2019 - A mid-year progress report from ASB Bank

25-Jul-2019 13:02:55

2019 is continuing the general themes of uncertainty that were with us in 2018. It's a case of some things better, some things worse, and some things just chugging along much as they were. 

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For New Zealand, recent growth has remained modest rather than robust, which has opened the door for the Reserve Bank (RBNZ) to lower the Official Cash Rate (OCR). This will support both the economy in general and property markets in particular, however, over time looming bank capital increases will nudge borrowing interest rates higher.

Global outlook

Global fortunes are still being influenced by Donald Trump's brinksmanship over trade, as he puts the pressure on frenemies and neighbours alike to try and achieve what he sees as a 'good deal' for the US. Trade tensions with China have flared up, with the US putting in place the new tariffs it had deferred while trade talks progressed. This latest move was intended to put pressure on the Chinese to "seal the deal ', but to date only risks further tit- for-tat action that could slow both economies down.

Meanwhile, in the UK, Brexit went to the edge of the cliff, stared over, and managed to get an extension until the end of October. UK politics are in disarray, and the eventual form of Brexit is up in the air.

All this is happening against a backdrop of slowing global growth. The main silver lining is that the non-appearance of inflation in the US has halted the interest rate increases that destabilised global equity markets late last year. Markets are instead taking heart from the possibility that US interest rates are lowered this year.

Local prospects

Despite the prospect of below-average global growth, New Zealand's export prices remain firm and are likely to be supported this year by constrained global supplies. Many provinces in New Zealand are benefiting from this income injection, which is feeding through to retail spending and property markets. Ongoing population growth will also continue to give the economy a tailwind.

Two significant shifts are arriving for New Zealand's property markets, both courtesy of the RBNZ. First, in the here and now, interest rates have fallen and may still have slightly further to go. The main reason for lower interest rates is that inflation pressures remain muted because economic growth has been falling short of the economy 's 'speed limit'. Recovery from 2018's slowdown has been surprisingly long in coming. With weak business confidence persisting and business indecision a real risk, the RBNZ has taken out extra insurance with its May OCR cut.

We expect another cut over the second half of this year, though it will be heavily event dependent. Term interest rates have also had a helping hand due to the US Federal Reserve's more cautious interest rate outlook. Since the end of last year, the benchmark US 10-year bond yield has fallen over 60 basis points and given global interest rates a push down. New Zealand's equivalent bond yield has fallen around 80 basis points. Low interest rates are here to stay for a while yet.

An offsetting influence in the longer term will be the impact of higher capital holdings for locally-incorporated banks, with the RBNZ proposing to substantially lift capital requirements.

The upshot of the changes, which will be finalised in November, will be a combination of higher than otherwise customer borrowing interest rates, lower than otherwise deposit interest rates, lower returns on shareholders' equity, and slightly less availability of credit.

The impact of all these factors is likely to be a slight permanent reduction in the size of the economy (roughly up to 1%). That ongoing 'insurance cost' should, in return, reduce the economic impact of future banking crises by making banks more resilient.

We estimate the customer interest rate impact of the proposal would be around 50 basis points on average, with a risk that it is higher. 

The availability of credit will be slightly less over the long term, and potentially affected more noticeably during the period when banks need to lift their capital holdings. But the impact is likely to be felt unevenly across loan types, as regulatory capital requirements vary in broad alignment with riskiness of loans. Home loans with high amounts of borrower equity require very little capital, while sub-20% deposit loans can require four to five times as much. Loans for various commercial purposes require banks to hold substantially more capital. The capital proposals are likely to have the biggest impact on low-equity home borrowers, small businesses, and the rural sector. Changes will take effect early next year and be phased in over a minimum of five years, but banks need to start factoring in the future impacts already. 

So where to for property?

The vanished threat of a capital gains tax takes away one potential price dampener for all property types. Interest rates are lower in the here and now though over time capital changes will gradually nudge them up. For residential, most regions outside Auckland and Canterbury will be buoyant over the next year on lower interest rates, until construction catches up. Lower finance costs and acceptable rates of return should help put a floor under commercial valuations. For rural property the story is more nuanced. Dairy is undergoing a transformation from a capital gains model to a cashflow model, along with an added focus on environmental outcomes. Horticulture, particularly fruit, is meanwhile benefiting from high export prices and a desire to expand. 

By Nick Tuffley, Chief Economist, ASB Bank

This article featured in NAI Harcourts' Key Assets magazine issue 2, 2019.
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