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Canada's Next Economic Quarter: Not so Bad After All?

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JIM FLAHERTY GDP GROWTH
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With Labour Day fast approaching, investors are getting ready to say farewell to a summer that has been less than kind in terms of not only equity market performance, but reflections on the economy as well.

The other week, we were prepared for bad news by both the Bank of Canada and Finance Department, in terms of the possibility that Canada's economy may have suffered a pullback in the second quarter.

Real GDP in Q2 posted a 0.4% decline on an annualized basis, following two solid 3%+ quarters. For most economists, this was pretty much expected given the string of dismal indicators early in the quarter (remember that a lot of the key numbers we examine come out with a longer time lag than the comparable stats out of the US). Housing statistics for one were less than impressive in the second quarter, and offered no net contribution to real GDP growth. However, it was Canada's trade sector that produced the largest drag on economic activity. Net real exports suffered a 2.6% decrease annualized, which was the largest decline since the recession.

On the plus side, much of Canada's malaise came at the front end of the second quarter and resulted from one-off factors like weather and supply disruptions tied to Japan's earthquake/nuclear crisis. In terms of the monthly GDP figures, output was flat in April, fell 0.3% in May and recovered 0.2% in June. The consumer, while not altogether a huge growth driver, wasn't in bad shape. Indeed, real personal expenditures expanded by more than 1.5% annualized. Business investment was also solid last quarter, as spending on machinery and equipment soared by close to 30% to a new record and fixed investment rose by about 10%, approaching the pre-recession high.

Back to housing, Canadian home prices improved by 1.7% in June, which was the fastest in two years; and housing starts rose a further 4.3% in July after a 3.4% gain in June. The direction of late-quarter indicators suggests that the third quarter will show a reasonable bounce after the contraction. No doubt, government officials will parade this improvement around once released. Unfortunately, we won't get third quarter GDP data until November.

The other thing to be careful about is how the August numbers pan out, given the shake-out in business and consumer confidence after the U.S. debt debacle and ensuing market correction. A hit to retail sales, for example, could detract from or derail third-quarter growth prospects. Ditto for a reversal in business investment spending, especially after the strong gains made in the second quarter.

That said, the early read on actual consumer performance at the cash register in August isn't that bad. U.S. auto sales for August were streaming in on the positive side of expectations at the time of writing, despite weaker confidence numbers. Similar gains for Canada would suggest that retail could escape the month in okay shape. The other cautionary note regards trade. While the Loonie has come off the boil as a result of the mid-summer risk aversion shift, we're not far off the average exchange trade versus the U.S. buck in the second quarter. Considering the weaker US spending figures for this quarter, it is unlikely exports will witness a rebound.

Whether or not this quarter turns out pleasant, officials are already hinting that economic stimulants stand at the ready. Just weeks after the Bank of Canada suggested a near-term tightening of policy, the consensus opinion is that the rates will be on hold for the duration of this year. Finance Minister Flaherty went further by indicating that there was more room to move on rates should it be needed. Yeah sure -- a whopping 1%.

I wouldn't hold my breath, however, on a rate cut. With year-over-year GDP growth still hovering near 2%, there is no dire need for Mr. Carney and crew to chop rates. The more than 1% drop in long-term bond yields is a more significant stimulant than anything the Bank can do anyway. And, finally, we have the stock market.

The recovery in the TSX since the first week of August, while choppy, has all the right ingredients going for it. A pattern of higher lows and highs and declining volatility will work to entice investors back into risk assets, and improving portfolios will bolster consumer sentiment. We still have a long way to go before a realistic assault on the spring highs can be mounted, but this is going to be a quarter-by-quarter grind and looking beyond current economic data will be key.

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