CANADA’S INVESTMENT-LED EXPANSION BODES WELL FOR FUTURE GROWTH

 By David Rossenberg (Gluskin Sheff)

An extract of David's Letter of December 7th 2010.  

There was little doubt that the Bank of Canada was going to stay on the sidelines at today’s policy meeting and provided a strong hint that the rate-hiking cycle was a three-strikes-and-you’re-out affair, just as the V-shaped recovery in the Canadian economy was a three-quarter bounce-back. Economic growth is slowing below forecast at the current time and underlying inflation is hardly an issue either. Moreover, the “output gap”, which measures the degree of excess capacity in the broad economy, remains high at 2.9%, though nowhere near the deflationary 3.6% levels prevailing in mid-2009.

As it turns out, and despite my earlier doubts, the Bank turned out to be 100% correct in hiking rates early as to defuse what was possibly becoming a housing bubble in Canada. So far, it looks like it has let the air out of the balloon gently without having to burst it.

There’s never a reason to become complacent, but hopefully the folks at the Bank of Canada will take some time to reflect on their success. After all, this gathering of the monetary policy clan occurs after the release of two of the most important pieces of economic data that underscored just how well the Canadian macro landscape is performing, particularly in light of the turmoil in so many other parts of the world.

Think about that for a second. The Bank of Canada did not triple the size of its balance sheet. In contrast to most of the major central banks around the world, from the Federal Reserve, to the Bank of Japan, to the ECB, to the Bank of England, the Bank of Canada never did embark on a course of jeopardizing the sanctity of its balance sheet through quantitative easing measures. And here we have Ben Bernanke on 60 Minutes already contemplating QE3.

The Bank did not allow policy rates to stay near-zero indefinitely, having boosted them three times since early summer. The Bank has not ratified a depreciating currency to stimulate the economy either. The Canadian dollar has actually been remarkably stable in recent months despite all the global financial and policy crosscurrents. In addition, the Federal government did not make repeated attempts to sustain growth as has been the case south of the border. We see just how fragile the U.S. recovery really is now that the entire outlook comes down to whether a tax cut that always had a 10-year shelf life should be extended. So, even without all the massive doses of policy steroids that seem to keep the U.S. economy afloat, it has been the Canadian economy that has been the one to not just reclaim but actually pierce the pre-recession peaks in both employment and real output.

Not only that, but we are starting to finally see some signs that Canada is catching on to classic ‘supply side’ economics, which will lead to a more sustainable growth path than the government and consumption-led model the United States is attempting to nurture through its ongoing array of Keynesian-style demand policies. In fact, it was the lingering weakness in the U.S. economy that was the principal cause of Canada’s low 1% annualized GDP growth rate in the third quarter. If not for a sharp deterioration in our net exports, real GDP would have actually posted an impressive 4.5% expansion.

The key factor behind this performance is business investment in machinery and equipment, which surged at a 28.7% annual rate and on the heels of a 32.7% run-up in the second quarter and a 17.8% boost in the first quarter. You have to go back at least 13 years to see the last time Canadian companies made this sort of spending commitment to the economy. Capital spending, of all the major components of the economy, is the one that exerts the most durable and perpetual impact on the economy, via job creation and productivity.

While Canada has lagged the United States for much of the past decade in terms of productivity performance, it is looking increasingly as though we are on the precipice of an important reversal. Productivity growth, while still low, is showing signs of accelerating, as one would expect with business capital spending rising as a share of GDP for three quarters in a row, and at nearly 9%, heading close to a record high. Our research shows that there is about a 4 to 5 quarter lag before stronger productivity growth begins to kick in and this will be crucial in future Bank of Canada decisions if it means that Canada’s non-inflationary growth potential has improved. Based on some preliminary in-house research of our own, it looks as though the positive supply-side investment shock that Canada is now experiencing could soon result in Canada’s “potential” GDP growth rate rising into a 3-4% range which would be very constructive for return on equity, the long end of the Government of Canada bond curve as well as the Canadian dollar.

Indeed, some early and positive signs are coming to the surface. Think about it. Over the past year, the Canadian economy expanded 3.4% and yet this growth performance still managed to coincide with a decline in the “core” (excluding food, energy and indirect taxes) inflation rate to 1.1% from 1.3% a year ago.

The reprint is because, David said it best, and I need to acknowledge his thought process