A look ahead at the Canadian and American economies October 10, 2017

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1 A look ahead at the Canadian and American economies October, 7 In Sync After a stellar year, Canadian economic growth looks to have peaked and will moderate in the year ahead. Real GDP expanded.7% y/y to Q, the fastest in years. It s on track for.% growth this year, double last year s pace and exceeding all other G7 nations. The expansion was supported by highly stimulative financial conditions, an earlier surge in Southern Ontario s housing market and a recovery in oil prices that boosted investment in energy-producing regions. The fastest job gains in a decade and an upturn in consumer loan growth led broad strength in household spending, with a fillip from enhanced federal child benefit payments (which provided a nearly.5 ppts lift to disposable incomes). Replacement demand, job growth and buoyant confidence are driving record auto sales. But with financial conditions tightening and special factors waning, the economy can t maintain this heady pace. Indeed, flat July GDP, reversing exports and cooling Southern Ontario housing markets suggest the downward shift has already begun. Real GDP likely grew.% in Q, a big demotion from.5% in Q. Real goods exports fell three straight months to August and the most in eight years, as the loonie s sharp rise toward fair value eroded an earlier competitive advantage for exporters. Although consumer confidence is near decade highs, households face rising interest rates and a fading lift from child benefit payments. Oil prices are not high enough to incent much new investment in the industry. In addition, as the economy nears full employment, obtaining qualified workers will become a chore. Consequently, we expect GDP growth to moderate to.% in 8, the average rate of the past seven years. After nearly, jobs were created in the -months to July, employment has moderated recently. Still, with the jobless rate at nine-year lows of.% and likely headed below % next year, worker shortages will mount. This will put a few extra dollars in workers pockets but also apply a modest brake on GDP growth. ECONOMIC RESEARCH economics.bmocapitalmarkets.com Sal Guatieri, Senior Economist sal.guatieri@bmo.com KEY MESSAGES After diverging in the past year, the Canadian and economies will converge to a.% growth track next year, with the former slowing on tighter financial conditions and the latter receiving a mild fiscal lift. Monetary policies in the two countries look to synchronize with overnight rates expected to rise a full percentage point before the end of 8. A tight labour market warrants higher rates, but doubts about whether it will fan inflation suggest a measured approach. After surging on the BoC s rate hikes, the loonie hit turbulence as rate spreads will likely stop moving in its favour. Still, firmer oil prices and some clarity on NAFTA should lift it above 8 cents US by late 8. After two years in recession, Alberta is expected to lead the national economy this year with.% growth due to record oil shipments to the Gulf Coast refineries. Growth should moderate to.% in 8, implying slow progress in reducing its high jobless rate (7.9%). British Columbia isn t far behind Alberta with expected.8% growth this year, a slight acceleration from.7% in. The pace will moderate to.5% in 8, though the province should reclaim its title as the fastest growing region. Ontario (.%) and Quebec (.7%) will likely fill in the third and fourth place spots this year, both benefitting from earlier strength A Publication of BMO Capital Markets Economic Research Douglas Porter, CFA, Chief Economist, BMO Financial Group

