Sunny With Fog Patches

A look ahead at the Canadian and American economies May 9, 8 Sunny With Fog Patches The Canadian economy is running near potential. Real GDP slowed to a.% rate in the second half of 7, and looks to have done no better early this year. Temporary support from the oil recovery, enhanced child benefits and Southern Ontario s housing boom have faded, while financial conditions have tightened. With the economy essentially at full employment and the population already running the fastest in years, sustaining better growth will require improvements in productivity and competitiveness. Following a.5% spurt last year, consumer spending is slowing in response to rising interest rates. Household credit has rolled over, rising 5.% y/y in March versus 5.9% last summer. Retail sales have weakened and auto sales are plateauing. ECONOMIC RESEARCH -8--5 economics.bmocapitalmarkets.com Sal Guatieri, Senior Economist -59-595 sal.guatieri@bmo.com KEY MESSAGES Fiscal stimulus will add steam to the economy this year, at the risk of propelling inflation. Stronger demand will help s economy slightly outrun its potential in the face of elevated household debts, restrictive housing policies and fading competitiveness. After rebounding last year, investment looks to cool due to uncertain trade policies and diminished competitiveness. Direct capital flows have shifted toward the with a net outflow of nearly $7 billion last year. posted a record goods trade deficit in March, despite an inexpensive currency and rising oil prices. In fact, export volumes have gone nowhere for three years. The bulk of the goods deficit is with China and in the auto industry, the latter being a notable shift from earlier decades when large surpluses were the norm. Trade looks to subtract from real GDP for five straight quarters for the first time since the mid-7s. Rising interest rates, stricter mortgage rules and other policy measures have corralled Vancouver and Toronto s high-priced housing markets. Still, the more affordable condo market remains piping hot in these cities, especially at the lowest-price points (studio and one bedroom). Across the rest of the country, all property types are affordable and activity remains healthy. Ottawa and Montreal are strengthening amid healthy affordability and increased demand from non-residents. However, Alberta and Saskatchewan continue to struggle with inventories build up during the oil shock. Stronger demand and federal infrastructure spending should allow for some modest improvement in s GDP growth in coming quarters. Encouragingly, manufacturing has turned up after lying dormant for several years. Growth of.% this year will reduce the jobless rate to 5.5% for the first time since 97. All provinces will downshift this year. Alberta could see growth sliced from a province-leading.9% last year (albeit after two years The Fed will outwalk the Bank of toward the exits, lifting rates each quarter this year. Trade protectionism and overheating are the two biggest threats to the North American expansion. A Publication of BMO Capital Markets Economic Research Douglas Porter, CFA, Chief Economist, BMO Financial Group

Page of 8 May 9, 8 in recession) to.% this year. This would allow B.C. to reassert itself as the nation s leader, benefitting from exports to fast-growing Asia. However, after four straight years of cruising above %, even B.C. will moderate to.% amid a flurry of tax increases (corporate, personal, housing, carbon and payroll). Following the fastest pace (.%) in 7 years, Quebec is expected to moderate to.% this year. Still, with companies ramping up investment amid tax relief, la belle province should once again top Ontario (.%), where business confidence is sagging. The Bank of has kept policy rates stable since January amid slower economic growth, trade policy risks and tougher mortgage rules. However, with the economy running out of slack, rates are likely to rise in July, assuming some clarity on the trade front. While elevated household debt warrants a go-slow approach to rate hikes, inaction can also heighten financial risks by encouraging more debt accumulation, according to Governor Poloz. We expect the current policy rate (.5%) to reach the low end of the Bank s estimated neutral range (.5%) by late 9. Like the economy, the Canadian dollar is stuck in low gear. After motoring above 8 cents (US) earlier this year, it has skidded back to a range of 7 to 79 cents. That s close to fair value on a purchasing power basis, estimated by Statistics at 77.5 cents for goods. Record trade deficits, NAFTA uncertainty and a resurgent greenback have offset higher oil prices to keep the currency spinning its wheels. A relief rally should NAFTA talks end well might lift it to 8 cents US by year-end. United States The economy will speed up this year. Although GDP slowed in the first quarter, the economy didn t weaken. Here s why: First, real GDP almost always downshifts at the start of the year given quirky seasonal adjustment. Second, at.%, growth still exceeded potential. Third, the slowing was largely in two areas that posted big gains in Q consumer spending and residential construction. Fourth, exports and capex stayed strong, up.% and.%, with the latter spread across industries (i.e., it wasn t just an oil story). Firmer retail and home sales flag a better second quarter, even as softer machinery orders indicate some moderation in capex. With fiscal stimulus estimated to add around % to GDP this year, growth should strengthen to.8% from.% last year. Despite rising late-cycle imbalances, the current expansion (now the second longest since at least the mid-8s) is on track to surpass the 9- run and become the longest ever by next summer.

