Peaking into 2023: Six things on our radar

Amid the descending gloom, we’re being asked about the big economic themes for next year. ‘Tis the season after all. Isolating the big economic trends for the following year has traditionally been a banana skin topic for economists (hands up who picked a pandemic!) But that doesn’t mean planning and risk analysis is pointless. This is particularly so given next year’s macro backdrop will look and feel noticeable different in our view, and not in a good way.

It’s by no means an exhaustive list, but some of the other themes on our radar for 2023 include:

• some inflation relief, but with margin pressures intensifying;
• the labour market to wobble but remain solid;
• a flattening in mortgage rates; and
• a bottoming in the house price cycle.

Finally, economic uncertainty is expected to remain in the stratosphere, meaning preserving flexibility and optionality will remain important in case the facts change. And they almost certainly will.

For each of the thematics above, we offer an indicator or two that we’ll be tracking as markers of these trends. Righto, into it.

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1. It’s gonna feel different, and not in a good way

We’re now well into the hangover phase of the economic cycle. There are pain points already. And yet, despite the countless road spikes laid in front of this year’s expansion, pundits have generally been surprised at how well the economy has held in there.

We reckon next year will be different.

Two things stand out to us in this regard. First, mortgage rate re-fixing. Interest rates have soared this year as the Reserve Bank has gone on the offensive against inflation. But the impact on mortgage holders has been delayed by the timing of fixed-rate rollovers. Advertised mortgage rates are now up around 6-7%, but the average rate being paid is still in the low 4’s. That’s about the same as where it was in early 2020.

This average rate will rise markedly in 2023. Just over half of all fixed rate mortgage holders will refix onto substantially higher rates over the coming 12 months. As a result, a push to 6% and beyond is largely baked in.

The looming tightening pipeline

Widespread mortgage distress should be avoided given the still strong employment market. Recent RBNZ data confirm arrears are very low. But something has got to give to accommodate these much higher incoming mortgage payments, particularly when more general cost of living hikes are already eating into household budgets.

The second, less visible, but no less important factor, is the sea change in global growth expectations underway.

Forecasts for such are being shunted down at a rate of knots, as central banks everywhere try to crush inflation with higher interest rates. China’s COVID-induced slowdown has also been a huge weight. Below-average global growth is assured, a full-blown global recession is increasingly a risk.

As the prior global growth tailwind flips into a headwind, the implication is a reduction in demand for our exports and a crimping in exporter incomes.

We’re seeing some of this already. For example, dairy prices are off about a third since the peak in March, admittedly to still very respectable levels. We expect the sputtering in global demand to result in further declines in commodity export prices through the first half of 2023.

Combined, these two unwelcome, but largely unshakeable, headwinds mean a recession for the NZ economy will be hard to avoid. Indeed, a small economic contraction has been built into our projections for a while.

Global growth ping-pong 

We suspect this will increasingly become the consensus view now that the RBNZ has admitted it requires a recession to achieve its inflation objectives. We see annual GDP growth slowing to fractionally below zero over the second half of 2023.

Importantly, how much pain is felt will differ across sectors and regions of the economy. Durables spending is one area of the economy set for a sharp pullback in our view. Retail, hospitality, and domestic tourism operators will likely find the environment tougher given the inbound pressures on discretionary spending. Residential construction stands out as another weak spot.

But there’s also some cushioning factors to bear in mind. These include the international tourism rebound, net migration returning to positivity, a NZ dollar still at fairly supportive levels, and the heady income growth emanating from the stretched labour market.

Beneath the surface, there’s a rebalancing underway. Away from household spending and towards exports, from capital income towards labour income, and from goods to services.

Key indicators to watch: China’s COVID policy, tourism arrivals, global share-market sentiment

2. Some inflation relief, but margin pressure to intensify

In our view, inflation is either in the process of peaking or has peaked already. We’re anticipating some relief, particularly over the second half of 2023. But, before getting too excited, it’s worth remembering that lower inflation is not the same as prices falling. Forecasting a slowing in the rate at which the cost of living is rising feels like cold comfort.

The burst of inflation that most countries are grappling with can be broadly split into two phases. The first was about global supply frictions built up during lockdowns and the surge in commodity prices (exacerbated by Russia’s invasion of Ukraine). The inflationary impulse from this source is now dissipating – see “tradables” line in the chart below.

The second phase is more about the secondary impacts that ripple through the economy as wage demands increase and cost shocks are passed on.

This sort of inflation is stickier. How long it lasts will determine where inflation (and hence interest rates) ultimately settles. It’s the bit the Reserve Bank worries about. Last week’s RBNZ meeting showed the Bank’s anxiety hitting new heights.

Inflation back into a 3-6% range in 2023

To date, many firms have been able to pass on decent chunks of the increases in their cost structure through to selling prices. Widespread supply shortages and peppy demand have been helpful in this regard. The pass through of the cost shocks has of course been less than complete; margins are clearly under pressure, and particularly in the manufacturing and construction sectors.

We suspect things will get more difficult on this front next year. A slump in demand, and the pressure on budgets, will crimp the extent to which firms can push through price increases. In turn, this may see a scaling back of employment and investment plans. All of which, we would add, is exactly what the RBNZ is trying to engineer via its interest rate policy.

