife. That’s a poor platform for growth. Key countries to watch include Italy, Spain and France. Not exactly minnows.

A still-solid pace of expansion for the Chinese economy, but with increasingly exposed fragilities. The goals of policy (more investment-centric growth) look to be at odds with what is actually required (more consumption). That’s a worrying trend. It’s called mal-investment and the piper invariably gets paid.

Australia to generate sufficient domestic demand to offset waning impetus from the mining boom. 200 basis points of interest rate stimulus have already been delivered, with more in prospect. However, one of the largest mining booms in history may have been squandered. Australia’s challenges are microeconomic as well as macroeconomic. They’ve been asleep at the wheel with the former.

We are forecasting trading partner growth to average just under 4 percent for the next few years, close to historical averages. Risks around the global economy are less one-way than they were 12 months ago. Nevertheless, the risk profile is still tilted to the downside.

GLOBAL ECONOMIC GROWTH FORECAST

Calendar years 2010 2011 2012 2013(f) 2014(f) 2015(f) 2016(f)

United States 2.4 1.8 2.2 2.3 2.9 3.0 2.9

Australia 2.6 2.4 3.6 2.6 3.1 3.2 3.1

Japan 4.7 -0.5 2.0 1.9 1.0 0.9 0.9

Eurozone 1.9 1.5 -0.5 -0.4 0.7 1.5 1.6

China 10.4 9.3 7.8 7.8 8.0 7.8 7.7

Trading Partner Growth 4.8 3.4 3.5 3.4 3.8 3.9 3.7


EXPORT COMMODITY PRICES

SUMMARY

Just about all NZ’s main soft commodities are set to show some improvement at the farm-gate in 2013/14. Often the main driver is supply reductions from weather-related events either domestically or abroad. But equally important are changing trade patterns, featuring increased demand out of Asia and other non-traditional markets. However, a supply response from Northern Hemisphere competitors is expected later in the year, which will place some downward pressure on international prices as the 2013-14 season progresses. We expect a 2013-14 milk price of $6.80 per MS, plus a dividend of $0.35 per share, giving an all-up payout of $7.15 per MS.

SUPPLY SIDE FOCUS

In recent months NZ’s soft commodity basket measure of in-market prices has jumped 21 percent courtesy of turbo-charged dairy prices. That’s the reality of a drought, which curtails supply. With drought conditions having eased, pricing pressure extremes – notably in dairy – will wane.

Soft Commodity Price Indices

50

100

150

200

250

300

Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12

Index (Jul 2000 = 100)

ANZ World Price Index

ANZ NZD Index

Sources: ANZ, FAO

FAO World Food Index

The question is: where to from here? International soft commodity prices are awaiting the main Northern Hemisphere planting and growing season for direction. All indicators at this stage point toward a large increase in the growing area of key foodstuffs such as corn, wheat, and soybeans. If normal weather patterns occur during the growing season, then crop yields are likely to return to trend. Combined with the increase in area planted, some very large crops could be delivered at harvest time. Such a scenario would place downward pressure on global soft commodity prices later in the year. However, the downside is limited somewhat by low inventory levels.

This will put some downward pressure on in-market prices for NZ’s main soft commodities through two channels. One will be an improvement in the price competitiveness of substitute products, e.g.

soy for dairy. The other will be an improvement in margins for livestock producers (dairy, beef, and other meat proteins for example) that use feed-based systems. This will boost their yields, production, and exports in 2014. So while in-market prices are expected to settle at the top of recent cycle highs for the first half of the 2013-14 season, price pressure is expected to emerge heading into 2014.

Movements in dairy prices are likely to remain volatile in 2013-14 as they adjust down from the recent spike. Three key areas to watch are end demand, the supply response from Northern Hemisphere producers, and the price of substitutes. Overall international dairy prices are expected to average above recent cycle highs until 2014, when a supply response from improved margins is expected from the major exporting countries. At this stage we expect Fonterra’s milk price for 2013-14 will be around the $6.80 per MS mark, with positive upside.

A modest improvement in lamb prices to $95 per head (17.5 kg carcass) is expected in 2013-14. This is driven by an improvement in lamb’s price competitiveness with other proteins in Europe, a smaller hangover of frozen inventory, and tighter supply. On balance, a slow grind higher in farm-gate beef prices is expected in 2013-14. Positive drivers include constrained beef production in our main market, the US, and increasing demand from non-traditional markets in North and South East Asia. Offsetting these factors to some degree are stretched retail and wholesale prices in many traditional markets. A slight improvement in crossbred wool returns is expected. Tighter supply of crossbred wool from major exporters, a slight pick-up in US demand for carpets, continued growth in domestic Chinese demand, and stable substitute fibre prices are expected to supersede weakness in demand elsewhere.

Apple prices are expected to lift by $1-2 per TCE (and possibly more) for this year’s harvest. Overall restricted supply from other Southern Hemisphere producers and within Europe, combined with a high quality crop more aligned to Asian markets, are expected to result in higher international pricing and premiums. Sauvignon Blanc grape prices are expected to average around $1,500 per tonne. Wine prices are expected to increase thanks partly to a stabilisation in bulk exports. Packaged wine prices are expected to be stable as the ability to pass on higher prices in the main markets will remain limited. In-market pricing for both Green and Gold kiwifruit is expect to be strong in 2013-14 as supply will be lower than previously anticipated. Offsetting this will be a negative NZD impact as hedging cover rolls off and the drought produces smaller but better-tasting fruit.


