Canada’s second-quarter GDP shrinks as tariffs choke exports

Canada's economy contracted by an annualized 1.6% in Q2, significantly exceeding the anticipated 0.6% decline and marking its first quarterly contraction in seven periods, alongside three consecutive months of output-based GDP decline. This sharp deceleration was primarily driven by a 7.5% slump in exports due to U.S. tariffs and a contraction in business investment, though robust household and government spending cushioned the impact with domestic demand growing 3.5%. The weaker-than-expected data has increased money market bets for a Bank of Canada rate cut in September to 48%, leading to a 0.17% depreciation of the Canadian dollar and a drop in two-year government bond yields.

Analysis

Canada's economy unexpectedly contracted at a 1.6% annualized rate in the second quarter, a significant deviation from the consensus forecast of a 0.6% contraction and marking the first quarterly decline in seven quarters. The downturn was primarily driven by external factors, with exports slumping 7.5%—the largest drop in five years, attributed partly to U.S. tariffs—and business investment in machinery and equipment contracting 0.6% for the first time since the pandemic. This weakness was partially offset by robust domestic activity, as indicated by a 3.5% growth in domestic demand, fueled by a 4.5% jump in household consumption, a 6.3% rise in residential investments, and a 5.1% surge in government spending. The surprisingly weak GDP print has directly influenced monetary policy expectations, with money markets increasing the probability of a September Bank of Canada rate cut to 48%. This dovish shift was reflected in financial markets, causing the Canadian dollar to depreciate 0.17% against the U.S. dollar and pushing two-year government bond yields down by 2.8 basis points.

Key Decisions for Investors

• Given the increased probability of a Bank of Canada rate cut, investors should consider increasing exposure to short-duration Canadian government bonds to potentially profit from further yield compression.
• The data points to fundamental weakness for the Canadian dollar, suggesting investors could hedge CAD exposure or consider short positions against the USD, as export-related headwinds are likely to persist.
• Equity allocation should favor domestically-focused sectors, such as consumer discretionary and residential-related industries, which benefit from strong household spending, while maintaining a cautious stance on export-oriented companies vulnerable to global trade friction.