Weak business investment casts cloud over strong GDP growth

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Canada's third-quarter gross domestic product report couldn't have come at a better time for the Bank of Canada, shining some light into some frustratingly foggy corners of the economy just as it begins wrestling with next week's interest-rate decision. And while the central bank's confidence was surely lifted by the strong growth numbers, the report crystallizes that there's one critical economic battle that the country is still losing: How to awaken comatose business investment.

Economists went into Wednesday's GDP announcement from Statistics Canada believing the economy had bounced back strongly from a second-quarter slump that was widely seen as a temporary aberration, and they weren't disappointed: Real GDP grew at a 3.5-per-cent annualized pace in the quarter ended Sept. 30, the strongest quarter-to-quarter expansion in more than two years. Statscan also upgraded its GDP estimates for each of the previous two quarters: The second-quarter contraction was revised to 1.3 per cent from 1.6 per cent, and first-quarter growth was raised to 2.7 per cent from 2.5 per cent. Putting the cherry on top, September GDP grew a better-than-expected 0.3 per cent month over month.

All of which was certainly welcome news for the Bank of Canada, which slashed its growth forecasts in October and had mused about an interest-rate cut, before deciding that the band of uncertainty surrounding its forecasts was so unusually wide, due to a litany of unresolved variables, that it needed clearer evidence. Among its list of uncertainties that were placing flashing asterisks on its forecasts: The new, tighter federal rules on mortgages; the impact of Ottawa's infrastructure stimulus and enhanced child benefits; the stalled recovery of exports; and the U.S. presidential election.

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Since that time, only one of these big question marks received an answer – the result of the U.S. election. And if uncertainty was your problem, the election of Donald Trump was about the furthest thing from a solution to that problem.

In a news conference following Bank of Canada governor Mr. Poloz's speech in Toronto earlier this week – his last public comments before next Wednesday's interest-rate announcement – he intimated that the flow of economic data this week, especially the quarterly GDP report, might narrow that unusually wide band of doubt around the bank's forecasts. In some respects, anyway, the governor got some answers that he will like.

By pure arithmetic, the strong quarter, coupled with the prior quarters' upward revisions, put the economy ahead of where the Bank of Canada believed it would be at this point. Third-quarter growth alone was 0.3 percentage points higher than the central bank had estimated in mid-October. The central bank's GDP growth forecast for all of 2016, at 1.1 per cent, looks like a considerable undershoot; real GDP is already 1.2 per cent above its end-of-2015 level. And given the strength of the economy in September, it entered the fourth quarter with more momentum than anyone had expected; the bank's tepid 1.5-per-cent forecast for the quarter suddenly looks overly pessimistic.

All of this may mean that the output gap – the difference between what the economy is actually producing and what it is capable of producing at full capacity – may be meaningfully narrower than the Bank of Canada has estimated. Which would mean a return to full capacity, and thus a need to increase interest rates, may come sooner than we previously thought. Unquestionably, the bank still faces a long list of uncertainties; but at very least, an economy that now looks to be ahead of the bank's pace will give it more of a cushion against the potential downside risks to its outlook, and significantly ease the case for a near-term rate cut.

Mr. Poloz will also take solace in the fact that the third-quarter growth rebound was driven in large part by exports, a perplexing sore point for the economy for much of the year. And the surprisingly strong household-consumption numbers suggest that the federal government's increased child-benefit cheques, which kicked in for low- and middle-income families in July, are stimulating consumer spending.

But the business-investment picture casts one enormous cloud over all this sunshine.

Business gross fixed capital formation fell 0.5 per cent from the second quarter, its eighth consecutive quarterly decline. Investment in machinery and equipment slumped 3.2 per cent, its biggest decline in five years. In September, wholesale sales of machinery and equipment slumped 3.7 per cent.

This persistent investment weakness, and the wide band of uncertainties that Mr. Poloz talked about earlier this week, are intertwined. Businesses remain hesitant to commit money to a future they can't adequately see. That has been the case throughout most of the post-recession era, and the numbers suggest that the latest set of uncertainties are feeding that reluctance.

With this in mind, perhaps the next key indicator for the Bank of Canada will be in the bank's next quarterly Business Outlook Survey, to be published in January. The critical information now for Mr. Poloz will be not so much statistics but business sentiment – how the country's corporate sector is choosing to perceive the uncertainties, especially those surrounding the incoming Trump presidency. That will signal whether we can expect a round of business investment to reinforce and sustain the economic upswing – or whether the growth is doomed to stall from the chronic lack of corporate fuel.