LABOUR MARKET OUTLOOK

SUMMARY

The labour market is improving, though it’s far from across the board. General economic frictions imply the same for the labour market. We expect the unemployment rate to gradually gravitate lower over the coming two years. Modest employment and wage growth beckon. It’ll be enough to support consumer spending but not propel it too far ahead.

SCRATCHING OUR HEADS

The official data portends a recent sharp improvement across the labour market, but trends are more modest. Q1 2013 saw a leap in employment, a sharp fall in unemployment, and a gargantuan rise in hours worked. On the face of it this suggests a huge turning point, but we’re mindful of official data’s volatility. The unemployment rate has bounced between 6.3 percent in late 2011 up to 7.3, and now back to 6.2 percent. That’s too wide a range to take the latest numbers at face value. What we also know is that job advertising, which leads employment by six months, has been fairly flat since mid-2011. This ties in more readily with modest employment growth (0.3 percent) over the entire year.

We suspect we may see some near-term recoil in Q2 from the sharp Q1 fall in the unemployment rate, rising back up before the strengthening domestic economy sees it resume its gradual trend improvement. It is also apparent that a greater margin of labour market slack exists than is suggested by a 6.2 percent unemployment rate. Hours worked per worker remain below historical averages, implying scope to work the existing workforce harder rather than employ more people. “Underemployment” (those who would like to work more hours but can’t find appropriate employment) is still high, at 4.2 percent of the labour force. Had the participation rate not fallen over the past year, the unemployment rate would currently be sitting a full percent higher.

Within the labour market, winners and losers are becoming unusually distinct, with sector and region-specific frictions between vacancies and the available pool of labour. We are likely to see these tensions for a while yet. Construction is the obvious sector that may cause employers (and the Reserve Bank) some headaches in time. In this context, it is good to see measures to encourage apprenticeships.

Business surveys suggest an increased willingness to take on staff. This is yet to fully manifest in job advertising, which is why we forecast a reasonably moderate near term improvement in labour market statistics. Despite

signs of strengthening demand, businesses remain relatively risk averse – entirely understandable given the bumpy ride the economy has been on since 2008. However, the stars are starting to align for a period of more sustained economic growth from the second half of this year. If our forecasts are to prove correct, we would expect to see job advertising to pick up in a more definitive manner from here.

Total job ads - newspaper plus internet (sa)

0

20

40

60

80

100

120

140

160

180

2005 2006 2007 2008 2009 2010 2011 2012 2013

Rest of NZ

Jan '05=100

Canterbury

Sources: ANZ, Seek, Trade Me, NZ Herald, The Press, Dominion Post The forecast improvement in the labour market is far from a return to the good old days. Average annual employment growth in 2014 of 1.1 percent will only slightly outpace the growth in working age population. With more jobs encouraging more workforce participation, the unemployment rate is likely to remain in a 5 to 6 percent range. Our forecasts for employment and GDP growth are based on the premise that NZ does not have the balance sheet for a marked run-up in debt from here. It also reflects the shift towards greater capital intensity, with New Zealand assumed to be more productivity focused, in trying to get more out of less.

Strengthening migration inflows are already starting to reflect that even a modest pickup in the labour market is a pretty appealing picture by current global standards. As job opportunities in Australia in particular continue to wane, more signs of life here will encourage increased net immigration. It could help address particular skill shortages, especially in Christchurch. But further pressure on the Auckland property market could be an unhelpful side effect. And kiwis returning home can’t be selected for their skills like other migrants.

We are forecasting moderate wage growth of around 3 percent over coming years, providing reasonable household income growth and offering no threat to monetary policy. However, as noted, pockets of wage inflation are likely, particularly in the construction sector.


FISCAL POLICY

SUMMARY

The fiscal accounts are on an improving trajectory and we expect a return to surplus by 2015. Fiscal retrenchment will be a material headwind to growth, but that’s a necessary side-effect of balancing the books. A small collection of microeconomic initiatives aimed at extracting more value deserves more positive attention than is being given.

FISCAL CONSOLIDATION EFFORTS ON TRACK The fiscal accounts are on an improving trajectory. Large deficits (9.2 percent of GDP) in 2011) are being replaced by small ones (0.9 percent in the next financial year). That’s a massive turnaround. The nucleus of the improvement has come from the structural side of the equation (i.e. contained spending) as opposed to being reliant on the economic cycle. The rate of spending growth has been halved. Such savings mount quickly over multiple years. That’s a durable improvement.

We expect a return to surplus by 2015, with net debt peaking just under 30 percent of GDP slightly after. That’s a far cry from the 60 percent debt projection detailed back in 2009, which was based on planned policy settings at the time.

Necessary fiscal retrenchment comes with a hook: it crimps growth. A fiscal stance estimated to be contractionary to the tune of 3¼ percent of GDP over the next four years is a material headwind for the economy. Of course it also helps keep interest rates low.

New Zealand looks in an enviable position relative to global peers, including Australia. The average level of net debt across the OECD is 65 percent of GDP. With Australia’s mining boom fading, the Australian Government now faces an $18 billion deficit (though Australia has a lower starting point level of debt).

New Zealand can ill-afford to be complacent.

A higher stock of total debt across the economy means NZ needs to be whiter than white in the

fiscal arena. Our high level of total debt continues to irk rating agencies.

Population aging challenges are set to emerge. Most countries have the same issue in some shape or form. However, the maths is simple: the stronger your fiscal position is when the demographic pressures mount, the greater the flexibility to deal with them.

New Zealand needs fiscal consolidation more than most: it can help take pressure off the high currency, and help keep interest rates low.

NEW ZEALAND RELATIVELY WELL POSITIONED We’re paying more and more attention to the microeconomic initiatives, in conjunction with the broad thrust of fiscal policy in the macro arena. The latter is well understood and centres on doing the basics well. The former look under-appreciated. Ultimately the collection of microeconomic initiatives can have a huge bearing on the macroeconomic environment.

