Highlights. Change from Previous Forecast

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1 Highlights January 19 The global economy s loss of momentum in the last quarter of 18 represents a poor handoff. That will penalize 19, the latter s GDP growth likely to be just below last year s estimated. print. An even weaker performance is possible should downside risks materialize. And here we re thinking of a ramp up of trade barriers, disorderly deleveraging and Brexit-related complications. After a strong 18, the U.S. economy is set to move down a gear. Domestic demand will decelerate as the impact of fiscal stimulus fades, taking steam out of consumption and business investment. Hammered by earlier dollar appreciation, trade will continue to subtract from growth. As such, we remain comfortable with our forecast of. for 19 U.S. GDP growth (or just 1.8 Q/Q). The latter is consistent with our view that there will be no more than one rate hike by the Federal Reserve this year. A flat yield curve and the possibility of inversion do not bode well for the credit cycle and hence GDP growth after 19. While Canada s export sector will get a lift from a still-solid U.S. economy, overall GDP growth is likely to be restrained by domestic challenges. The outlook for consumption spending has indeed become darker amid a very low household savings rate, high debt, rising interest rates, fading housing wealth effects, and a likely moderation of employment growth. And depending on commodity prices and global economic developments, business investment may also tread water, more so if reported excess capacity remains unutilized. The federal government may yet come to the rescue with pre-election handouts although those are unlikely to be enough to prevent a sub- GDP growth print for 19. Krishen Rangasamy Change from Previous Forecast United States GDP unch unch CPI inflation pp -. pp Fed Fund Target Rate* bp unch Ten-year bond yield* bp - bp Canada GDP unch unch CPI inflation pp -.1 pp Overnight rate* bp - bp Ten-year bond yield* bp - bp * end of period

2 World: Slower growth The global economy s loss of momentum in the last quarter of 18 represents a poor handoff. That will penalize 19, the latter s GDP growth likely to be just below last year s estimated. print. An even weaker performance is possible should downside risks materialize. And here we re thinking of a ramp up of trade barriers, disorderly deleveraging and Brexitrelated complications. Good riddance 18! The Year of the Dog, as the Chinese calendar aptly refers to it, was the worst for investors since 8 based on the nearly decline of the MSCI All- Country index. Global financial markets were hammered particularly hard last year by concerns about trade protectionism and monetary policy tightening by the U.S. Federal Reserve, both of which contributed to a deceleration of world GDP growth. World: 18 was a rough year for investors MSCI All-Country index annual chg NBF Economics and Strategy (data via Refinitiv) Near- drop in 18 was the worst since 8 Should investors expect better in 19? Perhaps not on the growth front. The global economy s loss of momentum in the last quarter of 18, as evidenced by synchronously plunging composite purchasing managers indices and oil prices, represents a poor handoff and hence will penalize 19, the latter s GDP growth likely to be below last year s estimated. print. World: A weak handoff from last year Markit s Global composite purchasing managers index versus WTI oil price But that does not mean stock market investors are guaranteed another year of losses. The Fed is set to pace down the pace of monetary policy tightening in 19 (see U.S. section), something that will be welcome worldwide, particularly in emerging economies which were rocked last year by rising bond yields and an appreciating U.S. dollar. More generally, monetary policy is likely to remain stimulative in light of persistently low inflation in both advanced and emerging economies. World: Inflation remains tame in BRIC economies Consumer price index in G7 countries versus Brazil/Russia/India/China y/y chg. BRIC G NBF Economics and Strategy (data via Bank of International Settlements and NBF calculations) There is less certainty, however, about the other major thorn in the side of global investors. Trade protectionism remains a problem and the possibility of a deterioration on that front cannot be entirely dismissed in light of ongoing negotiations between the U.S. and its trade partners. One can only hope some policymakers learn from 18 when their threats to disrupt global trade had real negative impacts, and work to remove related uncertainties. If, as we expect, trade tensions between the U.S. and its trade partners such as China and the European Union deescalate, a. or so growth print for world GDP is possible. Economic prosperity indeed hinges on open markets as evidenced by the strong correlation between global trade volumes and world GDP growth. World: Economic prosperity hinges on trade Global real GDP versus World trade volumes.8. WTI oil price (R) 7 US$/barrel Global PMI (L) 8 SER1 Real GDP chg q1 1q 1q 1q 17q1 17q 17q 17q 18q1 18q 18q 18q NBF Economics and Strategy (data via Bloomberg) Trade volumes NBF Economics and Strategy (data via IMF, CPB)

