It s fun to stay in the USMCA

It s fun to stay in the USMCA October 2018 After months of negotiations, Canada finally agreed to a revamped trade deal with the U.S. and Mexico. The United States-Mexico-Canada Agreement (USMCA for short) will replace NAFTA. Our Canadian GDP growth forecast for 2019, which had assumed a deal would be reached, is unchanged at 1.9%. But with this earlier-than-expected agreement, we ve brought forward the timing for C$ appreciation, now expecting USDCAD to reach 1.25 by the first quarter of next year. Buoyed by safe haven flows stemming from emerging market woes and tighter monetary policy by the Federal Reserve, the trade-weighted U.S. dollar has done well this year. It s unclear, however, if USD can maintain momentum over the longer term especially when investor attention eventually turns to the bloating U.S. budget deficit and fading impacts of the fiscal stimulus. Barring another round of stimulus from Congress, the greenback could lose steam. Of course, for USD weakness to be sustained, trade tensions between the U.S. and major trade partners such as China and the European Union will need to abate. While the euro remains grounded by the European Central Bank s loose policy as well as internal strife (e.g. Brexit, Italian politics), the common currency has potential to bounce back over the coming year when investors start to expect an end to Fed tightening. Stéfane Marion / Krishen Rangasamy 514-879-3781 514-879-3140 Current 03-oct-18 2018Q4 2019Q1 2019Q2 2019Q3 2019Q4 USDCAD 1.28 1.27 1.25 1.25 1.27 1.28 US cents per CAD 0.78 0.79 0.80 0.80 0.79 0.78 EURUSD 1.16 1.18 1.20 1.21 1.22 1.23 USDJPY 114 113 112 114 115 113 AUDUSD 0.71 0.72 0.72 0.74 0.73 0.71 GBPUSD 1.30 1.31 1.33 1.32 1.30 1.28 USDCNY 6.87 6.85 6.81 6.78 6.80 6.80 USDMXN 18.79 18.70 18.50 18.20 18.50 18.70 *Forecasts for end of period NBF Economics and Strategy NBF Currency Outlook*

USMCA to replace NAFTA Canada will have a new trade deal with the U.S. and Mexico by next year. That, of course, assumes Canada s parliament as well as Congress in the U.S. and Mexico give final approval. The United States-Mexico-Canada Agreement (USMCA for short) is dubbed as an upgrade to an out-dated NAFTA. First the good news about USMCA. Canada was able to preserve tariff-free market access for most of its exports to the U.S. The crucial auto sector, which had been threatened with tariffs, will be largely shielded should the Trump Administration make use of section 232 of the U.S. Trade Expansion Act to impose tariffs on grounds of national security. Rules of origin, whereby 75% of production (instead of 62.5% in NAFTA) must be sourced in North America is also positive. Canada will also benefit from the requirement that at least 40% of autos be produced using workers making at least US$16/hour that levels the playing field a bit in Canada s uphill battle with Mexico for U.S. market share. The preservation of the impartial arbitration panel for dispute resolution (recall Chapter 19 of NAFTA) was a crucial win. That should allow trade disputes to be resolved without political interference. Canada was also able to ditch NAFTA s Chapter 11 which allowed investors and corporations to sue the country. Ottawa, whose related litigation expenses reportedly topped C$300 million over the years, will be glad to see that one go away. Also gone is NAFTA s proportionality rule which had forced Canada to export a fixed percentage of its energy production to the U.S. In other words, were Canada to reduce its energy exports to the U.S., it would also have had to reduce production for domestic consumption. Not anymore. In return, however, Canada had to give in on several fronts including agreeing to a variant of the sunset clause the trade pact will come up for review every six years. This means the U.S. could, after six years, decide to walk away from the agreement, the latter then expiring ten years later. Ottawa also agreed to give U.S. farmers more access to the Canadian dairy market amidst the subsequent outcry, Ottawa promised to compensate affected farmers. Canada also had to accept that steel and aluminum exports to the U.S. would still be subject to American tariffs, although it s possible the latter will be replaced with quotas based on Trump s recent comments. And by extending patent protection for U.S. drug makers, Ottawa has basically agreed that drug prices will go up in Canada it will take longer for generics to become available. Retailers will not be pleased about the scrapping of duties Canadians have to pay on online purchases from the U.S. valued $150 or less. While Canadians consumers will benefit from this (at the expense of retailers), they will have to pay more on some other items amidst the extension of copyright protection. And here, we re thinking about higher costs for educational material which will impact students. Many will view USMCA as a good deal in the sense that concessions to the U.S. could have been more significant. Others, including folks working in the steel, aluminum and dairy industries, will feel Ottawa sacrificed too much to get a deal through. But there was absolutely zero chance of a perfect trade deal. With 75% of Canada s exports going to the U.S. and less than 20% of U.S. exports coming to Canada, it was clear from the outset that Canada needed a deal more than the U.S. did, and hence would need to make concessions. All in all, an imperfect deal is better than no deal, especially if it allows Canadian exporters to ship most of their wares tariff-free to the world s largest market. Our Canadian GDP growth forecast for 2019, which had assumed a deal would be reached, is unchanged at 1.9%. But with this earlier-than-expected trade agreement, we ve brought forward the timing for C$ appreciation, now expecting USDCAD to reach 1.25 by the first quarter of next year. Note: An alternative and definitely more entertaining explanation of the USMCA can be found on page 5 What s up with oil? The loonie could also benefit from oil s surge. WTI and Brent prices rose 5% or so in September, taking cumulative gains so far this year to more than 20%. Oil s ascent has contrasted sharply with other commodities, as evidenced by the CRB index which is down this year. An excess demand situation is allowing oil to buck the trend. Venezuela s declining oil production see our recent Geopolitical Briefing Venezuela s collapse for more details coupled with U.S. sanctions on Iran do nothing to ease the excess demand. True, sanctions are scheduled to come into effect only in November. But some of Iran s trading partners are not waiting that long, 2

