Oil prices jeopardize economy's continued strong performance

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Canada's economy grew faster than expected in the third quarter, but economists cautioned that plunging oil prices could spell slower times ahead.

Statistics Canada said Friday that real (i.e. inflation-adjusted) gross domestic product rose 2.8 per cent on an annualized basis in the third quarter, thanks to strong growth in exports and consumer demand, and long-awaited signs of life in business investment. That handily topped economists' estimate of 2.1 per cent.

Economists had expected the economy to slow from the brisk 3.6-per-cent pace in the second quarter, which largely reflected an economy playing catch-up after the harsh winter had held back activity in the first three months of the year.

After some sluggish growth figures over the summer, the economy expanded 0.4 per cent in September, its strongest month-over-month increase since May.

The September resurgence was led by gains in oil and gas extraction and manufacturing, as both sectors rebounded impressively from summer maintenance shutdowns.

"Domestic demand was again very strong, thanks in part to business investment spending which finally bounced back after disappointing for so long," National Bank of Canada senior economist Krishen Rangasamy said in a research note. "That was complemented by a solid performance by trade."

For the quarter, exports were up 6.9 per cent annualized, driven by big gains in intermediate metal products and oil shipments. Auto exports were also strong, although they moderated from their torrid second quarter.

Household consumption was up 2.8 per cent annualized, as low interest rates continued to fuel demand for big-ticket durable goods, bucking expectations that high household debt levels would temper spending. That was also evident in the housing sector, as investment in residential structures surged 12.5 per cent, contributing to a brisk 5.9-per-cent rise in business fixed capital formation.

Business investment in machinery and equipment – a factor, along with exports, that the Bank of Canada has identified as essential to a sustained economic recovery – rose by 5.2 per cent annualized in the quarter. But the investment story was mixed, as spending on non-residential structures dipped 2 per cent.

While economists were encouraged by the stronger-than-expected third-quarter performance, they cautioned that slower growth may be at hand in the fourth quarter and into 2015. Steep declines in commodity prices, especially oil, could hamper business activity, profits and export values.

"Over all, while an improving U.S. economy should continue to support export growth going forward, falling oil prices will weigh on the outlook for business investment. And with housing unlikely to sustain this torrid pace, any acceleration in economic growth over the coming quarters is likely to be fairly moderate," said David Madani, Canada economist for London-based Capital Economics.

Bank of Canada Governor Stephen Poloz recently said the $20-a-barrel drop in the North American benchmark price for crude oil from July to October, to about $85 (U.S.) a barrel, would shave about one-quarter of a percentage point off Canada's 2015 GDP growth if it's sustained.

Since then, the price has slumped another nearly $20, dipping below $66 a barrel in Friday's trading.

Previous Bank of Canada research and private-sector projections suggest that every 10-per-cent drop in crude could lower Canada's growth over the next year by about one-tenth of a percentage point.

That implies that the latest price declines, if they hold, threaten to lower growth next year by a further 0.2 to 0.25 of a percentage point – a significant downside risk to the Bank of Canada's current 2015 growth forecast of 2.4 per cent.

One major concern is that the energy sector, which has been a big contributor to Canada's much-needed business investment, will become much more restrained in its capital spending in light of the falling oil prices, thus choking off a key source for expected growth in the next year.

"The energy sector represents roughly a third of capital expenditures in the nation, and a meaningful drop in investment there will lean against gains in other areas. That's a cause for concern, given that the household sector's ability to contribute to growth going forward isn't likely to be as strong as what we are witnessing now," Canadian Imperial Bank of Commerce chief economist Avery Shenfeld said in a research report.

He noted that the brisk pace of consumer spending has lowered the national savings rate to just 3.9 per cent, from 4.7 per cent a year ago, raising questions about whether consumption can keep up its current pace for much longer.

"Similarly, while we don't think it will end with a spectacular thud, the housing boom is likely to at least level off, and therefore disappear as a growth contributor, in 2015."

Canada's real GDP (2007-present)