Meanwhile, away from the markets ...
While share prices plunged, the real economy is in rare good health
The turbulence on Wall Street and other global equity markets this week has been a case of fasten seatbelts — not brace for crash landing. Not yet, anyway; never say never. It is too soon to be sure what it means for the New Zealand economy because we don’t yet know what “it” is.
Is it a normal, healthy pull-back for a United States sharemarket where price/earnings multiples have become overstretched? Or early signs and portents of the transition from a bull to a bear market, which must happen eventually?
As the old adage has it, bull markets don’t die of old age, they are killed by interest rates.
Markets don’t keep rising in a straight line forever. The tension between a US sharemarket priced for a strong economy and interest rates priced for a weak one could not continue indefinitely. The monetary plaster cast has to be removed sometime.
But the fundamental picture is a world economy that is firing on all cylinders, with synchronised strength in all the major regions. That is rare. And of course it includes the US.
The trigger for the markets’ sudden rediscovery of risk was the news that wage inflation in the US had climbed to 2.9 per cent. Given that 70 per cent of the US economy is propelled by consumer spending, that is actually good news.
Not only have forecasts for world output and trade volumes been revised up of late, on the prices front New Zealand is enjoying exceptionally favourable terms of trade (the mix of export and import prices). Indeed, the Reserve Bank yesterday released forecasts which have New Zealand’s economic growth rate averaging 3.2 per cent over the next three years, in line with our trading partners. Governor Grant Spencer said the bank saw no reason to alter its forecasts in light of the equity market volatility.
“The US market had got pretty stretched over the past two months. Investors were looking for a bit of a correction. The market does appear to be nervous about the outlook for inflation and interest rates,” Spencer said.
But though things have settled down, it was a bit of a warning sign, he said.
The Reserve Bank would be more concerned if the volatility extended into interest rate markets. That would pose upside risk to its own interest rate forecasts.
As it is, it is forecasting that short rates will not start rising until the middle of next year, with a full 25 basis point increase not fully pencilled in until early 2020.
Major central banks continue to gradually normalise monetary policy settings but financial conditions remain highly accommodative, the bank says.
“What we are more nervous about is if happens quickly,” Spencer said.
“If bond rates go up sharply, the risk is that it can derail the global recovery . . . Currently we are confident it is a gradual thing. The risk is that it could be sharper.”
It is not as if inflationary wildfires are breaking out all over the place. Annual inflation rates across the OECD averaged 2.3 per cent in the fourth quarter of 2017. That is up from 1.6 per cent a year earlier and 1 per cent a year before that, but it is hardly Venezuelan.
And if the Federal Reserve ends up raising interest rates faster than the market had expected, the prospect of the Fed funds rate being higher than the New Zealand official cash rate for a while might even relieve some upward pressure on the kiwi dollar, all else being equal.
A rise in longer term US interest rates would ultimately put upwards pressure on fixed mortgage rates here.
If bonds sell off in international markets, it affects banks’ cost of funds, especially on fixed-term mortgages for new borrowers and those rolling loans over.
“This is why borrowers and banks need to be careful,” Spencer said.
“You need to be thinking about whether you can afford that mortgage if rates were 2 per cent higher. I’m not saying that’s where rates are going. It’s a buffer.”
The ratio of household debt to disposable income is historically high but that needs to be seen in the context of historically low interest rates.
And if that ratio is high, at least it does not seem to be getting worse. In the course of 2017, household debt rose 6 per cent, only slightly faster than labour market incomes. Statistics NZ reported this week that gross weekly earnings from wages and salaries rose 5.6 per cent in 2017.
Last year’s 6 per cent growth in household debt was down from 9 per cent in 2017 and 7 per cent in 2015 — a cumulative 23 per cent rise in debt levels over the three years compared with the 40 per cent rise in the three years before the last recession, when the OCR ultimately hit 8.25 per cent.
“When we get nervous is when debt ratios are going north and we are having higher interest rates,” Spencer said.
ANZ Capital chief economist Bevan Graham notes that higher debt levels mean the central bank will get more bang for its buck when it does start to tighten and so it should be expected to proceed more gingerly than it might have in the past.
Another third potential channel from equity market ructions to the real economy would be via the wealth effect and consumer sentiment.
But Kiwi households are less exposed to equity prices than their American counterparts. The NZX’s market capitalisation is equivalent to around half of gross national income, compared with around 150 per cent in the United States.
According to the Reserve Bank’s aggregate household balance sheet data, equities (excluding unincorporated businesses and unlisted companies) represent about a tenth of households’ net wealth. That is dwarfed by housing equity.
The fundamental picture is a world economy that is firing on all cylinders