NZ Economy- What sort of Landing?

Again, another article by Gareth Morgan dating from April 05, discussing where the economy could go over the next few years. Where are we headed now?

Sifting Through the Economic Scenarios
5 April 2005

There’s a flurry of discussion right now about where the global and New Zealand economies and investment markets are headed. As always pre-election periods tend to arouse the anticipatory saliva, as voters, businesses and political aspirants all look for opportunity amidst the chaos.
Then there’s the economists who endlessly debate hard verus soft landings, currency tumbles and housing collapses – knowing full well that any prognosis is only ever one scenario no matter how robust its internal logic might be. All up then, pre-election months see a feeding frenzy of interest in our future which, once the election passes and Christmas looms, dies a sudden death.
In this last business column from me for a few months, let’s then join in and sift through the economic and investment outlooks, try to get each in perspective, and summarise what the all-up implications are for investors. Right now I see three candidates vying for the scenario of the moment.
The first and most conventional, holds that the New Zealand dollar has now peaked and will drift gently back to its “fair” value of 55-60 cents US, our rate of economic growth will gently ease back and enable inflation-threatening capacity bottlenecks to clear. The Reserve Bank will be able to avoid further interest rates hikes, and after the pause-that-refreshes, the economy will resume a respectable and sustainable growth rate of 3% per annum. Exporters will do handsomely and our balance of payments deficit will be well contained within the band of tolerance our creditors bestow.
This “Dream Scenario” firmly believed by the eternal optimists within the business and political communities, should more aptly be thought of as a “Dreamers” outlook. There are so many things that have to fall in place as to make it pretty much impossible. For instance the US dollar has to settle into an updraught, our inflation has to fall back in the face of a 20% devaluation, and as interest rates drop, housing speculators have to stay in their kennels despite the commercial banks’ best efforts.
A second scenario is one that sees the Reserve Bank forced to raise interest rates further as the likelihood of inflation retreating below 3% fades. This interest rate scenario excites further interest in the NZ dollar, which resumes continues its upward climb. Set against a backdrop of ongoing strong world growth, the export sector stubbornly refuses to fall apart as ever-rising commodity prices cushion it against the higher dollar effects. Meanwhile in the domestic economy the government pour fuel on the flames of overall spending with a raft of infrastructure spends and expansion of the bureaucracy. The construction industry finds the demand for its services burgeoning despite being at full capacity. It is forced to raise prices aggressively in order to assist buyers rank their priorities. Banking sector innovation (aka competition) enables fixed mortgage rates to stay palatable for borrowers prepared still to devote a rising proportion of their incomes to debt servicing.
Under this “Hard Landing” Scenario (which I detailed a couple of weeks ago in this column) there’s finally a wee crisis of confidence in the structure and sustainability of New Zealand’s growth, so the currency plunges from giddy heights and the Reserve Bank is faced with having to sustain very high interest rates to restrain that fall. Economic growth shudders to a halt.
The third scenario is one that sees the NZ dollar leech value as our creditors are no longer excited by our interest rate offerings in the face of rising US rates. For an economy already at full capacity, facing rising inflation as a blossoming government sector competes for resources with a private sector still in top gear, the mainstay of inflation control – the rising dollar – is removed. This gives the Reserve Bank little option but to raise interest rates further, although not as far as under the “Hard Landing” scenario and so we don’t see a rising kiwi dollar.
Under this “Soft Landing” Scenario, the domestic economy enters a few years of “morning after” blues – high interest rates make the housing market too hard, leakage of skilled labour overseas accelerates and the New Zealand economy enters a funk. But in the tradeables sector, farming at least looks perkier thanks to dollar relief, though manufacturing fails to escape an ongoing thrashing from the Chinese price effect. But in all, our balance of payments deficit peaks and slowly comes down. Economic growth would bottom at around 2% pa, although sit there for a few years, waiting for population growth to revive.
So there’s just three scenarios – a dream, a hard and a soft landing. How to choose? The answer is you can’t and we can be reasonably sure none of them will be what actually transpires, but one will be closest. This tells investors, businesses and households then what they must do, given they have to make decisions now, not once they know what has happened. You have to assign probabilities to each and from those you derive the investment strategy that minimises the chances of a meltdown in your portfolio for any given upside you target.
Pick your own probabilities but mine right now would be 20% Dream Scenario, 30% Hard Landing and 50% Soft Landing. But, and here’s the rub, a 50% probability of a soft landing doesn’t mean it is going to happen so investors that position as though it’s certain, deserve a thrashing. That’s the whole point of tactical management – you take a detached viewpoint of the future, distil the implications of all scenarios and position your portfolio, your business, or your household budget to survive the worst scenario whilst capitalising as best you can on the most rosy.