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NZ Economic Outlook: Still Constructive, But Downside Risks Aplenty

Monday 8th August 2011

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• In line with a wider review of forecasts globally by our Goldman Sachs colleagues, we have updated our expectations for NZ's economic outlook. We expect GDP growth to average an above-consensus 2.4% in CY11, but a below-consensus 3.4% in CY12 (down from our previous forecasts of 2.5% and 3.9% respectively).

Key Points:
• While risks certainly remain, we are relatively constructive on NZ's near-term economic outlook. Despite the disruption and trauma from the February earthquake, economic momentum has been remarkably robust. Recent dataflow, particularly surrounding business optimism, suggests this momentum has continued. The labour market has stabilised.
• We believe the economy is responding to (previously) loose financial conditions, spare capacity (providing "room to grow"), a stabilisation in house prices and a slower pace of private sector deleveraging as incomes (both for households and farmers) have improved.
• However, we are becoming more cautious on the outlook for 2012. While earthquake reconstruction is forecast to contribute 0.8 percentage points to average CY12 growth, we have downgraded our forecasts overall (now below consensus) due to a weaker global economy (including a number of "tail risks") and the significant tightening in local financial conditions. This is compounded by a further lift in our NZ$ forecasts (discussed below).
• After making encouraging progress on improving some of its external imbalances, we believe some of this progress will reverse due to the stronger NZ$ and deteriorating export prospects. The domestic economy will also be naturally supported by earthquake reconstruction activity and a continued (but modest) recovery in household consumption.
• However, the high NZ$ does provide some inflation relief. We believe headline inflation has peaked and will return to the RBNZ's target band in 1Q12 and remain there (albeit near the top of the band) for the forecast period. This is after previously forecasting inflation above the band through until the end of 2012. "Core" inflation is forecast to gradually increase as spare capacity in the economy reduces.

Investment View:

• We forecast the RBNZ to remove its 50bp 'insurance' cut at its next meeting in September, on the back of better domestic momentum. However, this is certainly not fait accompli. Given global fragilities, we expect this decision will be a close call. Unlike many, we do not believe the RBNZ has "fallen behind the curve" and see it has the ability to remain patient. After a pause, we see 100bps of further tightening over 2012 taking the OCR to 4.0%.
• While we acknowledge it is "dangerous" to alter forecasts in the current volatile global environment, we have lifted our expectations for the NZ$ to 0.85, 0.87 and 0.90 on a 3-, 6-, and 12-month horizon respectively. This is a reflection of ongoing structural headwinds for the US dollar more than anything (notwithstanding the recent sharp reversal in risk appetite). Our NZ$/A$ forecasts lift to 0.79, 0.81 and 0.82 on a 3-, 6- and 12-month view (from 0.74, 0.75 and 0.75).

NZD Forecast Change: Lifting To 0.90 On A 12-Month View

Key Points:
• Notwithstanding the recent sharp correction (due to heightened risk aversion and market positioning), the NZ$ has been one of the best performing currencies in the G10 year-to-date, recently setting new post-float highs against the US dollar.
• While it is arguably a "dangerous" time to be altering currency forecasts, we are lifting our expectations for the NZ$ to 0.85, 0.87 and 0.90 on a 3-, 6- and 12-month view respectively (from 0.78, 0.79 and 0.80). This reflects the fact that markets were trading well through our previous forecasts and an expectation for ongoing structural headwinds for the US dollar. Our expectations for the NZ$/A$ lift to 0.79, 0.81 and 0.82 on a 3-, 6- and 12-month view (from 0.74, 0.75 and 0.75).
• If risk aversion remains at elevated levels, the possibility of further near-term falls in the NZ$ cannot be ruled out. However, this may prove to be short-lived given improving domestic economic momentum and the weak US dollar outlook. Furthermore, non-fundamental drivers (reinsurance flows and Asian central bank reserve diversification) are also supportive.
• Our forecasts are predicated on an expectation that global economic momentum will recover over 2H11 (notwithstanding recent downgrades to global growth) and there is no further disruption to financial market sentiment from debt concerns in both Europe and the US. But it goes without saying that these are the key risks to the outlook.
• This change in our NZ$ view is released in conjunction with other changes to our NZ economic forecasts where we have lowered our expectations for CY12 GDP growth to 3.4% (from 3.9%) and CY12 inflation to 2.5% from 3.1%.


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