A look ahead at the Canadian and American economies January 17, 2019

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1 A look ahead at the Canadian and American economies January 7, 9 The Big Fade The Canadian economy performed largely as expected in 8 with estimated annual growth of around.% falling just shy of our call at the start of the year. This would mark a sharp slowdown from the prior year s.% pace as three driving forces the oil price recovery, supportive financial conditions and enhanced child benefit payments all faded. Rising interest rates corralled household credit to the slowest pace since 98, slicing the rate of consumer spending almost in half to around %. New auto sales reversed 8% in 8 from record highs. After bolting out of the gate, business investment slowed, initially due to mounting uncertainty about NAFTA and then to rising concern about a global trade war. Tougher mortgage rules also took the wind out of the previous high-flying Vancouver and Toronto housing markets. On the plus side, exports benefitted from stronger demand and a weaker currency, while the federal government kept the spending taps open, despite a sizeable budget deficit. Moreover, the recent Business Outlook Survey showed positive intentions to increase spending and hiring. Growth is expected to ebb further to.8% in 9 owing to depressed oil prices, Alberta s mandatory crude output cuts, a slower and global economy, and GM s Oshawa plant closure. While Alberta s output cuts have dramatically shrank the discount on Western Canadian Select crude from record highs, the more enduring problem is that WTI prices plunged % in the final three months of the year. Thankfully, OPEC reductions have provided recent support, and we look for a partial recovery in WTI prices to an average of $9 in 9. Still, led by weakness in the energy sector, growth in business spending is expected to slip below % in 9, despite support from the accelerated depreciation allowance and (the assumed) approval of the USMCA by the new Congress. Consumer spending growth will downshift further to below %. Home sales and prices are unlikely to rise this year, while housing starts should decelerate from elevated levels that have been supported by the fastest population growth in 7 years. The good news is that the economy should expand enough to keep the jobless rate hovering near four-decade lows of.%. ECONOMIC RESEARCH -8-- economics.bmocapitalmarkets.com Sal Guatieri, Senior Economist -9-9 sal.guatieri@bmo.com KEY MESSAGES The and Canadian economies will downshift in 9 as past stimulus wanes and financial conditions deteriorate. A potential escalation in the trade war and political tensions, along with a deeper correction in equities and credit markets, are key risks to the economy. A further slide in oil prices would also hammer. These risks imply a slower pace of monetary tightening. We now see just two (instead of three) rate hikes from the Fed and BoC in 9, while markets expect even less. Even if oil prices recover somewhat, the C$ will continue to languish due to competitiveness issues, with energy transportation topping the list of challenges. After raising rates 7 basis points in 8, the Bank of has turned cautious as it assesses the impact of lower oil prices and tighter financial conditions on the economy. Low inflation all three of the Bank s core measures stood at.9% in November provides the luxury of time. Assuming some recovery in oil prices and financial markets, the Bank could raise policy rates in July and December. But the latter move should mark the end of the current tightening cycle, leaving A Publication of BMO Capital Markets Economic Research Douglas Porter, CFA, Chief Economist, BMO Financial Group

2 Page of 7 January 7, 9 the policy rate at.%. Under this scenario, the -year yield, which ended 8 below where it started, should climb only modestly further to.% by year-end. The Canadian dollar fell 8% against the mighty greenback in 8, undercut by the downturn in oil prices and ongoing competitiveness issues, such as the lack of pipeline capacity. The currency will struggle to get off the ground in 9, though a partial recovery in oil prices could prod it toward 7. cents (C$.) by year-end. United States The economy surprised modestly to the upside in 8 as businesses responded more forcefully to tax cuts and deregulation. Barring a soft Q (we see.%), real GDP likely grew the fastest since, with the estimated.9% advance marking a big step up from the post-recession mean of.%. The jobless rate touched a 9-year low of.7% in November before popping to.9% in December on greater labour-force participation. The economy created. million jobs in 8, even more than the. million in 7. However, the economy won t repeat this stellar act in 9. Annual growth is projected to slow to.% (and more tellingly to.% from.% on a Q/Q basis). Highly expansionary fiscal and monetary policies, and supportive wealth effects, are fading, just when capacity constraints are becoming more binding and political instability is set to ratchet higher. The current partial government shutdown, now the longest on record, will shave at least. ppts from Q growth, and significantly more if it lasts the entire quarter. The trade war is another cause for concern, especially if it opens on new fronts such as Europe and Japan. While a strong dollar has largely shielded consumers and businesses from the aggregate effects of tariffs, the damage could mount if trade talks between the and China fail. While the tariff toll on GDP is likely to be limited to.%, this assumes no further escalation apart from the planned -ppt hike in the tariff rate on $ billion worth of China s goods on March. Due to slower global demand and the trade-weighted dollar s 8% rise in 8 to -year highs, some further widening in the trade deficit (now at nine-year highs) is expected to carve. ppts from growth in 9. The lift from tax cuts and new federal spending, which added a full percentage point to GDP growth in 8, will fade to just. ppts in 9. New fiscal stimulus is limited by a budget shortfall fast approaching $ trillion. On the monetary side, with December s move, the Fed has pushed real policy rates comfortably above zero for the first time in a decade. We see it moving twice more in 9, in June and December. This should pressure -year Treasury rates modestly higher to.% by year-end.

