Opinion: Market pricing a more accurate foreteller of economic fortune

By Roger J Kerr

A good number of local economists continue to have a view that the NZ economy is really struggling and the media lap up their pessimism.

However, tellingly, the markets are signalling to us something completely the opposite about the current and future outlook for the NZ economy.

Consider the recent price action in the financial and investment markets:-

Foreign exchange market:
The NZD/USD propelled up to near post-1985 float highs of 0.8215 as news reports stated that Chinese sovereign wealth funds were allocating another $6 billion to invest into New Zealand. Whether the news was correct or not was of no matter as currency speculators rushed to buy the Kiwi before the Chinese did.

The popularity of New Zealand as an investment destination to meet their portfolio diversification needs is understandable with export prices and terms of trade at 30-year highs. The fundamentals of the NZ economy supplying protein to the massive urbanisation of Asia are very positive, and this is now being recognised by overseas investors with long-term investment horizons.

NZ Government bond market:
The considerable overseas investor demand for NZ Government bonds has driven the 10-year market yields down from 5.80% to 5.07% over recent months.

The Asian sovereign wealth funds do not hedge the NZ dollar denominated bond investments; that is, they just buy the Kiwi dollar to buy the bonds and happily take the currency risk while they hold the bonds. The Government’s budget two weeks ago alleviated any concerns about a credit-rating downgrade for New Zealand.

NZ equities market:
While not on a runaway boom, the NZ sharemarket has performed well over recent months with share investors clearly confident about earnings increases for listed companies in the current and future economic environment.

Artificially low interest rates here (like the US) do distort the performance of shares, as buying shares for dividend yield is more attractive than cash in the bank on deposit.

Wholemilk powder market:
Fonterra’s confirmation of $8.10kg milksolids payout for the season just ended and a generally higher than expected $7.15 to $7.25kg milksolids forecast for the 2011/2012 season ahead has to be seen as very positive for the NZ economy going forward.

Fonterra has confidence that the rise in international dairy prices over the past 12 months is sustainable.

The overall market pricing is signalling a strong economy and thus 4% plus GDP growth forecasts for next year have been given a tick as accurate and likely by the markets.

The RBNZ could be well advised to take note of these market price signals rather than relying solely on the housing market as their key lead-indicator for inflationary pressures.

As always, waiting for house prices to turn up before tightening monetary policy is a big mistake when the inflation risks are already increasing due to stronger than expected economic growth. There are signs already that farmers have started to spend again and even the OECD in their economic outlook for NZ last week see demand and spending picking up in the second half of 2011.

These markets tell me that the RBNZ and non-bank economists are underestimating future economic growth and are thus far too complacent on the future inflation threats.

Business firms who have had compressed profit margins over the last two years (due to higher input costs) will be very keen to recoup those lost profits when end-demand picks up and they can increase their prices. Higher wage settlements and higher KiwiSaver employer contributions are two of those increased input costs. Price-setting behaviour is about to change.
 
Three year fixed-rate money (three-year swap rates) at 3.80% looks startlingly and artificially cheap against this scenario of stronger growth and an annual inflation rate above 3.00%.