Slowing Canadian Economic Momentum: Implications for Equities and Currency Markets

The Canadian economy is navigating a precarious crossroads. While the Purchasing Managers’ Index (PMI)—a critical barometer of economic health—continues to signal contraction in both manufacturing and services sectors, equity markets have shown surprising resilience. This divergence raises urgent questions for investors: How should one interpret the signals from PMI data? What does it mean for asset allocation in a landscape where economic fundamentals and market sentiment appear increasingly decoupled?

A PMI-Driven Downturn: Contraction Deepens

Canada’s Q2 2025 GDP contraction of 0.4%, annualized at 1.6%, underscores a broader malaise. The Bank of Canada now forecasts growth below 1% for the year, citing weak manufacturing sales, soft investment, and housing weakness [1]. The PMI data corroborates this narrative. By August, the services PMI had fallen to 48.6, reflecting a sharp decline in new export business amid U.S. tariff uncertainty [2]. Similarly, the manufacturing PMI for Q3 2025 is projected at 48, indicating a modest but persistent contraction, driven by low export demand and logistical bottlenecks [3].

These readings highlight a structural vulnerability: Canada’s reliance on trade-exposed sectors. As U.S. tariffs and global supply chain shifts erode export momentum, the PMI becomes a leading indicator of broader economic fragility. For investors, this signals a need to recalibrate expectations for growth-driven sectors and prioritize defensive positions.

Equities: Resilience Amid Deteriorating Fundamentals

Despite the grim macroeconomic backdrop, the S&P/TSX Composite Index surged 8.53% in Q2 2025 [1]. This apparent disconnect between GDP and equity performance is not unprecedented but warrants closer scrutiny. The rally was fueled by outperformance in Information Technology and Consumer Discretionary sectors, which benefited from domestic demand and global tech trends [2]. Energy, however, lagged, reflecting the sector’s sensitivity to commodity price volatility and regulatory headwinds.

The PMI’s contractionary signals, meanwhile, suggest that this equity optimism may be short-lived. A services PMI of 48.6 in August and a manufacturing PMI of 48.3 in September 2025 indicate that the pipeline of new orders and business confidence remains weak [3]. For investors, this raises a critical question: Is the equity market pricing in a near-term rebound, or is it merely delaying the inevitable correction?

Currency Markets: CAD Volatility and Trade Policy Risks

The Canadian dollar has borne the brunt of the economic slowdown. In July, the loonie fell 0.2% against the U.S. dollar following disappointing services PMI data and rising risk aversion [4]. By September, further declines were driven by escalating concerns over U.S. trade policies under the Trump administration, which introduced fresh uncertainty for Canadian exporters [5].

The divergence between U.S. and Canadian economic performance—highlighted by stronger U.S. manufacturing PMI readings—has exacerbated CAD/USD volatility. For currency investors, this underscores the importance of hedging against trade policy shocks and aligning exposure with PMI-driven trends in cross-border demand.

Asset Allocation: Navigating the PMI Paradox

The current environment demands a nuanced approach to asset allocation. While the PMI signals a contracting economy, the equity market’s resilience suggests that investors are betting on a policy-driven turnaround. This creates a paradox: Should one overweight equities in anticipation of a rebound, or pivot to cash and defensive assets to mitigate downside risk?

The answer lies in sectoral differentiation. Sectors insulated from trade policy, such as healthcare and utilities, may offer safer havens. Conversely, technology and consumer discretionary stocks could benefit from domestic demand, provided the Bank of Canada avoids aggressive rate hikes. For currency investors, a tactical short on CAD against USD, hedged with options, could capitalize on the trade policy-driven volatility.

Conclusion

The Canadian PMI serves as a stark reminder of the economy’s fragility. While equities and currencies have diverged in their responses to this slowdown, the underlying trend—contraction in key sectors—cannot be ignored. Investors must now weigh the immediate allure of equity gains against the long-term risks of a PMI-driven downturn. In this climate, agility and sectoral precision will be paramount.

Source:
[1] Q2 - 2025 Quarterly Review - Kerr Market Summaries [https://kerrfinancial.ca/blog/kerr-market-summaries/q2-2025-quarterly-review/]
[2] Canada's services PMI dips in August as tariff uncertainty ... [https://www.investing.com/news/economic-indicators/canadas-services-pmi-dips-in-august-as-tariff-uncertainty-clips-activity-4224590]
[3] Canada manufacturing PMI shows continued contraction in..., [https://ca.news.yahoo.com/canada-manufacturing-pmi-shows-continued-133929686.html]
[4] Canadian dollar pares weekly gain as downturn deepens ... [https://www.reuters.com/markets/us/canadian-dollar-pares-weekly-gain-downturn-deepens-services-economy-2025-07-04/]
[5] Canadian Dollar backslides on fresh risk aversion [https://www.fxstreet.com/news/canadian-dollar-backslides-on-fresh-risk-aversion-202509021726]