Never change curl.

Only thing I really want is a story mode, the base lore of ARMS is good, so a narrative to go along with it is a no brainer.

Which again would be a foolish decision. Any competent publisher weighs sales potential when greenlighting projects, and ARMS simply has not achieved the kind of success that justifies tying down one of Nintendo's lead studios for years on end, it's already been pretty much forgotten little over a year since its release.

When has Nintendo ever done what makes surface level sense? Sure compared to Mario Kart, ARMS wasn't an amazing seller, and any normal publisher would've gutted the team afterward. But this is Nintendo we're talking about, they don't just measure success by raw profits, they also measure it by player enjoyment. ARMS made a profit, and players enjoyed it. Nintendo still regularly promotes the game, which should tell you they consider it a success if a modest one, and if Yabuki wants to make a sequel, he'll make a sequel, and Nintendo will let him. 

Nintendo does make nonsensical choices sometimes and I'm not ruling out them doing so here, but from a logical point of view, imagine you're a first party publisher with a limited amount of manpower. Do you commit one of your flagship teams to a sequel to a game that sold around 3m lifetime and fizzled out within a year, or a much bigger project with vastly more potential?

Nintendo has 11 in-house teams that work on multiple games at once. It's not like they can only choose one game at a time, so they can both grow the ARMS IP, as well as prepare the next Mario Kart entry as well.  So to answer your question, Why not both? 

Again, because it would be unwise use of resources better spent on more important projects with greater potential.

Nintendo better stop working on games like Xenoblade, Metroid and funding stuff like Bayonetta then, all sell less than ARMS per entry.

Those are all being undertaken by external or secondary studios, not flagship teams like the Mario Kart crew.

If Nintendo was a small indie developer with only 30 available employees at once, you'd have a point. But we're talking about a major developer with hundreds of developers and nearly a dozen internal teams at their disposal. They can do both ARMS and Mario Kart at the same time. 

Nintendo are not really that big. This year, the only games EPD have put out so far are Labo, Sushi Striker, Warioware Gold, and Dragalia Lost, all low budget products, one indie tier, one a port of a Wii U party game, and one an iOS title, and nothing big since Mario Odyssey last October. Their resources and manpower are quite limited.