Economy contracts for first time since recession

Canada now has its own two-speed recovery, with the domestic economy holding firm even as exports falter amid a slumping global rebound.

The economy shrank at an annualized rate of 0.4 per cent in the second quarter, the first contraction since the Great Recession, and a sharp reversal from the 3.6-per-cent growth rate of the first quarter, Statistics Canada figures showed. It's a sign that Canada, envied by many countries as a bastion of stability since the financial crisis, is not immune to global economic malaise.

In fact, among the Group of Seven club of rich economies, only Japan had a worse second quarter.

Sales abroad staged their steepest drop in two years, with exports plummeting more than 8 per cent on an annual basis. The high-flying Canadian dollar made it harder for businesses to sell their goods to weakening markets in the United States and Europe. Also, Japan's natural disasters created havoc in the automobile industry, while wildfires in northern Alberta and maintenance shutdowns in the oil industry curtailed energy production.

But there's a bright side to Canada's performance. Company purchases of machinery and equipment in Canada soared at a 31-per-cent annualized pace in the second quarter, the biggest surge since 1996.

That shows businesses remain upbeat about their prospects, but also illustrates the gulf in confidence between Canadian executives and their U.S. competitors, analysts said. Companies on this side of the border are spending some of the cash they piled up over more than two years of operating on a shoestring. Canadian companies are increasingly investing and hiring, while most U.S. businesses are still hesitant to add staff or expand even as they book record profits.

"If you're not confident, you're not going to invest,'' said Krishen Rangasamy, senior economist at National Bank Financial Group. "Exports are going to be under the gun here, with the strong Canadian dollar and the slowing global economy, but domestic demand is doing fine, and that's why businesses remain confident despite all the headwinds.''

Still, the fragile state of the global recovery means businesses cannot be counted on to invest at the current pace for much longer. "Businesses need customers to continue to invest,'' said Avery Shenfeld, chief economist at CIBC World Markets. "We do need either exports to recover, or for consumers to be a bit more eager to shop than they were in the second quarter.''

For now, though, strong business investment shows many Canadian CEOs have taken to heart the repeated pleas from policy makers and economists to be bold despite uncertainty and put in place the equipment and tools they need to improve their productivity and competitiveness over the long haul.

"Companies have a lot of cash and now they're spending it," said Jayson Myers, president of the Canadian Manufacturers and Exporters.

The strong loonie makes imported goods and state-of-the-art machinery cheaper, providing a silver lining in a turbulent environment. But many foreign suppliers know the loonie buys more now and have adjusted their Canadian prices accordingly, Mr. Myers said, adding that the Harper government's recent decision to extend a tax write-off of capital expenditures to the end of 2013 has also been a crucial boost for confidence.

Whatever the main cause, manufacturers are investing and taking on new workers despite the shrinking economy.

In eastern Ontario alone, Nestle just completed a 30,000-sq.-ft. expansion to boost production of soups, sauces and other food service products at its plant in Trenton; Kellogg Canada Inc. is adding a second production line for breakfast cereals at its Belleville factory; and Vantage Foods Inc. is completing a new packaged-meat plant, also in Belleville, creating 150 jobs.

"We're seeing all these new investments and we're getting a lot of inquiries," said Christopher King, president of the Quinte Economic Development Commission.

Canada's economy grew 0.2 per cent in June from the previous month, Statscan reported. Analysts said that should provide enough momentum for the economy to recover from its second-quarter drop and expand over the current half of the year, albeit at a sluggish pace.

Still, signs of potential trouble lie ahead, even if a return to recession is avoided.

Economists highlighted the healthy 3-per-cent annualized growth rate in "final domestic demand'' – a measure that strips out trade and inventories – even as they acknowledged that it would not have been nearly as strong without the eye-popping pace of business investment.

Consumers have proven resilient, as spending gained 0.4 per cent in the second quarter after shrinking in the first quarter, but soon they may be more focused on trimming their debt loads and less willing to spend. Plus, considering the slowdown in the United States and worries that European authorities may not be able to contain that continent's debt crisis, it's questionable how much more Canada can export after the ground lost in the second quarter is recovered.

That's why economists say Bank of Canada Governor Mark Carney will hold his benchmark interest rate at 1 per cent on Sept. 7, and possibly well into 2012.

Meanwhile, Finance Minister Jim Flaherty reiterated on Wednesday that he will "stay the course'' in balancing the federal budget. But he conceded that with the slowdown in global growth this year, policy makers must "recognize the fragility of the situation."

With reports from Tavia Grant and Julien Russell Brunet in Toronto