3 Our 19 growth forecast also assumes world policymakers can avoid disorderly deleveraging. Recall that total credit outstanding in the non-financial sector now tops of GDP in all of the G7 economies (with the exception of Germany) but also major emerging economies such as China. The problem is compounded by currency exposure. According to the Bank of International Settlements the stock of dollar-denominated debt held by non-financial entities outside the U.S. has grown from around US$ trillion in 8 to more than US$11 trillion, a third of which is now held in emerging markets. World: Highly levered non-financial sector Total credit to the non-financial sector in 18Q1 of GDP Hong Kong Japan Netherlands Belgium France Singapore Canada Sweden UK Switzerland NBF Economics and Strategy (data via Bank of International Settlements) HOUSEHOLDS CORPORATIONS GOVERNMENT Spain Italy U.S. Australia China Korea Malaysia Germany The 19 outlook is also at risk of geopolitical developments including those in Europe. The latter is not immune to a sudden downturn should social unrest in places such as France and Italy gather momentum or if Brexit spirals into something worse. And here we re thinking about repercussions of weaker economic growth in the UK. Related debt defaults, made more probable by deteriorating quality of corporate credit, could indeed rattle global financial markets and hence have negative spillovers well beyond British and European borders. World: Credit quality deteriorates Low-rated nonfinancial corporate bond issuance as a share of total nonfinancial corporate bond issuance NBF Economics and Strategy (data via IMF) UK U.S. Brazil Eurozone Japan World Economic Outlook Forecast Advanced countries United States Euroland Japan UK Canada Australia..7.7 New Zealand Hong Kong... Korea.7..8 Taiwan.7.. Singapore...7 Emerging Asia... China... India Indonesia..1. Malaysia.7..8 Philippines... Thailand..8.7 Latin America Mexico Brazil 1... Argentina Venezuela Colombia...7 Eastern Europe and CIS.8.1. Russia Czech Rep.... Poland.9.7. Turkey Middle East and N. Africa Sub-Saharan Africa..8. Advanced economies Emerging economies...7 World... Source: NBF Economics and Strategy