Throw together welfare reform, a unified parliament on addressing Auckland’s housing shortages, partial asset sales, continued recycling of low-value spending into higher priority areas, progress unlocking New Zealand’s abundant natural resource base, and so on and so on, and you see an agenda where more is happening than is openly recognised and commented on. There are missing elements. If we were picking the eyes out of political parties’ initiatives we’d support a capital gains tax and raising the retirement age. Moreover, progress in some areas is of the tortoise variety. We’ll still take it.

In some areas we see the usual political fracturing, which invariably leads to questions surrounding the 2014 election. At this stage we’re agnostic. Economic reality can be a remarkable policy pacifist. Amongst fiscally profligate peers and a global scene caught in the rip of populism, New Zealand probably underestimates how strong and robust its political and parliamentary institutions are relative to others.

FISCAL FORECASTS

June years 2012 2013(f) 2014(f) 2015(f) 2016(f) 2017(f)

Operating Balance ($bn) -14.9 1.8 0.3 2.6 2.9 4.3

– as % of GDP -7.1 0.9 0.1 1.1 1.2 1.7

OBEGAL ($bn) -9.2 -6.4 -2.1 0.1 0.4 1.7

– as % of GDP -4.4 -3.0 -0.9 0.0 0.2 0.7

Net Core Crown Debt ($bn) 50.7 58.5 65.4 68.8 70.3 71.3

– as % of GDP 24.3 27.5 29.1 28.9 28.5 27.8

Core Crown residual cash ($bn) -10.6 -7.8 -6.9 -3.4 -1.5 -1.0

Bond Tender Programme ($bn) 14.0 14.0 10.5 8.5 7.5 7.5


INFLATION

SUMMARY

Inflation is expected to remain low over 2013, capped by contained domestic drivers and disinflationary pressure from the high NZD. Inflation then looks set to move gradually higher over the projection period, settling above the target midpoint as suppressants slowly subside. The strengthening domestic expansion becomes the dominating driver of the inflation trajectory over the second half of the projection period, with our forecasts assuming the RBNZ’s action will be sufficient to keep core inflation outcomes within the 1 to 3 percent target range.

PICKING UP BUT WITH POCKETS OF FRICTION

Inflation is low. Annual inflation in the March 2013 year held at 0.9 percent, the third consecutive quarter below 1 percent. The high NZD, subdued global consumer good prices, lower global food prices, and a tough retail climate have seen tradable prices decline. Conversely, non-tradable inflation remains just above the target midpoint. Despite the Canterbury rebuild pushing up annual construction cost inflation in the region into double digits, a margin of spare capacity and competitive pressures are helping to cap increases in domestically generated inflation at the nationwide level. Various business survey measures of inflation expectations are anchored around the inflation target midpoint, after being somewhat above 2 percent previously.

We expect more of the same over 2013. The disinflationary impact of the high NZD is expected to persist, with the NZD’s 40 percent gain against the yen expected to push down tradable prices. Core inflation drivers are expected to remain benign, with margins under downward pressure, overall wage and unit labour cost growth likely to remain contained, and pricing power still firmly in consumers’ hands.

However, the inflationary picture will become less benign into 2014. By then the incremental deflationary pressure from the high NZD will be waning. Indeed, projected falls in the NZD over 2014 are expected to contribute to an upward drift in tradable CPI prices. The lagged effects of past rises in dairy commodity prices will flow into retail prices. Non-tradable inflation is expected to drift further above the target midpoint, as remaining spare capacity is utilised and domestic demand strengthens. Thereafter, annual inflation is expected to drift towards 2½ percent by the end of 2015, reflecting increasing capacity pressures on resources. The rise in the inflation profile also reflects a series of cost shocks: the lift in tobacco and fuel excise will add 0.3 percentage points to annual inflation over the next few years.

We expect to see a greater dispersion of outcomes as tensions mount from the contrasting shocks the economy is navigating. Relative price movements are a necessary signal as to where resources need to flow: in this case to the construction sectors in Auckland and Canterbury. Despite this, we expect the central tendency of inflation outcomes and expectations of wage and price setters to remain consistent with inflation outcomes around the target midpoint. The RBNZ will be keen to protect its hard-won inflation fighting credibility, and will not want to let core inflation outcomes drift too far above the target midpoint. Signs of a lift in expectations above this would necessitate a policy response, and we are counting on firms and households not pushing too hard.

CPI forecasts

-4

-2

0

2

4

6

8

92 94 96 98 00 02 04 06 08 10 12 14 16

Annual % change


TradableCPI

Non-tradable

CPI FORECAST

Quarter Qtr % chg Ann % chg

Mar-13 0.4 0.9

Jun-13 (f) 0.2 0.8

Sep-13 (f) 0.4 0.9

Dec-13 (f) 0.1 1.2

Mar-14 (f) 0.6 1.4

Jun-14 (f) 0.5 1.6

Sep-14 (f) 0.6 1.8

Dec-14 (f) 0.2 1.9

Mar-15 (f) 0.7 2.0

Jun-15 (f) 0.7 2.3

Sep-15 (f) 0.7 2.4

Dec-15 (f) 0.3 2.6

Mar-16 (f) 0.7 2.5

Jun-16 (f) 0.7 2.4

Sep-16 (f) 0.7 2.4

Dec-16 (f) 0.3 2.3


EXCHANGE RATE

SUMMARY

The NZD remains overvalued and we expect it to remain so through the coming two years: the reality of ugly duckling contests is that beauty is a relative as opposed to an absolute concept. We expect the NZD/USD to end 2013 towards 0.80/0.81 and slowly subside thereafter. It’s a similar story against the other crosses, bar the AUD, where the NZD has been re-rated into a higher zone. Looking ahead, a 0.8600/0.8700 rate beckons for the NZD/AUD.

