Stalling share prices and rising interest rates suggest a new economic cycle is nigh

by Pattrick Smellie / 16 January, 2017

Photo/Getty Images

There’s nothing like the unexpected resignation of a popular Prime Minister at the height of his powers to bring out an army of theorists looking for the “real” reason for his departure.

First out of the blocks on the day of John Key’s announcement that he was stepping down was New Zealand First leader Winston Peters, who assumed there must be “hidden economic reasons” behind the decision.

“The fact is that the economy is not in the healthy state that the Prime Minister has for so long claimed, and there are other issues that have caused this decision as well,” Peters thundered. “The public should have been informed of this a long time ago.”

Being the wily old political fox that he is, Peters knows the economy has been at a turning point over the past few months, and that in the year ahead, the economic story will start to change. Key, too, understands this, as he also knows that two basic baro­meters of economic performance explain much about why a government that a chunk of the public regard as uncaring and inactive on major issues such as housing supply and income inequality has continued to ride high in opinion polls.

 Those two barometer readings are as follows. First, since the depths of the 2008 financial crisis, the leading index of New Zealand shares, the NZX 50, has tripled in value. The benchmark index was at 4332 in October 2008, when chaos struck the American, Japanese and European banking systems. By November 2009, it had nearly halved, bottoming out at 2411. After that, however, the index began a seemingly relentless climb to peak at 7571 in September.

Second, in the same period, interest rates dropped even more dramatically than shares rose. Taking the two-year swap rate – a bellwether interest rate for corporate borrowing – interest rates fell fourfold, from a peak of 8.75% in November 2007 to a low of 1.9% this August.

The unprecedented plunge in the cost of borrowing explains how people have been able to afford mortgages to buy Auckland houses, with average household debt now sitting at a whopping 165% of average household income.

Also in the mix is an economy stoked by high migration, galloping international tourist arrivals, a construction boom, low unemployment and one of the highest rates of workforce participation in the developed world. Amazingly, this was against a background of two tough, loss-making years for dairy farmers, from which they’re now emerging. The figures help demonstrate that typically oblivious city dwellers never really missed a beat.

If that old slogan about politics – “it’s the economy, stupid” – holds true, then these few indicators might be enough to explain a core of contentment in a large part of the electorate. However, in the past three months, the persistent share-price and interest-rate trends of the past seven years have halted.

The NZX 50 index has undergone a “technical correction”, falling more than 10% to a low point of 6643 on November 9, before recovering slightly.

And although the Reserve Bank cut the official cash rate (OCR) – the cue for commercial bank interest rates – again on November 10, to 1.75%, banks have not cut their rates accordingly. If anything, longer-term mortgage rates have ticked up slightly.

BNZ’s Stephen Toplis. Photo/Hagen Hopkins

All change

Global factors, not least the prospect of a faster-growing, higher-inflation US economy, mean the domestic economy is now at an inflexion point. The long run-up in share prices and a steady fall in interest rates look likely to be replaced by a period when easy gains for share investors are over and tighter times are ahead for borrowers.

“There are two separate things going on,” says Bank of New Zealand head of research Stephen Toplis. “It’s possible to be almost unequivocally positive about the real economy,” he says, pointing to the range of factors outlined above. Like fellow economist Robin Clements at UBS, who sees the economy slowing a bit over the next two years from its present high 3.3% growth rate, he thinks there’s plenty of momentum.

“It’s really hard to see that the real economy won’t function quite well,” Toplis says. “The question is what does that mean for asset prices?” By which he means real estate, shares (or equities) and interest-bearing bonds.

“For those in equities, the interesting thing is going to be the trade-off between the increased value attributed to those equities because their earnings rise, compared with the decreased value of equities as interest rates rise.”

Simply put, shares that pay decent dividends are likely to be more heavily favoured than so-called “growth” stocks, which rely on their future prospects to deliver a rising share price rather than current earnings to deliver regular income to shareholders.