4 U.S.: How serious is an inverted yield curve? After a strong 18, the U.S. economy is set to move down a gear. Domestic demand will decelerate as the impact of fiscal stimulus fades, taking steam out of consumption and business investment. Hammered by earlier dollar appreciation, trade will continue to subtract from growth. As such, we remain comfortable with our forecast of. for 19 U.S. GDP growth (or just 1.8 Q/Q). The latter is consistent with our view that there will be no more than one rate hike by the Federal Reserve this year. A flat yield curve and the possibility of inversion do not bode well for the credit cycle and hence GDP growth after 19. Barring additional fiscal stimulus a tough ask considering the widening budget deficit and a divided Congress, it will be tough for the U.S. economy to replicate last year s performance. Tax cuts and increased government spending had the intended effect of temporary lifting domestic demand, allowing real GDP and employment to grow at the fastest pace in years in 18. And with job creation tilting towards full-time positions, wage inflation managed to return to pre-recession levels. U.S.: Tilt towards full-time employment helping boost wage inflation Full-time share of total employment versus Hourly earnings y/y chg..... Hourly earnings (R) Full-time share of 1. employment (L) NBF Economics and Strategy (data via Refinitiv) While the partial government shutdown will lead to temporary furloughs of federal employees, the overall labour market should continue to generate further wage gains and consumption growth, more so considering reported shortages of workers. Household balance sheets are also healthy after the Great Recession s deleveraging. The net worth of households climbed to a record US$9 trillion in the third quarter last year. Household debt also rose, but at a much slower pace. So much so that the ratio of debt to net worth sank to a -year low. Similarly, financial obligations as a share of disposable income a ratio of flows as opposed to the above-mentioned ratio of stock variables is also low by historic standards. All told, consumers are in good shape and promise to once again be among the major drivers of U.S. growth in 19, although to a slightly lesser extent than last year considering fading impacts of tax cuts. U.S.: Household balance sheet best in years Debt to net worth ratio for households & non-profit organizations NBF Economics and Strategy (data via Federal Reserve) 1. ratio in 18Q was the lowest since 198 Ditto for business investment spending whose outlook remains positive amid strong corporate profits and tax reforms, albeit less so than in 18. U.S.: Another good year for business investment? Real business investment in equipment versus Corporate profits (with inventory valuation and CCA) lagged 1-year y/y chg. Real business investment in equipment * * Based on first three quarters of 18 NBF Economics and Strategy (data via Bureau of Economic Analysis) Corporate profits, lagged one year Despite those juicy incentives, it s unclear how much of those investment outlays firms will be willing to make in an environment of decelerating demand both at home and abroad. Indeed, a softer global economy, the threat of a trade war escalation and a strong dollar do not bode well for exporters. Recall that the combination of nominal dollar appreciation and rising inflation has pushed the U.S. dollar to a 1-year high in real effective terms. This decline in relative competitiveness suggests trade will remain a drag on the U.S. economy for yet another year. 18 Q

5 U.S.: Strong dollar means trade likely to remain a drag on economy Contribution of trade to GDP growth versus Real effective U.S. dollar U.S.: Inverted yield curve tends to hurt credit growth, albeit with a lag Loans and leases versus Yield difference between -yr and -yr Treasuries y/y chg. Loans and leases (L) yr- yr yield difference (R) Real effective U.S. dollar (R) Contribution of trade to GDP growth (L) NBF Economics and Strategy (data via BEA, Bank of International Settlements) Shaded areas represent U.S. recessions NBF Economics and Strategy (data via Refinitiv) All in all, we remain comfortable with our forecast of. for 19 U.S. GDP growth (or 1.8 Q/Q). Growth could, however, be lower if the partial government shutdown extends long enough as to hurt confidence. Regardless, our forecast is less optimistic than the Federal Reserve s recently downgraded 19 GDP growth forecast. The Fed sounded more cautious last December, lowering its expectations for the fed funds rate just two hikes are now slated for this year, down from three in its previous projections. Concerning developments in the global economy and financial markets and their potentially negative implications for the U.S. economy seem to have convinced the Fed to adopt a slightly less aggressive path to policy normalization. Domestic issues may also have convinced the Fed to climb down from its prior hawkish stance. The FOMC will be particularly concerned about the potential for an already flat U.S. yield curve to invert, i.e. -year bond yields rising above -year yields. While yield curve inversions were not all followed by recessions in the past (e.g. 1998) they remain a decent predictor of an economic downturn the last three U.S. recessions were all preceded by yield curve inversion. So why is an inverted yield curve often followed by recession? It s easy to understand why higher fed funds rates (which raise the short-end of the yield curve) can be a problem for interest-sensitive sectors of the economy such as business investment, the housing market and even consumption of big ticket items such as durable goods. And as we ve seen in the past, the related slowdown can turn into a full blown downturn if the Fed overtightens policy. Low long rates, often a result of investor concern about the economic outlook and lower inflation, can also be a problem. Financial institutions make some of their profits by borrowing short-term and lending long term and hence do not have a lot of incentives to make such loans if the yield curve inverts. So, it s no coincidence that an inverted yield curve is often followed by a moderation in credit and hence slower GDP growth. But given the lag involved, any yield curve inversion may leave 19 U.S. GDP growth largely unscathed and instead threaten the longer-term outlook, say -1. A credit crunch then, could potentially have devastating consequences. And here we re thinking of corporations who are likely to have trouble financing operations should financial markets seize up à la 8-9. Corporations have increasingly tapped bond markets in recent years to raise funds as evidenced by debt securities outstanding for non-financial firms now topping US$ trillion. But with corporate spreads on the rise, firms now seem to be heading towards banks to find financing commercial and industrial loans rose in Q last year at the fastest pace in two years. Should that source of financing also dry up, one can expect defaults. And as we saw in 8-9, this could have ripple effects across global financial markets. It doesn t take much for small defaults to turn into a wave in light of the roughly US$1 trillion in leveraged loans to firms with weak credit ratings, and diminished protection for lenders/investors as much as 8 of new loans offered by non-bank lenders/investors in 18 were covenant-lite. As such, the Fed should arguably be looking at macroprudential regulations to mitigate risks to the financial system. U.S.: Massive corporate debt under scrutiny amid rising interest rates 7 Non-financial corporate debt securities outstanding US$ trillion Surging corporate debt threatens U.S. financial stability amid rising interest rates of GDP (R) Corporate debt securities outstanding (L) NBF Economics and Strategy (data via Bank of International Settlements, BEA, IMF) Moody s loan covenant quality index score (annual average) for leveraged loan issuance and declining protection for investors