opting instead to immediately reduce oil imports and forcing Iran to cut back production. Iran s oil output is now hovering near 3.5 million barrels/day, down more than 6% from the peak reached last December. In other words, there is upside potential for oil prices more so if global economic growth shows resilience amidst ongoing turbulence in emerging markets. But even taking into account WCS weakness, the Canadian dollar should have been stronger than current levels. WCS averaged $42/barrel in Q3, and historically that would have been consistent with a USDCAD cross near 1.25. As it turns out, USDCAD averaged 1.31 in Q3. Loonie weaker than what would be expected given WCS oil price WCS oil versus USDCAD, quarterly data since 2008Q2 World: Excess oil demand situation persists amidst plunging Iranian output Brent oil and Oil balance Iran oil output and Share of OPEC 1.40 1.36 1.32 2018Q3 average Excess supply Excess demand 1.5 1.0 0.5 0.0-0.5-1.0-1.5-2.0-2.5 Million barrels per day Oil balance (L) Brent oil (R) US$/barrel Oil prices on the rise due to excess demand situation 2008 2010 2012 2014 2016 2018 NBF Economics and Strategy (data via Datastream, OPEC) 120 110 100 90 80 70 60 50 40 But Canada could have benefited more from the global oil price surge. The lack of pipeline capacity is indeed costing Canada dearly. Because shipments of heavy oil (via pipelines and rail) cannot keep up with production, inventories are rising and hence depressing prices of Western Canada Select (WCS). So much so that the spread between WCS and WTI averaged roughly US$30/barrel in September, the highest since 2013. 4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 Million barrels per day Iran s share of OPEC (R) which is being made worse by Iran s declining production Iran s oil production (L) Aug. 2015 2016 2017 2018 Canada: Lack of pipeline capacity forcing producers to sell at a discount WCS oil price and Spread with WTI US$/barrel WCS-WTI spread (R) US$/barrel -8 12.0 % -12-16 -20-24 11.6 11.2 10.8 10.4 10.0 9.6 9.2 8.8 CNDOLL$ USDCAD 1.28 1.24 1.20 1.16 1.12 1.08 1.04 1.00 0.96 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 105 110 NBF Economics and Strategy (data via Bloomberg) WCS oil price (US$/barrel) SER01 This departure from fundamentals could be blamed on uncertainties related to trade. If so, the USMCA should help push USDCAD closer to 1.25. The improvement of the Canada-U.S. interest rate differential could help boost the loonie over the near term. The announcement of the trade deal with the U.S. removes the last obstacle to monetary policy normalization by the Bank of Canada. The central bank, which had been concerned about exports and investment amidst rising trade barriers, can now more forcefully address mounting inflation pressures core inflation in August was the highest since 2012. Since the overnight rate hasn t kept pace with inflation, real interest rates remain deep in negative territory. With zero economic slack, there is no reason for real rates to be negative and hence the central bank has some catching up to do. 90 80 70 worst spread since 2013-28 -32-36 Canada: Real interest rate still negative Real target interest rate = Central bank target rate minus target core annual inflation rate 60 50 40 30 WCS price (L) 2.0 1.6 1.2 % 20 0.8 10 Sep. 2013 2014 2015 2016 2017 2018 NBF Economics and Strategy (data via Bloomberg) * 0.4 0.0 U.S. This forced discount offered by Canadian producers (largely to U.S. buyers) has resulted in billions in lost revenues. By our calculations, had the spread averaged $13/barrel (as was the case last year) instead of this year s massive spreads, Canadian producers of synthetic oil would have generated an extra US$2 bn in the first seven months of 2018. -0.4-0.8 Canada -1.2-1.6-2.0 Aug. -2.4 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 NBF Economics and Strategy (data via Datastream) 3