GLOBAL INFLUENCES

The NZD remains hostage to global gyrations. Overlay the NZ TWI on the US equivalent and you get a good match. We expect these nuances to continue dominating.

The question is, however, being asked whether the NZD has reached a turning point. The debate resides with the spectre of a stronger USD on the unwinding of QE, dents in the previously bullet-proof AUD, and concerns over the sustainability of China’s so-called economic miracle. We could go on at length here, for there are a myriad of fresh concerns emerging globally, not the least being renewed appetite for the US dollar, and scepticism towards gold as global inflation falls. When you throw in some local specifics – overvaluation, a poor net external position – and you have the recipe for a correction. We’ve arguably seen part of that over the month of May, with the NZD/USD peeling back from 0.86 cents with relative ease.

Nonetheless, we’re not convinced a turning point has been reached.

We’ve been here before. Since breaking through 0.80 in 2011 on the way up, the NZD/USD has had at least 4 runs down through 0.80. In all but one instance, the next stop has been 0.8300.

We don’t believe the Fed is set to end QE anytime soon. Recent testimony by Fed chairman suggests we will see some scaling back in the pace of asset purchases. This depends crucially on a “real and sustainable” improvement in the labour market outlook. This has yet to be achieved, and even when purchased are scaled back, this will be done so gradually, rather than “cold turkey”.

New Zealand’s “beauty pageant” credentials still look solid. On an absolute basis, local specifics such as yields, commodity prices, and the current account position signal sell the NZD. Markets are trading relativities, however.

The overvalued NZD continues to compete with currencies that are either structurally impaired (the USD) or structurally flawed (the euro). Big borrowers like the former that lack attractive interest rates need to see a discount reflected in their exchange rates. By contrast, the latter needs a fiscal union to be sustainable. Sadly, that’s not around the corner, and despite hope we’ll get there, politics will see that we don’t.

Insurance flows have been significant. While the bulk of the flow will have already occurred, with global insurers hedging their exposures relatively quickly once they have been estimated, upward revisions to estimates by the Crown are likely to be matched by similar revisions by the private sector, bringing fresh FX flow with it.

Bond buying has been significant. As the top chart below shows, offshore holdings of NZGS have surged in recent months, reaching a record high of $42.5bn at the end of March. Although holdings fell in April, this was thanks to a bond maturity, and not as a result of net selling. Looking ahead, as the second chart shows, New Zealand is one of the few markets where investors can obtain risk without taking duration. Consequently, we would expect to see sustained buying.

NZGS Held by Non-Residents

0

5

10

15

20

25

30

35

40

45

1994 1997 2000 2003 2006 2009 201220%

30%

40%

50%

60%

70%

80%

90%

Face Value (LHS)

% Total (RHS)

Sources: ANZ, RBNZ

NZ$bn %


EXCHANGE RATE

-0.5%

0.5%

1.5%

2.5%

3.5%

2013 2015 2017 2019 2021 2023

Maturity Date

NZD USD

EUR (GE) JPY

Annualised Expected Government Bond Returns

Sources: ANZ estimates, Bloomberg

Return (%)

We’ve pencilled in the NZD/USD ending 2013 at 0.81 and 2014 at 0.78. In spirit this means we’re picking the NZD to remain structurally overvalued for quite a while yet.

This means more angst locally towards what can be done about it. Don’t bank on anything more than portfolio-related currency intervention from the RBNZ: the RBNZ’s further criterion for intervention is that “market conditions exist to successfully achieve the desired exchange rate adjustment”. Bear in mind that the NZD is one of the 10 most actively traded currencies in the world. Moreover, the Finance Minister is understandably reluctant to speculate in the currency markets with taxpayers’ money. Printing money is simply so absurd it’s hardly worthy of comment. It’s the struggling economies that are undertaking QE: pouring more liquidity into the New Zealand economy (and Auckland property market) is a recipe for inflation and higher interest rates.

Despite appearances, the Trade Weighted Index (TWI) probably exaggerates the impact of the high NZD. This is thanks to the fact that it is a 50/50 trade/GDP weighted index. So while the US’s weighting is upsized thanks to its size, so too are those of German, Japan and the UK. Yet it is these latter currencies we have really appreciated against since December 2009 (by around 20 percent, compared to just 11 percent against the USD). By contrast, the NZD has barely moved (or gone slightly backwards) against many Asian currencies like the CNY, SGD, MYR and THB. Had the TWI employed NZ’s top 10 bilateral trade weights, it would have appreciated by something closer to 7 percent since the end of 2009, whereas the TWI is up close to 15 percent. That’s not to downplay the problem. Rather, the extremes.

New Zealand's Bilateral Trade and the TWI

0%

5%

10%

15%

20%

25%

30%

35%

Aust

ralia

Chin

a

USA

Japan

Kore

a

Germ

any

Sin

gapore

Mala

ysi

a

UK

Thailand

Sources: ANZ estimates, Statistics NZ

Share of NZ's bilateral Trade between Top 10 trading partners

TWI weights

Share/weight (%)year ended March 2013

Furthermore, all hope is not lost:

Commodity prices remain a key source of support. That’s cold comfort to the manufacturing sector, but still important for the other 70-odd percent of NZ’s merchandise exports.