6 Canada: Consumers under pressure While Canada s export sector will get a lift from a stillsolid U.S. economy, overall GDP growth is likely to be restrained by domestic challenges. The outlook for consumption spending has indeed become darker amid a very low household savings rate, high debt, rising interest rates, fading housing wealth effects, and a likely moderation of employment growth. And depending on commodity prices and the global economic developments, business investment may also tread water, more so if reported excess capacity remains unutilized. The federal government may yet come to the rescue with pre-election handouts although those are unlikely to be enough to prevent a sub- GDP growth print for 19. Canada s economy has more slack than previously thought. The industrial capacity utilization rate, i.e. ratio of actual output to estimated potential output, was revised down by Statistics Canada for the last three years, much in line with earlier-reported GDP downgrades. So much so that most sectors now have lower utilization rates than before the Great recession of 8-9. Canada: Just how much slack is there? Capacity utilization rate Old series Revisions show lower capacity utilization than previously assumed 1 NBF Economics and Strategy (data via Statistics Canada) Revised data 18 Q Forestry Manufacturing Construction Oil and gas TOTAL Of course, this larger-than-expected economic slack does not bode well for investment spending. Even sectors such as oil & gas, where utilization is higher than pre-recession levels, are unlikely to see much investment in 19 given depressed energy prices. Another driver of investment, namely business optimism, also seems to be moving in the wrong direction. The aggregate indicator of the Bank of Canada Business Outlook Survey indeed fell last quarter along with investment intentions and expectations of sales. The balance of opinion about sales growth over the next year even fell into negative territory i.e. more respondents expecting a sales decline than expecting an increase, and that for the first time since 11. Clearly, the deteriorating global economic picture had an impact in getting firms to reassess their sales targets. Mining Power Capacity utilization rate by industry -year average before Great recession 18Q Most industries have lower capacity utilization rate than before Great Recession Canada: Business sentiment weakens Balance of opinion on sales growth over the next year and investment Q NBF Economics and Strategy (data via Bank of Canada) Investment intentions Sales growth expectations Declining business sentiment reflected by expectations of weaker sales in 19 Perhaps more concerning, given their much larger share of the economy, is the outlook for consumption spending. Recall 1-1 when depressed commodity prices was starting to hurt the labour market and household disposable incomes. Even during those challenging times, consumption growth managed to remain stable as households resorted to their savings to maintain their spending habits. But raiding the nest egg to finance spending is unlikely to have a similarly stabilizing impact on consumption given that the household savings rate is now close to all-time lows. Canada: Consumption outlook darkens Real consumption, real household disposable income and household savings rate 1 y/y chg. Disposable income (L) Consumption remained stable during 1 oil shock because savings were used to offset sinking disposable incomes Savings rate (R) -1 Consumption (L) but such offset may not be possible - in 19 given rock bottom savings rate Q NBF Economics and Strategy (data via Statistics Canada) A less buoyant labour market may also restrain consumers in 19. With slower GDP growth in the cards, it will indeed be tough to beat last year s.9 employment increase. Moreover, if recent history is any guide, weak oil prices will, with a lag, hit employment in Alberta. In other words, unless oil prices pick up materially, a sharp moderation in overall Canadian employment growth can be expected this year and next