Page of 8 May 9, 8 The fiscal jolt has put a spring in the Fed s tightening step. Policy rates are widely expected to rise in June, and we see further moves in each quarter until mid-9. With core PCE inflation (.9%) a hair below target and the jobless rate (.9%) a hair above half-century lows, the Fed s dual mandate is a fait accompli. Its focus now should be on returning policy rates to neutral (closer to %) to prevent the economy from overheating. The trade-weighted dollar s % depreciation in the past year ended with a % jump in the past month, as fiscal stimulus and firmer inflation warrant a more deliberate Fed response, while many other central banks are still looking for the exits. Although rising trade and budget deficits will restrain the dollar, the risks skew to the upside. Risks Positive comments from officials in all three NAFTA nations, and a one-month extension of the metal tariffs exemptions, have raised hopes of a deal, at least in principle, by month s end. However, if talks fail, the consequences could range from the status quo (if Congress vetoes a repeal), to a so-called Zombie NAFTA (that is held up in court for years), to an outright termination. In the event that NAFTA is repealed, the outcomes range from just modestly weaker growth if governments abide by WTO trade rules, to a recession in and Mexico and much weaker growth if governments resort to more punitive protectionist measures. Business surveys cite growing concern about material costs and supply chain disruptions arising from import tariffs on steel and aluminum and the -China tariff tiff. While the duties proposed to-date are insufficient to materially harm either economy, several rounds of retaliation would quickly ramp up the damage. Trade protectionism, loose fiscal policy and $7 oil imply heightened risks for inflation and interest rates, the usual cause of recessions. Oil prices could climb further as the reinstates sanctions on Iran. This would not only raise inflation risks but also weaken the expansion. Every % increase in oil prices slows growth by about. ppt. With the budget deficit approaching $ trillion next year (or nearly 5% of GDP), the government will have little scope to cushion the next downturn without avoiding a credit-rating downgrade. Brexit uncertainty has undermined U.K. growth and could slow the European economy. Pro- and anti-brexit forces within the U.K. parliament have debated whether to pull the region out of the EU

Page of 8 May 9, 8 customs union. This issue will largely determine whether the U.K. faces a soft or hard Brexit. A fractured government means Italy could head back to the polls this summer, raising the risk that a coalition of populist, Euro-skeptic parties will run the country. On a positive note, North and South Korea have agreed to a denuclearization deal, allaying tensions between North Korea and the ahead of a crucial leaders meeting.

