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Data today showed the Canadian economy came to a complete halt in the second quarter, with the 0.0% growth reading coming in much weaker than the consensus estimate of 1.2%.
On an unrounded basis, the economy recorded a slight contraction of -0.049%, which would annualise to a -0.2% decline. Furthermore, the advance reading of no growth in July suggests that the growth slowdown persisted into the third quarter. Even the first quarter figures, a bright spot for the Canadian economy that contributed to the BoC resuming its hiking cycle in June, were revised down by a considerable margin of 0.5pp to 2.6%. We had anticipated to see signs of a slowdown in Canada, but these figures were shockingly weak. Virtually all remaining risk of a September hike was priced out by money markets, while the odds of a hike at any point by year-end was slashed to 1 in 3. The two drivers of softer growth we had anticipated did materialise—household consumption was virtually non-existent in Q2 and the trade sector posed a large drag—but a big decrease in inventory investment explains the downside surprise. Given the terribly weak Q2 figure and the downward revision to Q1, the economic landscape no longer looks like a soft landing is forthcoming. Instead, we could be looking at a mild to moderate recession if the demand slowdown continues.
For the Bank of Canada, the calculus surrounding the balance of risks will have swung sharply away from inflation to growth concerns. We now expect Governor Macklem to significantly tone down his hawkish stance, otherwise markets may begin to worry that he might hike into a severe recession. This does not necessarily mean cuts are on the table just yet, but hiking the policy rate would be unthinkable. As such, today’s growth data vindicates our long-standing view that the BoC is now at its terminal rate.
Falling inventory build drives slight contraction in Q2 GDP
One of the key trends within the data was a continued decrease in housing investment. Fixed capital formation in residential structures contracted by -8.2% annualised, the fifth consecutive decline. Although the pace of decline slowed from the first quarter, this reading suggests that the post-pandemic surge in home prices will continue to pose tremendous challenges for the political class, with the lack of housing affordability driven by lagging supply being top of mind for Canadians. Although housing investment declined, investment as a whole actually bounced by 1.2% annualised, driven by a 10.3% surge in non-residential buildings, machinery, and equipment.
Consumption growth was specifically concerning, with consumers appearing to be bracing themselves for economic pain ahead. StatsCan reported that household disposable income rose by 2.6% in Q2, driven by a 2.2% increase in employee compensation and a 3.1% gain in self-employment income. But even with greater incomes, Canadians saved a larger share, with the household savings rate climbing to 5.1% from a reading of 3.7% in Q1. The decline in consumption was widespread across most categories. Both goods (+0.6%) and services (-0.1%) spending softened from growth rates that nearly cracked 5% annualised in the first quarter, and within the goods sector, both durables (-2.0%) and semi-durables (+1.8%) softened substantially. Only non-durable consumption growth rose from the previous quarter, to a rate of 1.6%.
The household consumption crunch also fed through to corporate incomes, which declined for the fourth consecutive quarter.
In the monthly GDP by industry report, StatsCan noted that virtually every industrial sector of the economy contracted in June, led by a -3.0% decline in wholesale trade. As a whole, the economy shrank by -0.2% in June, which matched last month’s advance reading as well as the consensus estimates. Forest fires were cited as a key culprit of the continued economic slowdown, primarily affecting the mining and quarrying sector (-5.7% MoM) as several mines were forced to close. The fires also led to a temporary suspension of a rail line that connects to an iron mine in Labrador, which also contributed to a -6.6% decrease in rail transportation. However, forest fires weren’t the whole story, as there were only small pockets of growth across industries. Just real estate (+1.1%) and the public sector (+0.4%) expanded, signifying that the Bank of Canada’s rate hikes are binding even in areas that are not influenced by the fires.
The market reaction to today’s report was pessimistic, and rightly so. On top of the decrease in money market expectations, Canada 2-year yields plunged by 10 bps to 4.54%, widening the US-Canada spread by another 5bps. This saw the loonie weaken by -0.4%, interrupting its recovery against the dollar, and leading it to decline against every G10 currency. The losses could have been worse, though. Equities are trading in positive territory after a US jobs report led Fed expectations lower, and a 1.5% rally in crude oil which has WTI eyeing the $85 handle, is also preventing greater CAD downside.
Even with today’s soft GDP report, traders are still too cautious about pricing in BoC cuts for 2024. Overnight swaps have gone from pricing no cuts to almost fully pricing one cut by the end of next year, but we expect the Bank of Canada to trim the policy rate even further next year. Markets should begin to factor this in once weaker growth conditions start to take hold in the inflation data, as softer core inflation now looks imminent.
Author:
Jay Zhao-Murray, FX Market Analyst