7 Canada: Oil price plunge suggests challenges for 19 employment Employment versus Western Canada Select oil price in Canadian dollars (WCS) y/y chg. WCS (R) Alberta (L) y/y chg down a gear last year, coinciding with a sharp drop in the pace of house price inflation. The federal government may yet come to the rescue of Canadians with pre-election handouts, although fiscal anchors e.g. Ottawa s pledge to keep reducing debt as a share of GDP mean such measures are unlikely to materially change the consumption outlook. Canada: Housing wealth effect is now fading Annual changes of real consumption spending and the Teranet-National Bank house price index 1 CANADA (L) NBF Economics and Strategy (data via Statistics Canada) ex-alberta (L) Another headache for highly indebted Canadian consumers is the prospect of further interest rate increases. At 1. of disposable incomes, the debt service burden of households is already the highest since 9. Mortgage payments by themselves account for. of disposable incomes, the highest since the early 199 s when the Canadian housing market went into a severe downturn. Canada: Debt service burden worsens Debt servicing as a of household disposable income NBF Economics and Strategy (data from Statistics Canada) 1. in 18Q is highest since 9Q1 Non-mortgage capital payment Non-mortgage interest payment Mortgage capital payment Mortgage interest payment While we re not expecting a similar housing downturn, we suspect home price increases will continue to moderate. After rising roughly 11 in both 1 and 17, resale home prices (as measured by the Teranet-National Bank House price index) rose just last year, the slowest pace since 1. That, of course, was a result of tougher B- regulations which, in addition to lowering the share of high ratio mortgages i.e. those with loan-to-income ratio of over, led to a significant drop in the growth of mortgages (lowest since 1). We anticipate overall house price inflation to soften further this year, dragged down by cities such as Toronto and Vancouver where affordability remains the worst in decades. The housing wealth effect will therefore fade, and hence won t be as supportive of consumption as in previous years. Recall that consumption growth moved Dec. 18 Q Teranet-National Bank house price index (R) Real consumption (L) NBF Economics and Strategy (data via Statistics Canada and Teranet-National Bank) Amid such a backdrop, there s arguably little need for an aggressive monetary policy stance from the Bank of Canada. The central bank signalled just that in January s Monetary Policy Report, highlighting risks to the economy and downgrading its 19 GDP growth forecast to just 1.7 (from.1). The downgrade was due to a lower contribution to growth from domestic demand compared to last October s forecasts. In light of data revisions by Statistics Canada, the output gap at the end of last year was larger than first thought, between -1 and. And with the central bank s projected GDP growth forecast over 19- averaging close to the estimated potential of 1.8, the output gap is set to remain open for several quarters. As such we expect no more than two interest rate hikes from the BoC, which would put the overnight rate at year-end near the lower end of the estimated range of.-. for the neutral rate. Canada: Output gap likely to remain open for several quarters Bank of Canada s estimate of the output gap (average of Integrated framework and Extended multivariate filter) Old estimate New estimate * Projections based on BoC s GDP growth forecasts and Potential GDP growth of 1.8 over forecast horizon NBF Economics and Strategy (data via Bank of Canada) Projections* 7

