A look ahead at the Canadian and American economies November 28, 2017

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1 A look ahead at the Canadian and American economies November 8, 7 Peak Growth After a stellar run, s economy is downshifting to a more sustainable pace. Real GDP grew.7% in the year to Q and likely.% in 7, double last year s rate. Highly stimulative financial conditions, an earlier surge in Southern Ontario s housing market and a recovery in energy-producing regions fueled the expansion. The fastest job gains in a decade and an upturn in consumer borrowing supported household spending, with a fillip from enhanced federal child benefit payments (which provided a nearly.5 ppts lift to disposable incomes). Buoyant confidence drove record auto sales. However, with one-off factors fading, growth likely slowed in Q. Four monthly declines in exports, a cooler Ontario housing market and a decline in August GDP suggest a sub-% pace. This partly reflects the temporary CAMI auto strike and temporary plant shutdowns in the chemical and oil industries for maintenance. The reopening of these plants should lift growth modestly to.5% in Q. Tighter financial conditions point to.% growth in 8, similar to the average of the past seven years. The loonie s earlier sharp rise toward fair value has eroded a competitive advantage for Canadian exporters. Although consumers remain confident, they face rising interest rates and a fading lift from child benefit payments. Oil prices, despite firming to ½-year highs of $57 a barrel (WTI) on tensions between Saudi Arabia and Iran, are not high enough to incent an investment boom in the industry. In addition, with full employment in sight, finding qualified workers has become a chore. ECONOMIC RESEARCH economics.bmocapitalmarkets.com Sal Guatieri, Senior Economist sal.guatieri@bmo.com KEY MESSAGES s economy outran the (and all other G7 nations) in 7 but trends will reverse in 8, with the former slowing on less supportive financial conditions and the latter likely to see a fiscal bump. Monetary policies will tighten further, but likely more in the than in. Tight labour markets warrant higher policy rates, but persistent low inflation suggests a cautious approach. A careful Bank of and sour NAFTA talks could hold the Canadian dollar below 78 cents US in 8. After nearly, new positions were created in the -months to July, job growth has moderated recently. Still, with the jobless rate close to cycle lows (.% in October) and likely headed lower, worker shortages will intensify, applying a modest brake to the economy s expansion. Rebounding from recession, Alberta is expected to lead s economy this year with.% growth amid record oil shipments. But growth will moderate to.% in 8, implying less progress in reducing a still-high jobless rate of 7.8%. British Columbia isn t far behind Alberta with expected.8% growth this year, a slight acceleration from last year. Its pace will moderate to.5% in 8, though the province should reclaim the 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 previous strength in exports and sturdy housing markets. Quebec s A Publication of BMO Capital Markets Economic Research Douglas Porter, CFA, Chief Economist, BMO Financial Group

2 Page of 8 November 8, 7 jobless rate recently hit an all-time low, while Ontario s rate is close to the lowest levels since the tech boom. 's housing market remains healthy, albeit with vast 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 firming. The Toronto region is still adjusting to earlier measures introduced by the Ontario government, notably a 5% sales tax on non-resident investors. Resale activity is down 7% y/y in October but has turned higher in recent months. Although benchmark prices are up % from a year ago, they have fallen 8% since the spring. Benchmark single-family detached prices are down about % from their peak, with sharper declines in regions north of the city where investors (both foreign and domestic) were out in force prior to the rule changes. Condo prices are still up % y/y, as this segment remains a much more affordable option than the detached market. The market balance for detached homes is skewed slightly toward buyers, suggesting prices could drift lower in the face of rising interest rates and OSFI s proposed rule changes that take effect in January. However, if Vancouver is a guide, Toronto s prices should resume moving modestly higher in 8, supported by a healthy economy and steady demand from international migrants and millennials. Vancouver has regained its footing after stumbling in response to the foreign buyers sales tax. After falling % y/y in February, sales rebounded to 5% y/y in October. Benchmark prices are up % y/y, led by condos (%) which remain in short supply. While detached house prices have fully retraced an earlier ½% decline, they are rising at a more sustainable rate (% y/y) than in mid- (9%). After raising policy rates twice in the summer to take back the 5 rate cuts, the Bank of has turned cautious, and will likely delay the next move until March. The Bank is worried that indebted households won t be able to handle higher rates and that NAFTA talks could go further off the rails. It also suspects that low inflation reflects longer-lasting forces such as globalization, automation and e-commerce. Still, we expect further rate increases in 8, as the output gap is virtually closed and the policy rate remains well below the neutral.5%-to-.5% range estimated by the Bank. We see overnight rates rising from.% currently to.75% by the end of 8 and to.5% in 9. After leaping % to 8 cents US in the four months to September, the loonie has slipped to 78 cents as the central bank walked back rate-hike expectations. Weaker economic data, NAFTA uncertainty and a broadly stronger greenback have also weighed, with some offset from firmer oil prices. While the currency is still up 5% since the start of the year, it will struggle to make headway, and we