3 Page of 7 January 7, 9 Along with nagging tariffs, slowing profits, and growing labour shortages, companies will need to contend with more political instability. The current government shutdown is likely just a sample of the drama that will be served up by a divided Congress and a combative Administration. The debt ceiling will need to be raised or suspended later this year to avoid a payment default and possible credit-rating downgrade. While the economy will surely slow in 9, all is not lost. The jobless rate is expected to ease to.% in the second half, matching the second lowest level since 9. Equity markets have retraced some of their losses. Lower mortgage rates will give the housing market a muchneeded fillip. Recession odds this year are likely no more than one in four, meaning there s a good chance the expansion will become the longest on record (dating back to 8) at over a decade should it last until July. Strong employment, firmer wages, lower gasoline prices, and a record-low debt-service burden are sturdy pillars for household spending. In fact, auto sales ended the year on a high note. Businesses will continue to add capacity (largely via automation) to address worker shortages. Subdued inflation will limit further Fed rate increases. For now, the fundamentals look reasonably healthy, suggesting the economy is merely downshifting to a more sustainable pace. And, if productivity turns higher, growth might even top expectations again. Risks A more heated trade war or deeper dive in equities and oil prices would pose bigger headaches for the North American economy. If oil prices drop further, top-producers Alberta, Saskatchewan and Newfoundland & Labrador will underperform the ½% growth rate expected for each province this year. fiscal policy could turn outright restrictive if Congress fails to pass legislation to avoid automatic spending cuts of about $ billion (.% of GDP) starting in October. With the U.K. parliament shooting down Prime Minister May s Brexit deal with the EU, the drama will come to a head before the March 9 deadline. A no-deal outcome is one option (among many) that could lead to a much weaker U.K. economy, though the impact on North America should be limited.

4 Page of 7 January 7, 9 Forecasts CANADA 8 9 ANNUAL I II III IV I II III IV Real GDP (q/q % chng : a.r.) Consumer Spending Business Investment (non-residential) Consumer Price Index (y/y % chng) Unemployment Rate (%) Housing Starts (s : a.r.) Current Account Balance ($blns : a.r.) Interest Rates (average for the quarter : %) Overnight Rate month Treasury Bill year Bond / Interest Rate Spreads (average for the quarter : bps) 9-day year UNITED STATES Real GDP (q/q % chng : a.r.) Consumer Spending Business Investment (non-residential) Consumer Price Index (y/y % chng) Unemployment Rate (%) Housing Starts (mlns : a.r.) Current Account Balance ($blns : a.r.) Interest Rates (average for the quarter : %) Fed Funds Target Rate month Treasury Bill year Note EXCHANGE RATES (average for the quarter) US /C$ C$/US$ /US$ US$/Euro US$/ Note: Shaded areas represent BMO Capital Markets s

5 Page of 7 January 7, 9 VOLATILITY RISES United States (as of January, 9) CREDIT SPREADS WIDEN United States (ppts) Ted Spread VIX Corporate Bond Spreads mnth Eurodollar minus -mnth T-bills (bps) CBOE market volatility index year BoA Merrill Lynch AA Corporate Yield less -year Treasury Yield EQUITIES CORRECT (indices : as of January, 9) LOONIE LANGUISHES (US : as of January, 9) Equities Canadian Dollar S&P (lhs) 9 Parity TSX (rhs) Despite trade deal LUMBER AND COPPER RETREAT Commodity price range since start of 8 OIL PRICE BOUNCES OFF -MONTH LOW (US$/bbl : as of January, 9) Materials & Foodstuffs (as of January, 9) Lumber. [current] (US$/ sq ft).. Metals & Energy (as of January, 9) Gold 9. (US$/oz) WTI Crude Oil Soybeans (US$/bu) 7. Wheat (US$/bu) Oil (US$/bbl). Natural Gas (US$/mmbtu) Corn (US$/bu) Copper.8 (US$/lb)

6 Page of 7 January 7, 9 GROWTH TO MODERATE (y/y % change) US CONSUMERS STILL SPENDING FOR NOW (y/y % change) Real GDP Real Personal Consumption Expenditures US INVESTMENT TO MODERATE (y/y % change) HOUSING MARKET COOLS Existing Homes (y/y % change : -month m.a.) Real Non-Residential Business Investment Sales Prices FULLY EMPLOYED (percent) INFLATION SUBDUED Consumer Price Index (y/y % change) Unemployment Rate United States Headline.7% Headline.% Core.% Core.9% - 7 7

7 Page 7 of 7 January 7, 9 7 NEARING END OF TIGHTENING CYCLE (% : as of January, 9) Overnight Rate.%.%.7% Year Bonds RATES TO RISE MORE SLOWLY (% : as of January, 9).7%.99% - Spread -7 bps.% (yr. end 9).9% (yr. end ).%.% General Disclosure BMO Capital Markets is a trade name used by the BMO Financial Group for the wholesale banking businesses of Bank of Montreal and its subsidiaries BMO Nesbitt Burns Inc., BMO Capital Markets Limited in the U.K. and BMO Capital Markets Corp. in the BMO Nesbitt Burns Inc., BMO Capital Markets Limited and BMO Capital Markets Corp are affiliates. This document is issued and distributed in Hong Kong by Bank of Montreal ( BMO ). BMO is an authorized institution under the Banking Ordinance (Chapter of the Laws of Hong Kong) and a registered institution with the Securities and Futures Commission (CE No. AAK89) under the Securities and Futures Ordinance (Chapter 7 of the Laws of Hong Kong). 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