Outlook dims thanks to Trump, trade wars

Risks are forcing policy-makers to proceed with caution, Kevin Carmichael writes.

The Bank of Canada had a good week. Governor Stephen Poloz’s crew took some risks and was rewarded.

On Wednesday, the central bank surprised some by effectively closing the door on an interest-rate cut, a move that the bond markets didn’t see coming. And then the following day, Carolyn Wilkins, the senior deputy governor, told an audience in Calgary that Alberta’s struggle to adjust to lower oil prices wasn’t reflective of the broader national economy. “This has led to painful adjustments for many of you here and has weighed on Canada’s bottom line,” she said. “Seen from a macro perspective, nonetheless, Canada’s economic performance has been solid.”

Those conclusions carried some reputational risk. Looming over the Bank of Canada’s latest policy decision was the release of Statistics Canada’s tale of economic output in the first quarter. StatCan could have blown up the central bank’s story. Instead, the latest numbers confirmed it was true.

Gross domestic product grew at an annual rate of 0.4 per cent in the first three months of 2019, weaker than a lot of Bay Street estimates, but essentially what the Bank of Canada had predicted when it updated its outlook in April. That’s a poor result. It matched the fourth-quarter growth rate, confirming the worst six-month stretch for the economy since 2015. But it’s the past. What matters for the central bank is what the report says about the future. And beyond the headline, the news was mostly positive, suggesting that economic growth is set to rebound.

Two numbers stand out, both pleasant surprises.

Household spending jumped 0.9 per cent, the strongest since 2017 and a little better than the quarterly average, according to data that date to 1961.

Consumption accounts for about 60 per cent of GDP, so our ability to grow as an economy is dictated to a significant degree by our willingness (or ability) to buy stuff.

The Bank of Canada has assumed for a long time that spending would slow under the weight of a decade-long debt binge. Late last year, household purchases slowed too much, forcing the central bank to pause its plan to tug interest rates back to a more normal level. So a sign of life is welcome, suggesting that this year’s impressive run of hiring data, including some evidence that the hot labour market might finally be putting upward pressure on wages, is offsetting the burden of households’ record debt load.

“Consumer spending bounced back strongly after a poor performance in the second half of 2018,” Matthew Stewart, director of economics at the Conference Board of Canada, said in an email. He called the increase “substantial” and added that “households may not be having as much difficulty with their substantial debt burden and rising interest rates as many feared.”

The other important indicator was business investment. Canadian companies spent $78.4 billion on new machinery and equipment in the first quarter, a nine-per-cent surge from the previous quarter and the most since early 2008. The quarter-to-quarter increase was the biggest since 1996, suggesting that Canadian companies, which have been piling up profits for years, finally got off the sidelines.

Poloz said that would happen. The Bank of Canada’s surveys of business intentions kept showing that executives were gearing up to invest. The resolution of the new North American trade agreement eased worries about the terms on which commerce would be based on the continent, and federal tax cuts on investment also likely created a tailwind.

Investment is key because it signals future activity. Companies are spending because they are struggling to keep up with orders, see an opportunity to become more productive, or both. Any of those scenarios bode well for the current quarter and the rest of the year, assuming an external shock doesn’t knock the economy off course.

“The composition of growth was actually stronger than we had anticipated, with significant support from consumption and business investment,” Veronica Clark, an economist at Citibank, said in a note to her clients. “This reinforces our view that the early-year slowdown will be temporary.”

To be sure, an external shock remains a present danger. Traders re-upped their bets that the Bank of Canada will be forced to cut interest rates, putting more weight on Donald Trump’s decision to escalate the trade wars than all the positive indicators contained within the latest GDP report.

By linking punitive duties on Mexico to the flight of refugees from Central America, Trump risks erasing whatever positive sentiment he instilled by ending aluminum-and-steel duties on shipments from Canada and Mexico. And the conflict with China feels like it could get worse before it gets better.

The volatility of trade policy is why there was no indication from the Bank of Canada this week that it intends to resume raising interest rates.

Wilkins reminded reporters in Calgary that the benchmark rate still is lower than inflation, meaning real interest rates are negative. That’s not normal and explains why policy-makers will push borrowing costs higher as soon as conditions allow. But those conditions won’t exist as long as the trade wars rage.

Fourth-quarter GDP was crushed by a big drop in exports, as unusually tough winter conditions froze commerce. Trump is proving as unpredictable as the weather. Policy-makers have no choice but to proceed with caution.