3 Page of 8 November 8, 7 expect it to trade below 78 cents in 8 unless NAFTA talks improve or oil prices rise further. United States After a slow start to the year, the economy has regained momentum amid solid consumer spending and an upswing in investment. Despite hurricane-related disruptions, real GDP grew a hearty.% in Q (before revisions), and will likely maintain this pace in Q amid reconstruction activity. New auto sales have benefitted from the replacement of flood-damaged vehicles and dealer incentives to trim inventories. The ISM business indexes are near their highest levels in a dozen years. Despite the increased difficulty of finding qualified workers, job growth remains healthy, reducing the jobless rate to a near 7-year low of.%. The latter is expected to slip further next year, marking the lowest rate since 97 outside of the tech boom at the turn of the century. With jobs plentiful and equities forging new highs, consumer confidence is also perched at 7-year peaks, supporting household spending. One soft spot for the economy is the housing sector. Although new home sales spiked to decade highs in October, the much larger resale market has sagged this year. The slippage is likely in response to fading pent-up demand after six years of expansion, leaner listings and eroding affordability (especially for first-time buyers) due to higher mortgage rates and near % increases in house prices. Assuming some support from lower taxes and easing regulatory burdens, the economy is expected to grow a slightly faster.% in 8, compared with an estimated.% in 7. While the current tax reform plan by House Republicans could provide a material lift to the economy, it is doubtful that aggressive reductions can be legislated without drilling a sizeable hole in the budget deficit. The Senate s plan, which has not yet been approved, packs even less punch as it delays the reduction in the corporate tax rate. For now, we assume only a two-tenths lift from fiscal policy next year. The Fed has raised policy rates a full percentage point 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 move on December, followed by three additional increases next year, taking the range for policy rates to.%-to-.5% in late 8. The risks to this, however, are on the downside, if persistent low inflation (core PCE prices.% y/y in September) and wages (unit labour costs.5%

4 Page of 8 November 8, 7 y/y in Q) remain a mystery to the current chair, Yellen, or her nominated replacement, Jerome Powell. Risks The biggest near-term risk to is the threat of protectionist measures by the government. The fourth round of NAFTA talks turned bitter, as the demanded changes to country-oforigin rules, the dispute settlement system and access to government procurement contracts that were unacceptable to and Mexico. The Administration has already slapped punitive tariffs on Canadian lumber and Bombardier. With most American businesses lobbying to preserve the agreement, it s debatable whether Congress will allow the country to withdraw. A worst case for is if the not only withdraws from NAFTA but also imposes more punitive tariffs than prescribed under WTO rules. Elevated house prices in a few regions and high levels of household debt pose an ongoing risk to the economy in the event of a deterioration in income growth or in the cost/availability of credit. While neither condition is likely to trigger a recession on its own, both could aggravate an economic downturn, resulting in adverse feedback to household finances and spending. New federal underwriting standards on uninsured mortgages also risk extending the recent correction in Toronto s house prices. Tension between the and North Korea over the latter s nuclear missiles program 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. The Catalan independence movement in Spain and an uncertain future for German Chancellor Merkel s government are further complications in the Euro Area.

5 Page 5 of 8 November 8, 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 November 8, 7 MARKET VOLATILITY BENIGN United States (as of November 7, 7) CREDIT SPREADS NARROW 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 AT NEW HIGHS (indices : as of November 7, 7) LOONIE LAGGING (US : as of November 7, 7) Equities Canadian Dollar 5 S&P 5 (lhs) 5 9 Parity 5 TSX (rhs) MOST CROP PRICES REMAIN SOFT Commodity price range since start of 7 OIL PRICES AT TWO-YEAR HIGHS (US$/bbl : as of November 7, 7) Materials & Foodstuffs (as of November 7, 7) Lumber. [current] (US$/ sq ft).8 5. Metals & Energy (as of November 7, 7) Gold 9.9 (US$/oz) WTI Crude Oil Soybeans (US$/bu) 8.78 Wheat (US$/bu) Oil (US$/bbl). Natural Gas (US$/mmbtu) Corn. (US$/bu)..9 Copper (US$/lb)

7 Page 7 of 8 November 8, 7 Real GDP CANADIAN GROWTH HAS PEAKED (y/y % change) CONSUMER SPENDING HEALTHY (y/y % change) Real Personal Consumption Expenditures US While gains momentum US BUSINESS INVESTMENT STRONG (y/y % change) HOME PRICES RISING BRISKLY Existing Homes (y/y % change : -month m.a.) Real Non-Residential Business Investment Sales Prices FULL EMPLOYMENT MOSTLY ACHIEVED (percent) INFLATION STILL SUBDUED Consumer Price Index (y/y % change) 8 Unemployment Rate -Year Low Headline.% Core.9% United States Headline.% Core.8%

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