Canadian building permits came in much weaker than expected in February, dropping 1% in the month. Market expectations had been for a 1.3% increase. The disappointing picture for the near-term outlook for construction was darkened further as January's plunge was revised down to a drop of 3.5% from the initially reported 2.9% decline. Building permits have now fallen for four consecutive months.

The surprise in the report was not only the unexpected drop in February but also the source of the weakness - the non-residential component declined a sizeable 25.6%. Some weakening had been expected in this component after the 16.7% surge in January, although this increase was expected to be only partially retraced. All three non-residential components dropped, with institutional off 35.7%, commercial down 16.2% and industrial plunging 39.4%.

A partial offset came from residential permits, which rose 18.2%, more than offsetting the 15% drop recorded in January. The increase in the residential component reflected gains in both multi- and single-family dwellings of 31% and 11.6%, respectively.

The weakness was largely concentrated in Ontario where permits plunged 16%, with the non-residential component off a massive 44.9%. Residential building permits in the province provided some offset, rising 21.3%. If Ontario were to be excluded from the national total, building permits would have surged 9.8%.

The drop in February permits is discouraging since it is the fourth consecutive monthly decline. Given recent deterioration in housing affordability, some weakening in residential permits was expected through 2008. More disappointing is that non-residential activity is not providing the expected offset. The earlier-released Statistics Canada survey of private and public investment spending had suggested that non-residential investment spending would likely rise 6.8% this year, up from a 4.7% gain in 2007. However, the disappointing performance of this component so far this year raises the risk that the recent credit tightening along with increased discussion of a possible U.S. recession is weighing on business spending. To counter this restraining factor, we expect that the Bank of Canada will continue to cut interest rates, sending the overnight down to 2.75% mid-year from 3.50% currently.