Firms’ are pushing the productivity envelope. The fact NZ exporters have survived (and some still thrived) at extended currency levels bears tribute to their ability to adapt. More assistance across central and local government to streamline costs would not go amiss.

Asian currencies – by virtue of their huge current account surpluses will face the greatest pressure to appreciate over the coming decade. As noted earlier, the NZD has tended to perform most poorly against non-Japan Asia, yet it is this region where export growth is coming from (in part thanks to that very fact). Moreover, direct currency convertibility with the CNY (currently under negotiation) looks set to further lower transaction costs.

Continued appreciation of the NZD against the AUD looks set to be an enduring feature of coming quarters. By and large, we expect this to be driven by:

Divergent monetary policy expectations. Whereas the RBNZ has a tightening bias, the RBA is still in easing mode.

Divergent economic prospects, as demonstrated by the chart of manufacturing indices below.


EXCHANGE RATE

Manufacturing PMIs

30

35

40

45

50

55

60

05 06 07 08 09 10 11 12 13

Australia

Index

Sources: ANZ, Bloomberg

New Zealand

Relative commodity price performance. Whereas the ANZ Commodity Price Index hit a record high in April, the RBA’s commodity index is down 21 percent since its 2012 mini-peak, and almost 30 percent off its all-time (2008) high.

Add to this the divergence in fiscal policy attitudes and an Australian federal election, and you have more uncertainty across the Tasman. Indeed, whereas Australia will miss balancing its books this year and has pushed its target to do so out by 3 years, NZ is tracking ahead of plan, and is forecast to reach surplus by 2014/15 – one year ahead of the new Australian forecast.

NEW ZEALAND DOLLAR FORECAST (END OF QUARTER)

Quarter NZD/USD NZD/AUD NZD/JPY NZD/GBP NZD/EUR NZ TWI

Dec-09 0.72 0.81 67.2 0.45 0.50 66.3

Dec-10 0.78 0.76 63.2 0.50 0.58 69.2

Dec-11 0.78 0.76 59.8 0.50 0.60 69.3

Dec-12 0.83 0.80 71.9 0.51 0.63 74.4

Mar-13 0.84 0.80 78.9 0.55 0.65 76.9

Jun-13(f) 0.80 0.85 80.0 0.54 0.61 75.2

Sep-13(f) 0.80 0.86 84.0 0.54 0.60 75.7

Dec-13(f) 0.79 0.86 83.0 0.53 0.58 74.4

Mar-14(f) 0.78 0.86 81.9 0.51 0.56 73.1

Jun-14(f) 0.77 0.87 84.7 0.50 0.53 72.3

Sep-14(f) 0.76 0.87 83.6 0.48 0.52 71.3

Dec-14(f) 0.75 0.87 82.5 0.47 0.51 70.3

Mar-15(f) 0.75 0.87 82.5 0.47 0.51 70.3

Jun-15(f) 0.75 0.87 82.5 0.47 0.51 70.3

Sep-15(f) 0.75 0.87 82.5 0.47 0.51 70.3

Dec-15(f) 0.75 0.87 82.5 0.47 0.51 70.3


INTEREST RATES

SUMMARY

The OCR is going to have to be normalised at some stage, but calling an aggressive rise doesn’t pass the smell test. We’re picking the first half of 2014 to be the start of a slow and steady normalisation of monetary policy. Tensions from conflicting economic forces (housing stronger, a high NZD bludgeoning the export sector) mean macroprudential tools as an ancillary policy weapon are a reality: this will support but not replace monetary policy and the OCR. We expect local bond yields to rise gradually in coming years, with global yields set to rise from late 2013 as the US Federal Reserve inches closer to paring back its asset purchase program.

WHAT GOES DOWN MUST GO UP

The OCR is going to have to rise at some stage. For a start the OCR is trading well below what we consider the neutral rate – around 4 to 4.5 percent. This is where the RBNZ has the foot on neither the accelerator nor brake. With momentum building across the economy, inflation set to rise, and housing a key focal point at present, the bias for interest rates is up, not down. There’s been a clear shift in the risk profile for interest rates in the past few months. One could articulate a rate cut scenario a few months ago; this is a low probability event now. Low inflation affords the RBNZ the luxury of time, but the risk profile has tilted.

We’ve seen the risk profile change numerous times over the past few years and are coy about jumping at shadows. The OCR has not shifted for 17 meetings. In the meantime we’ve seen aggressive swings in market pricing. For example, since the beginning of 2012, the 2 year swap rate (widely regarded as a bellwether for near-term monetary policy expectations) has traded as high as 3.14 percent and as low as 2.36 percent. Of note, the market traded up to that high over the space of 2 months, only to collapse to the low less than 3 months later. The 2 year swap was at 3.05 percent in February. It subsequently fell to 2.79 percent in early May, and now stands at around 3 percent.

We’re still looking for some sort of tweak to the OCR in the first half of 2014. While the next move is up, pencilling in an aggressive rise in interest rates doesn’t pass the smell test:

Global currency debasement is keeping the NZD divergent from local fundamentals. This must be compensated by yield convergence for financial conditions to remain neutral. Australia tried the out-of-step strategy: the OCR went up to 4.75, the AUD went to USD1.10, and it crucified the economy. The global economy and NZ are

“coupled,” which means financial variables can’t be too far out of line with global nuances.

New Zealand’s largest trading partner is cutting interest rates. Seldom have the two nations been on divergent monetary policy trajectories.

Global interest rates will remain low for a while yet. The realities of the 2008 global financial crisis are still being worked through.

Cutting the OCR is not likely to drive the NZD down, but lifting the OCR will most certainly be a one-way bet to drive the currency up.

