Canada’s economy unexpectedly shrinks. But is there reason for optimism?

Canada's economy unexpectedly shrank 1.1% in the second quarter, which is well below the 2.5% growth that was expected. Now, even more worrisome is the first month of this quarter. Stats Canada estimates the economy contracted 0.4% in July. Sri, what's your take on this latest GDP data?

It was definitely disappointing, we had expected the recovery to continue in the second quarter, maybe economic momentum to decline a little bit just because of the third wave and then the associated restrictions, but not to decline entirely. So it definitely was a little disappointing. And then when we think about the July data where reopening continued and people started going out and spending more, we expected growth to come out even stronger than what it had in June. But here we're seeing a decline. So it does suggest that the recovery is taking longer than what we had previously expected.

OK, so what drove the drop in the second quarter then?

So in the second quarter there were two main factors. One, you had residential investment really fall, and that was because the housing market, which was very, very strong through the pandemic, start to cool off. And as it starts normalizing, it weighed on growth quite a bit. And secondly, you also had exports fall significantly by 15% on a quarter over quarter annualized basis. And this is because of the supply chain disruptions, specifically semiconductor shortages, really hitting production of motor vehicles and parts. And so that really weighed on growth as well. And so these were the two main factors that brought GDP growth into negative territory in the second quarter.

Now, consumer spending on durable and semi durable goods was relatively flat during the quarter as well. Was this a red flag for you, given that consumption is a big driver of GDP?

So we didn't necessarily expect consumption to have a very strong showing in the second quarter. We had the pandemic, after all, and restrictions from the pandemic. So, in terms of spending, we did expect consumption to be a little bit on the weak side. Now, in terms of durable and semi durable spending, consumption in this regard was quite strong through the pandemic. So the level was high and it's harder to continue to improve from a pretty robust level of spending. So we did expect that to come off a little bit as well. But one point I'd like to make here is that the supply chain issues, such as the motor vehicle production, could have weighed on spending on durables a little bit. If you wanted to buy a car but was unable to find one that you like, maybe you held off on spending on these goods until inventory was replenished.

And what impact could today's GDP data have on the Bank of Canada's rate policy when they meet next week?

I do think it would have some implications for sure. It does suggest that the economy is taking longer to recover. But the bank did state in previous communications that it only expects the economy to get back to its full operating capacity somewhere in the second half of next year. So even though we're starting to see some weakness currently, it could be that the recovery instead is a little bit stronger later on and still we're able to get to that target. But the bank will be considering this data carefully because it would suggest maybe the economy is not as resilient as the bank had previously expected.

OK, so given this new data, will your economic forecast change?

We are looking to revise down our 2021 numbers, we have seen a weaker second quarter and because July was weaker, it does imply the third quarter will likely come in below what we had expected. So this would mean a lower forecast for 2021.

And looking forward, what are some of the risks to the outlook?

The main risk really is from the Delta variant and we're thinking past the third quarter into the fourth quarter. We're starting to see hospitalizations and cases pick up across the country. So even though provinces and businesses have taken a number of steps to mitigate the fourth wave, it could have impacts on consumer and business confidence, which then could weigh on economic activity as a whole. So all together, it does suggest that the economic recovery will be prolonged and it we may just not get back to full capacity or operating at full capacity early in the year next year. Maybe it might be later on in 2022.

Sri, thank you very much for your time.

Thanks, Anthony.