Key indicator to watch: firms’ pricing intentions

3. Labour market to wobble but remain solid

The labour market remains miles out of whack, with firms’ desire to hire more workers nowhere near satiated by the market’s ability to supply. Hence the surge in wage rates and the sudden appeal of entering the workforce for folk previously outside it. Labour force participation has never been higher.

There are a few signs firms’ demand for labour is being reined in a little, although we’re not sure if these are genuine or some firms simply giving up on looking.

Either way, we think this trend is likely to gather pace next year. A much shakier economic footing, and associated slowing in demand/orders, will encourage a further scaling back of hiring plans. In some sectors, such as construction, this appears to be underway already.

Still, we don’t think this will drastically weaken the labour market. The supply side of the equation will remain tight. Population growth looks set to remain well below the trend we got used to pre-COVID. And the ability of firms to keep pulling in help from people previously outside the labour force looks close to tapped out.

A lift in migration should help loosen the shackles a little. But we still expect the overall lift in the unemployment rate next year to resemble more of a creep than a jump (chart below), and for wage growth to remain brisk.

The RBNZ’s own forecasts have average hourly earnings growth continuing to run hot around 8-9%y/y next year. This will be an important cushioning factor against the gathering macro storm clouds, namely the housing market decline, cost of living squeeze, and broader economic slowdown.

Unemployment slower to rise?

Key indicators to watch: firms’ employment intentions, migration

4. No mortgage rate relief, but uptrend flattens

Hopes we were nearing the peak in mortgage rates were dashed by the RBNZ last week. The Bank is stepping up its war on inflation and higher mortgage rates are the primary weapon in the fight.

It now looks as if the mortgage rate uptrend has further to run given:

• The RBNZ intends to lift the Official Cash Rate a further 125bps from here, to a peak of 5.5% around mid-2023. We’ve adopted the same forecast track, albeit while flagging the risk that not all of this tightening may be required.
• The expiry of the RBNZ’s “Funding for Lending” scheme – a source of cheap funding for banks – next month will add incremental upward pressure onto bank funding costs and hence mortgage rates.

In past interest rate cycles, the peak in mortgage rates has tended to occur around the same time, or a little after, the peak in wholesale rates. The latter has, in turn, roughly coincided historically with the last OCR hike in the cycle.

We currently have the final OCR hike pegged for April. It could come a little earlier if inflation falls faster than RBNZ forecasts imply, and other factors give the RBNZ confidence it will continue to do so. However, from where we stand now, this scenario is much too uncertain to hang our hats on. Thus, it’s possible the mortgage rate uptrend continues through to around the middle of next year. We suspect the upside on shorter-dated terms is greater than that on longer-dated terms.

Key indicators to watch: CPI inflation outcomes, inflation expectations

5. House prices to find a floor, but recovery might disappoint

We’re now a year into the house price downturn. Average prices at a national level are down about 12% from the November peak. Already the largest downward adjustment on record[1] (noting the exceptionally high starting point!), there’s understandably plenty of interest in where and when the correction might wind up.

House prices down 12% from peak

In our view, the number one precondition for such is the end of the mortgage rate uptrend. That’s not necessarily a fall in mortgage rates, but at least the end of the increases.

Higher mortgage rates have been doing most of the damage to house prices to date, and we tend to observe a 3–6-month lag from changes in rates to conditions in the property market (although we admit it’s far from an exact science).

So, if we do see the mortgage rate upturn flatten off next year, the trend decline in house prices could start to bottom out around mid-year. By that stage, our best guess is that prices will be threatening the bottom end of the 15-20% peak-to-trough correction we have long discussed.

House prices closely linked to mortgage rates

Put another way, we’re just under two thirds of the way through the downturn. If we’re somewhere close to the truth on all this, the correction would end with house prices still 10-15% higher than pre-COVID levels.

Overall, we’re loath to get too cute about trying to pick the exact turning point in the housing cycle. We do think though, that any recovery later next year will be tepid.

First, given the scale of the RBNZ’s inflation task, there’s little prospect of mortgage rates coming down appreciably next year, absent some sort of global meltdown.

Second, we’re nervous about the supply response. We know there’s a big housing supply pipeline out there thanks to the residential construction boom of recent years. This is turning up at the same time that housing demand has cooled rapidly courtesy of stalled inward migration. And while unsold inventory has recently climbed to 3-year highs, this is not a reflection of this new supply being worked through. It entirely reflects low levels of house sales. All of this confirms to us there remains a decent supply pipeline out there.

Keep an eye out for a new publication in the New Year that will take a deeper look at all things property and mortgage rates.

Key indicator to watch: REINZ house sales

6. Uncertainty to remain pronounced

All of the above is our best guess at the lay of the land but, as we’ve repeatedly seen in the past three years, stuff crops up that no one could have foreseen. Next year is looking particularly uncertain.

Economists talk about the “known unknowns” confronting the outlook – current examples being things like the resolution or otherwise of Russia’s invasion of Ukraine, the evolution of China’s policies to contain COVID, and NZ political uncertainty as we head into next year’s election. But there’s also the “unknown unknowns” that can turn up at any time and throw things wildly off course.

The implication is to take forecasts with a grain of salt, even more so than usual. On the flipside, stress testing and scenario analysis become more useful in the current environment. Make a plan but be flexible in case the facts change. Because they will.

[1] REINZ House Price Index

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