Two polarising extremes are dominating: housing’s frothiness and currency overvaluation. We consider both to be more secular than cyclical, which means tension in the monetary policy arena for a while yet.

Monetary policy signals are going to become increasingly fractured over the coming year. There are the obvious inflation risks. Auckland has a shortage of housing. Natural disasters are inflationary. New Zealand’s potential growth rate is no higher than 2 percent, so our speed limit is low. However, inflation suppressants are material too: deleveraging is deflationary, fiscal policy is contractionary, and the NZD is expected to remain elevated.

The RBNZ is set to get some assistance from prudential policy, which, while explicitly aimed at financial system stability, could take some heat out of the property market. However, it’s far from a panacea. Demand management via the likes of loan-to-value ratio restrictions won’t suddenly make 30,000 houses appear in Auckland: you need a multi-pronged attack. We are seeing this, with legislation to streamline the consent process, housing accords to lift land supply, and reform of social housing. All will help keep interest rates lower than otherwise, but the supply-side response will also add to demand pressure! But when you throw together currency palpitations, a natural disaster, housing shortages, and the wrong mix of monetary conditions, it’s a tall order to manage. There’ll be frictions. The RBNZ now has more tools at its disposal, and they’ll be deployed. Expect fiscal policy in the microeconomic arena to step up to the plate too. We wouldn’t be surprised to see the spectre of capital gains tax on housing or other tax changes to start doing the rounds again.

We’ve pencilled a gradual normalisation of monetary policy settings from 2014. Looking into 2014 we’ve pencilled in a typical stop-start normalisation profile of 50 basis point moves every 9-


INTEREST RATES

12 months. A slew of mortgages on short-term rates (the average duration of bank mortgage debt is around 7 months, with 76 percent of mortgage debt either floating or fixed for 12 months or less) will give monetary policy punch.

We expect the OCR to peak at around 4.5 percent this cycle, but this is unlikely to occur until 2016. This peak is within our estimated range for the neutral OCR (4.0 to 4.5 percent), and higher than the 3-3.25 percent OCR endpoint from the March MPS projections. We’re not as convinced as the RBNZ that inflation expectations will remain anchored in concrete. We don’t believe the inflation genie will escape of the bottle, but have pencilled in some upwards drift.

GLOBAL RATES: NORMALISATION FROM YEAR-END

Global yields are set to rise from late 2013 as the US Federal Reserve inches closer to paring back its asset purchase programme, with normalisation in yields set to be a gradual process. The so-called “tail risks” to the US economic outlook have reduced in recent months as growth drivers broaden, monetary stimulus feeds through to the real economy, and the economy moves closer to energy self-sufficiency. However, much depends on further improvements to the US labour market outlook, particularly now that the Fed has pinned the timing of the paring back of QE on the data-flow. Timing will be a key uncertainty – while we see yields rising later on, in coming months Treasury yields will be anchored by near-term fiscal tightening and the recent consolidation in manufacturing surveys.

US Bond Yields vs ISM Manufacturing and Non-manufacturing Average

1.5

2.5

3.5

4.5

5.5

6.5

7.5

8.5

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 201230

35

40

45

50

55

60

65

US 10yr (LHS)

ISM Average (RHS)

Sources: ANZ, Bloomberg

While we are encouraged by the US outlook, record levels of quantitative easing in the US and Japan, together with downside cycle risks in Europe and Asia, will likely delay the

anticipated normalisation in core country bond yields. Global inflation pressures remain weak, against a backdrop of tepid growth and lower commodity prices. Macro momentum in Europe remains poor as the region struggles under a heavy debt load, although politicians have been successful in limiting tail risks. A fragile recovery in China poses downside risks to the global growth outlook as the economy transitions from an investment to consumption-centric model. Our economists are forecasting official rate cuts in both China and Australia.

NZ LONG END: TO RISE ON GLOBAL MOVES

New Zealand long-end bond yields will remain at the mercy of moves in global bond markets, and are forecast to normalise from early 2014, both as the US Federal Reserve pares back its own asset purchase programme and as the RBNZ moves to tighten domestic monetary policy. However, NZ and Australian yields are highly correlated, and with the RBA set to maintain an easing bias into 2014, we expect the rise in global yields to be partially offset in the local market by a contraction in spreads. Global investors have flocked to the NZ bond market in the past year, buying a net $700m of NZGS bonds per month. NZGS bonds can offer a higher-yielding, defensive play in an environment of yield normalisation. However, there is some risk that global yield convergence flows into NZGS could run their course later in the year. Thus we expect local bond yields to rise gradually in coming years, but outperform the normalisation in US yields.


INTEREST RATES

INTEREST RATE FORECAST (END OF QUARTER)