2 Page of 8 October, 7 in exports. Quebec s jobless rate recently hit record lows, while Ontario s rate is the lowest since the tech boom. 's housing market remains healthy, albeit with stark regional differences. Most areas remain sound and balanced, with prices in Ottawa and Montreal strengthening. The oil-driven cities of Calgary and Edmonton are stabilizing, with sales above year-ago levels and prices edging higher. The Toronto region is adjusting to the measures introduced by the Ontario government in April, notably a 5% sales tax on non-resident speculators. The measures have had a chilling effect, with sales falling 5% y/y in September. Benchmark prices are still up % from a year ago, but have fallen 8% from the spring peak, slicing the yearly rate from % in April. Benchmark single-family detached prices are down about % from their highs, with sharper declines in regions north of the City of Toronto where investors (both foreign and domestic) were running rampant prior to the rule changes. Condo prices are slightly softer, though still up % y/y as this segment continues to benefit from better affordability than the detached market. The market balance for detached homes is skewed slightly toward buyers, suggesting prices could drift lower. However, if Vancouver is a guide, Toronto s prices should turn modestly higher in 8, supported by a healthy economy and steady demand from international migrants and millennials. Still, rising interest rates, poor affordability and OSFI s proposed rule changes for uninsured mortgages will have a braking effect. Vancouver has regained its footing after stumbling in response to the 5% non-residents sales tax implemented in August. After falling % y/y in February, sales have rebounded. Benchmark prices are up % y/y in September (though down from % prior to the tax), led by accelerating condos (%), the final refuge for most buyers in the city. Detached home prices have fully retraced an earlier ½% decline, but are rising at a more sustainable pace (% y/y) than in mid- (9%). After raising rates for the first time in seven years in July, the Bank of followed up with a similar 5-bp increase in September, taking the overnight rate to.%. However, recent official comments suggest it will delay the next increase until January as it cautiously assesses the impact of higher rates and a stronger currency on debt-burdened households, the economy and inflation. The Bank can afford to be patient in normalizing policy, as belowtarget core inflation of around ½% reflects some lingering economic slack as well as structural forces such as globalization, automation and e-commerce. Risks related to NAFTA talks and household debt also warrant a careful approach. Still, further rate increases are expected, as the output gap is expected to close soon and the policy rate is still well below neutral (between.5% and.5% according to the Bank). We expect the policy rate to climb to.% by late 8, before rising to.5% in 9.

3 Page of 8 October, 7 After soaring % in recent months, the Canadian dollar hit turbulence as the central bank walked back rate-hike expectations. While the currency will likely trade around current levels of 8 cents US for the rest of this year, firmer oil prices and some increased clarity on NAFTA could lift it to four-year highs above 8 cents US by year-end 8. That s still close to fair value (the exchange rate that equates average prices in the two countries), limiting the adverse impact on the economy. United States The economy continues to grow at a near.% underlying rate, as per the post-recession annual mean. This pace won t win any races, but it actually works in favour of extending the expansion, which is now in its ninth year and the third longest in the post-war era. Real GDP growth likely improved to.% in 7 from.5% in, led by stronger business investment, healthy consumer spending and perkier exports, with the latter benefitting from firmer global demand. The economy showed some pep prior to the recent hurricane disruptions, which likely slowed GDP growth to.% in Q from.% in Q. However, reconstruction and replacement activity should support a near complete rebound in Q. New auto sales were among the highest on record in September, benefitting from replacement of flood-damaged cars and dealer incentives to cut inventories. The ISM business indexes hit their highest levels in a dozen years. Apart from recent hurricane distortions, employment is rising steadily, reducing the jobless rate to a -year low of.%. The latter is expected to slide below % next year, marking the lowest rate since 97 outside of the tech boom at the turn of the century. Not surprisingly, consumer confidence is near -year highs, supporting demand. Surprisingly, the housing market has lost traction this year, with home sales turning lower and starts levelling off. The slippage in sales is likely in response to less pent-up demand after six years of steady expansion, fading affordability for first-time buyers due to higher prices and mortgage rates, as well as a lean supply of listings. House prices have been rising at a 5%-to-% clip for the better part of two years. We look for continued moderate GDP growth of.% in 8, assuming a mild upward bump from an easing in taxation and regulatory burdens for businesses. While the current tax reform plan by the Administration and Republican leaders could provide a material lift to the economy, it is doubtful that aggressive reductions can be legislated given the adverse impact on the budget