8 United States Economic Forecast Q/Q (Annual change)* Gross domestic product (1 $) Consumption Residential construction (1.8) Business investment Government expenditures 1. (.1) Exports (.1) Imports Change in inventories (bil. $) Domestic demand Real disposable income Household employment Unemployment rate Inflation Before-tax profits (1.1) Federal balance (unified budget, bil. $) (87.) (.) (779.) (981.) (1,.) Current account (bil. $) (.9) (9.1) (.) (.8) (7.) * or as noted Financial Forecast** Current Q 18 Q 19 Q Q1 19 Q 19 Q 19 Q Fed Fund Target Rate month Treasury bills Treasury yield curve -Year Year Year Year Exchange rates U.S.$/Euro YEN/U.S.$ ** end of period Q1 18 Q 18 Q 18 Q 18 Q1 19 Q 19 Q 19 Q 19 actual actual actual forecast forecast forecast forecast forecast Real GDP growth (q/q chg. saar) CPI (y/y chg.) CPI ex. food and energy (y/y chg.) Unemployment rate () National Bank Financial Quarterly pattern 8

9 Canada Economic Forecast Q/Q (Annual change)* Gross domestic product (1 $) Consumption Residential construction.. (.7) (1.1) (1.9) (.) (.) (1.8) Business investment (9.9) Government expenditures Exports Imports (.) Change in inventories (millions $),91 17,8,9,8 1,91,8 1, 1,8 Domestic demand Real disposable income (.7) Employment Unemployment rate Inflation Before-tax profits Current account (bil. $) (.9) (.1) (.9) (.) (7.) * or as noted Financial Forecast** Current Q 18 Q 19 Q Q1 19 Q 19 Q 19 Q Overnight rate month T-Bills Treasury yield curve -Year Year Year Year CAD per USD Oil price (WTI), U.S.$ 8 8 ** end of period Quarterly pattern Q1 18 Q 18 Q 18 Q 18 Q1 19 Q 19 Q 19 Q 19 actual actual actual forecast forecast forecast forecast forecast Real GDP growth (q/q chg. saar) CPI (y/y chg.) CPI ex. food and energy (y/y chg.) Unemployment rate () National Bank Financial 9

10 Provincial economic forecast f 19f f f 19f f Real GDP ( growth) Nominal GDP ( growth) Newfoundland & Labrador Prince Edward Island Nova Scotia New Brunswick Quebec Ontario Manitoba Saskatchewan Alberta British Columbia Canada Employment ( growth) Unemployment rate () Newfoundland & Labrador Prince Edward Island Nova Scotia New Brunswick Quebec Ontario Manitoba Saskatchewan Alberta British Columbia Canada Housing starts () Consumer Price Index ( growth) Newfoundland & Labrador Prince Edward Island Nova Scotia New Brunswick Quebec Ontario Manitoba Saskatchewan Alberta British Columbia Canada e: estimate f: forecast Historical data from Statistics Canada and CMHC, National Bank of Canada's forecast.

11 Economics and Strategy Montreal Office Toronto Office Stéfane Marion Matthieu Arseneau Warren Lovely Chief Economist and Strategist Deputy Chief Economist MD & Head of Public Sector Strategy Krishen Rangasamy Paul-André Pinsonnault Marc Pinsonneault Senior Economist Senior Fixed Income Economist Senior Economist Kyle Dahms Jocelyn Paquet Angelo Katsoras Economist Economist Geopolitical Analyst General This Report was prepared by National Bank Financial, Inc. (NBF), (a Canadian investment dealer, member of IIROC), an indirect wholly owned subsidiary of National Bank of Canada. National Bank of Canada is a public company listed on the Toronto Stock Exchange. The particulars contained herein were obtained from sources which we believe to be reliable but are not guaranteed by us and may be incomplete and may be subject to change without notice. The information is current as of the date of this document. 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