Quarter OCR 90-day 2-year swap

5-year swap

10-year bond

US 10-year bond

AU 10-year bond

Dec-09 2.50 2.8 4.6 5.6 5.8 3.8 5.6

Dec-10 3.00 3.2 3.8 4.7 5.9 3.3 5.5

Dec-11 2.50 2.7 2.7 3.3 3.8 1.9 3.7

Dec-12 2.50 2.7 2.7 3.1 3.5 1.8 3.3

Mar-13 2.50 2.6 2.9 3.5 3.5 1.8 3.4

Jun-13(f) 2.50 2.8 2.9 3.4 3.4 1.8 3.2

Sep-13(f) 2.50 2.8 3.1 3.5 3.4 1.8 3.2

Dec-13(f) 2.50 2.8 3.3 3.7 3.4 2.0 3.2

Mar-14(f) 2.75 3.2 3.7 4.0 3.7 2.3 3.4

Jun-14(f) 3.00 3.3 3.8 4.2 3.9 2.5 3.6

Sep-14(f) 3.00 3.3 4.0 4.4 4.1 2.7 3.9

Dec-14(f) 3.25 3.7 4.3 4.7 4.4 3.0 4.3

Mar-15(f) 3.50 3.8 4.4 4.9 4.6 3.2 4.6

Jun-15(f) 3.50 3.8 4.5 5.1 4.8 3.4 4.9

Sep-15(f) 3.75 4.2 4.7 5.3 5.0 3.6 5.1

Dec-15(f) 4.00 4.3 4.8 5.5 5.2 3.8 5.3

Mar-16(f) 4.00 4.3 4.8 5.6 5.4 4.0 5.5

Jun-16(f) 4.00 4.3 4.9 5.7 5.5 4.1 5.6

Sep-16(f) 4.25 4.7 5.1 5.9 5.6 4.2 5.7

Dec-16(f) 4.50 4.8 5.1 5.9 5.6 4.2 5.7


ECONOMIC FORECASTS

Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15

Real Gross Domestic Product

Total GDP, QPC 0.3 0.4 0.8 0.8 0.8 0.8 0.7 0.6 0.6 0.5 0.5 0.5

Total GDP, APC 2.3 2.4 3.1 2.4 3.0 3.3 3.2 3.0 2.7 2.5 2.3 2.2

Total GDP, AAPC 2.4 2.4 2.7 2.6 2.7 3.0 3.0 3.1 3.1 2.9 2.6 2.5

Real GDP Components

Private Consumption, QPC 0.5 0.6 0.7 0.7 0.6 0.6 0.6 0.6 0.5 0.5 0.5 0.5

Private Consumption, AAPC 1.9 2.0 2.6 2.7 2.8 2.7 2.5 2.5 2.4 2.3 2.2 2.0

Public Consumption, QPC 0.3 0.0 0.0 0.1 0.1 0.0 0.0 0.0 0.1 0.1 0.1 0.1

Public Consumption, AAPC 0.4 0.1 -0.1 0.1 0.0 0.1 0.3 0.2 0.2 0.2 0.2 0.3

Residential Investment, QPC 5.8 2.3 5.7 4.8 3.7 3.8 3.3 2.8 2.4 2.0 2.2 2.0

Residential Investment, AAPC 16.4 17.3 17.0 18.3 17.7 18.3 18.3 16.9 15.7 13.7 12.0 10.6

Other Investment, QPC 2.0 3.5 3.5 3.4 2.7 2.5 2.1 1.6 0.9 0.7 0.6 0.6

Other Investment, AAPC 5.7 4.3 6.4 8.2 10.7 12.8 12.5 11.6 9.9 8.1 6.3 4.7

Gross National Expenditure, QPC -4.1 0.8 1.4 1.2 1.5 0.7 1.0 0.7 1.0 0.2 0.6 0.4

Gross National Expenditure, AAPC 2.7 3.5 4.5 3.4 3.7 3.5 3.3 4.5 4.1 3.7 3.2 2.8

Exports, QPC -1.1 -1.4 -0.7 -0.1 0.6 0.7 0.8 0.8 0.7 0.6 0.6 0.6

Exports, AAPC 2.4 2.8 1.0 -0.2 -1.3 -1.7 -0.6 0.9 2.1 2.7 2.9 2.9

Imports, QPC 1.8 1.0 1.2 1.4 1.3 1.2 1.1 1.1 1.1 1.0 0.8 0.7

Imports, AAPC -0.5 0.3 0.8 2.1 3.8 4.4 5.2 5.0 4.9 4.7 4.4 4.1

Prices

Headline CPI, QPC 0.4 0.2 0.4 0.1 0.6 0.5 0.6 0.2 0.7 0.7 0.7 0.3

Headline CPI, APC 0.9 0.8 0.9 1.2 1.4 1.6 1.8 1.9 2.0 2.3 2.4 2.6

Non-tradable CPI, QPC 1.1 0.5 0.6 0.5 1.1 0.8 0.8 0.6 1.2 0.9 0.9 0.6

Non-tradable CPI, APC 2.4 2.4 2.5 2.7 2.7 3.0 3.2 3.3 3.4 3.6 3.7 3.7

Tradable CPI, QPC -0.5 -0.1 0.2 -0.4 -0.2 0.3 0.4 -0.3 0.1 0.5 0.5 -0.1

Tradable CPI, APC -1.1 -1.3 -1.1 -0.7 -0.5 -0.1 0.1 0.2 0.5 0.6 0.7 0.9

External Accounts

Ann. Balance on Goods, % of GDP 0.6 0.7 0.9 1.0 1.1 1.2 1.2 1.3 1.2 1.1 1.0 0.8

Ann. Balance on Services, % of GDP -0.6 -0.7 -0.8 -0.8 -0.8 -0.8 -0.7 -0.7 -0.7 -0.7 -0.7 -0.6

Ann. Balance on Invisibles, % of GDP -4.8 -4.8 -5.1 -5.3 -5.7 -5.7 -5.8 -5.8 -5.9 -5.8 -5.8 -5.6

Ann. CAB, % of GDP -4.8 -4.9 -5.0 -5.1 -5.3 -5.3 -5.3 -5.3 -5.3 -5.4 -5.5 -5.5

Net Intl. Invt. Position, % of GDP -72.8 -74.2 -75.0 -75.3 -75.6 -76.1 -76.6 -76.7 -76.9 -77.3 -77.8 -78.4

Terms of Trade (SNA basis)