4 Page of 8 October, 7 deficit and progressivity of the tax system. We are assuming only a two-tenths lift from fiscal policy next year. The Fed has raised policy rates by a total of bps since late 5 to a range of.%-to-.5%. It has begun the lengthy process of shrinking its portfolio of Treasury and mortgage notes (by phasing out reinvestments of maturing principal and interest receipts). We expect the next rate hike to occur in December, followed by three more moves next year, taking the range for policy rates to.%-to-.5% in late 8. The risks to this, however, are on the downside, as well behaved inflation and wages remain an enduring mystery to Yellen. However, the possibility that Yellen will be replaced by a more hawkish chair when her term expires in February partly counters this risk. Risks The biggest near-term risk to the Canadian outlook stems from the threat of protectionist measures by the Administration. While a border adjustment tax is off the table, a NAFTA rewrite notably of country-of-origin rules, the dispute settlement system, and access to government procurement contracts could disadvantage Canadian businesses. The Administration has already slapped punitive tariffs on s lumber and aerospace industries, setting a poor tone for the trade talks. Elevated house prices in Vancouver and Toronto, combined with high levels of household debt, pose an ongoing downside risk to the economy, notably in the event of an adverse change in job prospects or in the cost and availability of credit. While neither condition, on its own, is likely to trigger a recession, both could aggravate an economic downturn, resulting in adverse feedback to household finances. OSFI s proposed changes to underwriting standards on uninsured mortgages could extend the recent correction in Toronto s house prices. Rising tensions between the and North Korea over the latter s threats to deploy nuclear missiles poses the biggest geopolitical threat to the outlook. Acrimonious Brexit talks could devolve further, slowing the U.K. economy and hampering the Euro Area s recent pickup. Catalonia s independence movement in Spain is a new complication for the Euro Area.

5 Page 5 of 8 October, 7 Forecasts CANADA 7 8 ANNUAL I II III IV I II III IV 7 8 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

6 Page of 8 October, 7 MARKET VOLATILITY BENIGN United States (as of October, 7) CREDIT SPREADS NARROW United States (ppts) Ted Spread VIX Corporate Bond Spreads mnth Eurodollar minus -mnth T-bills (bps) CBOE market volatility index All eyes on the new government year BoA Merrill Lynch AA Corporate Yield less -year Treasury Yield 5 5 Equities EQUITIES AT NEW HIGHS (indices : as of October 9, 7) ¹ (divided by ) TSX lagging S&P 5 TSX¹ Canadian Dollar Parity LOONIE LEVELS OFF (US : as of October, 7) COPPER PASSES THE GRADE Commodity price range since start of 7 OIL PRICES RANGEBOUND (US$/bbl : as of October 9, 7) Lumber (US$/ sq ft).8 Materials & Foodstuffs (as of October 9, 7).7 [current].7 Metals & Energy (as of October, 7) Gold.8 (US$/oz) WTI Crude Oil Soybeans (US$/bu) 8.78 Wheat.9 (US$/bu) Oil (US$/bbl). Natural Gas (US$/mmbtu) Corn (US$/bu)...9 Copper (US$/lb)

7 Page 7 of 8 October, 7 CANADIAN ECONOMY PEAKING (y/y % change) CONSUMER SPENDING HEALTHY (y/y % change) Real GDP Real Personal Consumption Expenditures US doing OK, awaits fiscal lift BUSINESS INVESTMENT RECOVERS (y/y % change) HOME PRICES RISING BRISKLY Existing Homes (y/y % change : -month m.a.) Real Non-Residential Business Investment Sales Prices NEAR FULL EMPLOYMENT (percent) INFLATION SUBDUED Consumer Price Index (y/y % change) 8 Unemployment Rate -Year Low Headline.% Core.9% United States Headline.9% Core.7%

8 Page 8 of 8 October, Overnight Rate MONETARY POLICIES IN SYNC (% : as of October, 7).%.5%.% Year Bonds LONG RATES IN NO HURRY (% : as of October, 7).%.% - Spread - bps % (yr. end 8).% (yr. end 7).5%.7% 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 55 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 57 of the Laws of Hong Kong). 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