Page 5 of 8 May 9, 8 Forecasts CANADA 7 8 ANNUAL I II III IV I II III IV 7 8 9 Real GDP (q/q % chng : a.r.)...5.7.5...9...8 Consumer Spending.5..7..5.8..8.5.5.8 Business Investment (non-residential). 9.5 5. 8.......7. Consumer Price Index (y/y % chng).9...8...5.... Unemployment Rate (%)..5.. 5.8 5.8 5.7 5.5. 5.7 5.5 Housing Starts (s : a.r.) 7 9 8 8 Current Account Balance ($blns : a.r.) -5. -. -7. -5. -7. -. -. -. -.9-5. -. Interest Rates (average for the quarter : %) Overnight Rate.5.5.8..5.5.5.75.7.. -month Treasury Bill.7.5.8.9...5.7.9.. -year Bond.7.5.95.9....5.78.5.8 / Interest Rate Spreads (average for the quarter : bps) 9-day - -7-5 - - - -58-5 - -55 - -year -7-75 - - -5 - - -58-55 -59-5 UNITED STATES Real GDP (q/q % chng : a.r.)....9..8.9.9..8.5 Consumer Spending.9......5..8.5. Business Investment (non-residential) 7..7.7.8...8..7.9. Consumer Price Index (y/y % chng)..9....7.8.5... Unemployment Rate (%)......9.8.7..9.5 Housing Starts (mlns : a.r.)..7.7...8..8..9.8 Current Account Balance ($blns : a.r.) -5-95 - -5-5 -55-57 -59 - -55-5 Interest Rates (average for the quarter : %) Fed Funds Target Rate.7.9....7.9...8.7 -month Treasury Bill..9...58.85.5..95.9.55 -year Note....7.7.95.5...95.5 EXCHANGE RATES (average for the quarter) US /C$ 75. 7. 79.9 78. 79. 78.7 79. 79.8 77. 79. 8. C$/US$..5.5.7.5.7..5.98.. /US$ 8 8 7 7 US$/Euro.7..8.8.......7 US$/..8...9.9...9..5 Note: Shaded areas represent BMO Capital Markets s

Page of 8 May 9, 8 VOLATILITY RETURNS United States (as of May, 8) CREDIT SPREADS STILL LOW United States (ppts) Ted Spread VIX Corporate Bond Spreads 5 5 8 7 9 5 7 7 9 5 7 -mnth Eurodollar minus -mnth T-bills (bps) CBOE market volatility index 7 8 9 5 7 8 5-year BoA Merrill Lynch AA Corporate Yield less -year Treasury Yield EQUITIES WOBBLE (indices : as of May 8, 8) LOONIE NEAR FAIR VALUE (US : as of May 8, 8) Equities Canadian Dollar 5 5 S&P 5 (lhs) TSX (rhs) 5 5 9 8 7 Parity 77. 5 7 9 5 7 5 5 7 9 5 7 9 LUMBER PRICES HIT THE ROOF Commodity price range since start of 8 OIL PRICES NEAR -YEAR HIGHS (US$/bbl : as of May 8, 8) Lumber (US$/ sq ft) 5. Materials & Foodstuffs (as of May 7, 8). [current]. Metals & Energy (as of May 7, 8) Gold 9. (US$/oz). 5.95 5 5 WTI Crude Oil Soybeans (US$/bu) 9. Wheat (US$/bu). 9.7 5.. 5.9 Oil (US$/bbl) 59.9 Natural Gas.7 (US$/mmbtu).55 7.7 7.7. 75 5 Corn.7 Copper.8 (US$/bu) (US$/lb)..79.95 no thanks to softwood lumber duties.7 5 7 9 5 7 no thanks to Iran sanctions

Page 7 of 8 May 9, 8 US ECONOMY GETS FISCAL JOLT (y/y % change) CANADIAN CONSUMERS TO DOWNSHIFT (y/y % change) Real GDP Real Personal Consumption Expenditures - - 7 8 9....8 - US.5..8.5 8 8 Canadian growth cools - - 8 8 BUSINESS INVESTMENT HEALTHY (y/y % change) CANADIAN HOUSING MARKET SLOWS Existing Homes (y/y % change : -month m.a.) Real Non-Residential Business Investment - - - 8 8 Sales 8 - - 5 5 Prices 5 5-5 - -5-5 5 FULLY EMPLOYED (percent) INFLATION PERKS UP Consumer Price Index (y/y % change) Unemployment Rate United States Headline.% Headline.% 8 7 75 8 85 9 95 5 5 Core.% - 7 9 5 7 9 Core.% - 7 9 5 7 9

Page 8 of 8 May 9, 8 7 5 Overnight Rate MONETARY POLICY TIGHTENS (% : as of May 8, 8).5%.75%.5% 5 7 9 5 7 9 5 -Year Bonds LONG-TERM RATES RISE (% : as of May 8, 8).98%.5% - Spread - bps.5% (yr. end 9).% (yr. end 8).55%.5% 7 8 9 5 7 8 9 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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