Now that expectations have been beaten down to virtual nothingness, there’s plenty of room for some blowout Canadian GDP numbers ahead – and capital investment may well be the catalyst.
How times have changed. In the wake of the Great Recession, the Canadian economy was seen as a favourite child, one who is accomplished, smart, with lots of friends. A real go-getter. Over the past couple of years however, Canada has fallen out of favour and is now seen as a problem child who sits in the basement playing video games, watching reruns of Weeds into the wee hours while eating takeout pizza.
Now that this new identity is adopted, its hard to shift the perception, particularly now that the parents (i.e. the Bank of Canada) appear to have started whispered discussions of trade school and/or converting the space above the garage into an apartment for said troubled youth who may never leave home.
In that same vein, economic underperformance of the past several quarters has been extrapolated into the future. Expectations of mediocre growth for the next several years are now the mainstay of private sector, International Monetary Fund and Bank of Canada forecasts, with expectations centred around about 2.25 per cent – a far cry from the heady and league-topping 3.3-per-cent growth achieved in 2010.
To be sure, many of the main engines for growth, which made Canada the favourite child a few years ago, are no longer there. As usual in the first stage of recovery, households sustained growth by taking advantage of cheap financing to buy cars, household durables and especially real estate.
What sent the Canadian economy to the basement was that businesses failed to assume the mantle of growth as normal in previous recovery phases. In the best year of the recovery, 2010, machinery and equipment investment (capital expenditure or capex) barely edged above 10 per cent and has averaged barely 1 per cent in the past six years. Commercial construction fared somewhat better in the early stages of the recover in 2010 and 2011 but has ground to a standstill in the past four quarters. With global growth, and hence exports, sluggish and an uncertain global outlook, it was perfectly understandable that businesses restrained capex outlays.
But should past performance still be a predictor of the future? The Bank of Canada has roughly 4-per-cent capex growth in 2014 baked into their gross domestic product forecasts, which is about half the pace needed every year just to replace worn-out capital. If businesses even increase capex to keep pace with replacement demand, GDP growth could be closer to the top end of the bank’s predicted range of 1.8 to 2.8 per cent. If businesses decide to actually expand their productive capital, as bank surveys indicate businesses desire, GDP growth could easily come in well above 2.8 per cent.
The seeds of a strong capex cycle seem to be in place. There are emerging signs of accelerating growth in the U.S., U.K. and Japan. The cost of capital remains near record lows, with the Toronto Stock Exchange continuing to set new cycle highs and interest rates at or near cycle lows, not to mention the mountains of cash available on corporate balance sheets.
Moreover, almost six successive years of stagnant capex investment means that the stock of capital is now critically low and capacity pressures may soon become apparent. The Band of Canada’s October Business Outlook Survey reported a six-year high in businesses that would find it difficult to meet an unexpected rise in demand. Capacity utilization rates tell a similar story with businesses running at over 80 per cent of productive capacity in the second quarter, about 2 per cent above the 20-year historical trend.
What this potential growth surprise means to investors is that the short end of the yield curve is not anticipating a sufficient possibility of a rate hike from the Bank of Canada in 2014. Moreover, with virtually every private and public sector forecaster predicting that Canada’s economic performance will fall short of the U.S. by about 0.3 percentage points, there’s plenty of room for the Canada/U.S. bond spreads to widen as well.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.