Robin Clements of UBS. Photo/Martin Hunter

My bond is my bind

Meanwhile, in the back-to-front world of corporate bonds – in which rising interest rates make bonds less valuable – Toplis sees life becoming “problematic” for professional investors. But for conservative investors, who simply save money in a bank account or on term deposit, slightly better returns will start to emerge as deposit rates rise after years of income erosion.

Property price rises, says Toplis, should moderate with rising interest rates, but the chronic undersupply of housing and high inward migration should underpin the housing market, although an increasingly buoyant Australian economy is likely to discourage the flow of expat Kiwis returning home. The historic tendency for the “west island” to siphon New Zealanders across the Ditch may also resume over the next couple of years.

So, for savers, the news is good but not that exciting, whereas the news for borrowers is not apocalyptic. Interest rates will rise, but there’s little chance that they’ll return to pre-financial crisis mortgage-interest levels of 9%.

Kiwibank chief economist Zoe Wallis notes that the Reserve Bank is signalling no change to the OCR until well into 2019, so any upward pressure on interest rates will be coming from rising global rates and an emerging war for local savers’ deposits because regulations require the country’s banks to hold minimum quantities of local cash on their balance sheets.

However, Wallis warns that about two-thirds of mortgage lending is on fixed interest rates of less than one year’s duration, so rising mortgage rates will feed through quickly to the wider economy. “Most people will be hit very quickly,” she says. Some heavily indebted households will feel the strain.

“That’s going to have a much faster effect than the positive stimulus [of the fast fall in rates after 2008], when most people were fixed at five years or more.”

Kiwibank’s Zoe Wallis. Photo/Hagen Hopkins

The Key factor

Throw into this dynamic the absence of a Prime Minister whose strong suits have been credible economic management and an optimistic mindset in a world beset by financial and political crises. Will Key’s departure also have an effect on economic performance or is there something more robust than a personality cult underpinning our financial fortunes?

Clements sees no reason for Key’s departure to have any significant impact, except on that most ephemeral factor: public and business sentiment. “The initial question is ‘Does it affect confidence?’” says Clements. While financial markets reacted predictably to Key’s announcement, sending the dollar lower and interest rates a little higher, they recovered within hours.

“It’s clearly a negative factor for the National Party. It has a decreased likelihood of a fourth term, at the margin, but I can’t see why businesses would suddenly think it’s the end of the world.”

Although National-leaning business people might start to take fright if the party suddenly starts to poll far worse, Clements reckons the building blocks that give the economy comparative strength are too entrenched to be easily changed by an incoming government.

“Markets may take a dim view [of a likely change of government] and would be concerned about regulatory risk, potential for overspending and the effect that might have on the exchange rate and interest rates. But markets tend to fret about potential changes whereas the reality is typically not as bad.”

Offshore winds

There is another reality, too. What happens beyond these shores is almost always the greater influence on New Zealand’s economic fortunes.

On the one hand, central banks around the world are giving up on the “money-printing” experiment of the past few years and attention is turning to what kinds of debt-backed investments governments can make that will stimulate economic growth and productivity.

“Globally, in the past three months, there’s been an acceptance that monetary policy has done as much as it can,” says Clements. “It’s time to look to fiscal stimulus.”

This is at the heart of the economic plans that US president-elect Donald Trump has talked up, but not yet fleshed out – a combination of massive new infrastructure spending and personal tax cuts to stimulate the world’s largest and richest consumer economy.

Those plans are expected to ignite inflation – dead in the developed world for the past five years – and in turn justify higher interest rates. Along with a recovery in commodity prices, especially oil, the stage is set for a return to something more like the “old normal”: positive interest rates, measurable inflation and higher global growth rates.

That is, of course, if the giant debt overhangs in the global economy caused by money printing, and similarly giant debt built up in the Chinese economy, don’t implode. If that happens, we’re all in it together.

This article was first published in the December 17, 2016 issue of the New Zealand Listener. Follow the Listener on Twitter, Facebook and sign up to the weekly newsletter.


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