Export Prices, QPC 0.9 2.2 0.5 1.3 1.3 1.3 0.3 0.8 0.9 0.3 0.3 0.5

Export Prices, APC -4.0 -2.3 1.6 5.0 5.4 4.5 4.3 3.8 3.4 2.4 2.3 1.9

Import Prices, QPC -2.1 1.0 -0.8 -0.4 0.5 1.0 -0.3 0.5 0.3 0.5 0.1 0.1

Import Prices, APC -1.9 -2.1 -1.9 -2.3 0.3 0.3 0.8 1.7 1.5 1.0 1.5 1.0

Terms of Trade, QPC 3.1 1.1 1.3 1.7 0.8 0.4 0.6 0.3 0.5 -0.2 0.1 0.4

Terms of Trade, APC -2.1 -0.1 3.5 7.4 5.0 4.2 3.5 2.1 1.9 1.3 0.8 0.9

Labour Market

Employment, QPC 1.7 -0.5 0.5 0.5 0.4 0.4 0.3 0.3 0.3 0.3 0.3 0.2

Employment, APC 0.4 -0.1 0.8 2.2 0.9 1.8 1.6 1.4 1.3 1.2 1.1 1.1

Labour Force, QPC 1.0 -0.3 0.3 0.2 0.3 0.3 0.3 0.2 -1.0 -1.0 -1.0 -1.0

Labour Force, APC -0.3 -0.7 -0.5 1.2 0.5 1.1 1.0 1.0 2.0 2.0 2.0 2.0

Unemployment Rate, sa 6.2 6.3 6.1 5.9 5.8 5.6 5.6 5.5 5.5 5.5 5.5 5.5

Participation Rate, sa 67.8 67.5 67.5 67.5 67.5 67.5 67.5 67.5 68.3 68.3 68.3 68.3

QES Private Sector Wages, APC 2.3 2.6 1.9 2.7 3.0 3.1 3.1 3.2 3.1 3.1 3.1 3.1

QES Public Sector Wages, APC 1.4 3.2 3.3 2.7 2.0 2.1 2.1 2.2 2.1 2.1 2.1 2.1

Forecasts in bold QPC – quarterly percent change APC – annual percent change AAPC – annual average percent change sa – seasonally adjusted


KEY ECONOMIC INDICATORS

NZ Exports ($b)

0 1 2 3 4 5 6 7 8 9 10 11

Australia

China

USA

Japan

UK

Korea

Taiwan

Germany

Hong Kong

Other Asia

Other Europe

Other

12 Months to April 2012


NZ Imports ($b)

0 1 2 3 4 5 6 7 8 9

Australia

China

USA

Japan

UK

Korea

Taiwan

Germany

Hong Kong

Other Asia

Other Europe

Other



NZ Exports and Imports by Selected Commodities12 Months to April 2013, in NZ$b

0 5 10 15 20

Meat

Dairy

Wool & Skins

Horticulture

Processed Agric

Forestry

Fish & Seafood

Metals

Crude Oil / Petroleum

Transport Eqpt / Machinery

Other products

Imports Exports

NEW ZEALAND COMPARED TO MAIN TRADING PARTNERS (LATEST AVAILABLE FIGURES)

NZ Australia USA Japan UK China Germany South Korea

Taiwan Malaysia Hong Kong

Singapore Indonesia

Population, in millions 4 23 315 127 63 1,354 82 50 23 30 7 5 249

Area in 1,000 km2 268 7,741 9,827 378 244 9,597 357 100 36 330 1 1 1,905

Inhabitants per km2 16.6 2.9 32.1 337.3 259.4 141.1 229.5 501.5 648.0 89.7 6,487 7,621 130.5

GDP, in billion NZ$ 209 1,891 19,140 7,440 3,010 10,081 4,225 1,381 582 368 320 336 1,071

Change in real terms (yr-on-yr %) 2.4 3.5 2.3 1.9 0.3 -16.0 1.3 2.5 0.7 5.3 1.5 1.8 6.3

Nominal GDP per capita in NZ$ 46,917 82,932 60,708 58,369 47,639 7,446 51,568 27,618 24,973 12,430 44,809 63,317 4,307

NZ exports to …, NZ$ m (FOB) n/a 9,729 4,259 3,097 1,375 7,538 948 1,617 848 824 832 913 828

Share of NZ Exports (%) n/a 21.0 9.2 6.7 3.0 16.3 2.0 3.5 1.8 1.8 1.8 2.0 1.8

NZ imports from , NZ$m (VFD) n/a 7,083 4,223 3,105 1,264 7,759 2,100 1,958 745 2,012 142 1,961 751

Share of NZ Imports (%) n/a 15.1 9.0 6.6 2.7 16.5 4.5 4.2 1.6 4.3 0.3 4.2 1.6

Current Account balance (% of GDP)

-4.7 -4.0 -3.1 1.2 -3.2 2.6 6.9 4.1 9.9 6.4 1.7 20.9 -2.2

Real GDP Growth

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Annual % change

New Zealand

OECD Average

90 Day Interest Rate

0%

5%

10%

15%

20%

25%

30%

1973 1978 1983 1988 1993 1998 2003 2008

Percent

New Zealand

OECD Average

Long-Term Government Bond Yield

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Percent

New Zealand

OECD Average

Inflation Rate

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Annual % change

New Zealand

OECD Average

NZX50 Share Price Index

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Annual % change

New Zealand

OECD Average

Current Account Balance

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

% of GDP

NZD/USD Exchange Rate

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Employment Growth

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Annual % change

New Zealand

OECD Average

Unemployment Rate

0%

2%

4%

6%

8%

10%

12%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Percent

New Zealand OECD Average

Sources: ANZ, Statistics NZ, Bloomberg, OECD


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