In addition to delivering an interest rate hike in October, the Bank of Canada may tighten the screws three more times in 2019 and close the gap a little with the Fed. The central bank could be even more aggressive should Ottawa deliver some stimulus ahead of next year s federal elections. As such, watch closely the federal government s Fall Economic Statement which should be released in November. Despite those rate hikes, and assuming inflation holds steady, monetary policy would still be stimulative with real rates not far from zero. In other words, barring an unexpected shock, economic growth is unlikely to stall despite those rate hikes. Another channel through which the loonie could benefit is through capital inflows. Prior uncertainties may have been responsible for this year s observed weakness in foreign purchases of Canadian securities. The roughly C$55 bn worth of net foreign purchases from January to July is the weakest 7 month inflow since 2013. Thanks to the USMCA, foreign investors may now find Canada a little bit more attractive. Even FDI inflows may benefit. Canada: Weakest portfolio inflows in five years Net foreign purchases of Canadian securities, cumulative for the first 7 months of every year 130 C$ bn 120 110 100 90 80 70 60 50 40 30 20 10 0-10 Money Market 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 NBF Economics and Strategy (data via Statistics Canada) Bonds Has the USD peaked? Equities TOTAL Also supporting our view of a stronger loonie over the near term is the belief that generalized USD weakness is just around the corner. Emerging market currencies have sank so much so fast that such depreciations are bound to reverse at some point (unless, of course, the current precarious situation in emerging economies deteriorates into a financial crisis). True, the ongoing U.S.-China trade dispute is not reassuring investors about emerging markets. But should investor sentiment improve e.g. there is an improvement in the U.S.- China relationship or value seekers feel tempted to dive right back in after this year s stock market slump in emerging economies the USD could struggle. Investors will also have an eye on diverging monetary policies between the Fed and the rest of the world, something that has been largely responsible for this year s USD surge. The Fed continued with its gradual approach to monetary policy normalization by raising the fed funds rate again in September and warned that more hikes were coming the dot plots indicate one more hike this year and at least three additional hikes next year. Encouraged by strong U.S. economic activity, the Fed upgraded its (Q4/Q4) GDP growth forecasts for this year to 2.9-3.2% and for 2019 to 2.1-2.8%. We also expect an additional rate hike from the Fed before the end of 2018. But because we re not as optimistic as the Fed about 2019 U.S. growth, we have pencilled in just two hikes for next year, i.e. one less than expected by the FOMC. Unless Congress approves another round, fiscal stimulus will eventually fade. This year s USD surge could also slow exports and inflation in 2019. Should growth and inflation come short of the Fed s forecasts, markets could reprice their expectations about monetary policy tightening in the U.S. Any USD descent would be amplified by the reversal of massive net long positions on the USD. Of course, for USD weakness to be sustained, trade tensions between the U.S. and major trade partners such as China and the European Union will need to abate. Speculative net long positions on USD highest since May 2017 Net long non-commercial position on U.S. dollar 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0-10,000-20,000 contracts 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 NBF Economics and Strategy (data via Bloomberg) 4

Picture and lyrics below from the Village People have been tweaked slightly. The video to sing along can be found at: https://www.youtube.com/watch?v=vc0gybtnctu Picture edited by Giuseppe Saltarelli Canada, there's no need to feel down I said, Canada, pick yourself off the ground I said, Canada, cause you're in a new deal There's no need to be unhappy Canada, there's a place you can trade I said, Canada, when you're short on your dough You can stay there, and I'm sure you will find Many ways to boost your exports They have everything for exporters to enjoy You can sell to U.S consumers You can get yourself rich, you can have a good deal You can do whatever you feel Canada, are you listening to me? I said, Canada, what do you want to be? I said, Canada, you can make real your dreams But you got to know this one thing No trading nation does it all by itself I said, Canada, put your pride on the shelf And just go there, in the USMCA I'm sure they can help you today They have everything for exporters to enjoy You can sell to U.S consumers You can get yourself rich, you can have a good deal You can do whatever you feel Canada, I was once in your shoes I said, I was down and out with the blues I felt no Trump cared if I were alive I felt the whole world was so jive That's when Lighthizer came to me And said, Canada, take a walk to the White House There's a place there called USMCA They can start you back on your way They have everything for exporters to enjoy You can sell to U.S consumers USMCA, it's fun to stay in the USMCA Canada, Canada, there's no need to feel down Canada, Canada, get yourself off the ground USMCA...you'll find it in the USMCA 5

Annex 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 Euro 1.65 1.60 1.55 1.50 1.45 1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 1.00 0.95 Canadian dollar 0.8 0.90 150 145 140 135 130 125 120 115 110 105 100 95 90 85 80 Japanese yen 1.15 1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 0.55 0.50 Australian dollar 75 British pound 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 0.45 Chinese yuan 8.8 8.6 8.4 8.2 8.0 7.8 7.6 7.4 7.2 7.0 6.8 6.6 6.4 6.2 6.0 5.8 5.6 NBF Economics and Strategy (data via Datastream) Current 03-oct-18 2018Q4 2019Q1 2019Q2 2019Q3 2019Q4 USDCAD 1.28 1.27 1.25 1.25 1.27 1.28 EURCAD 1.49 1.49 1.50 1.51 1.54 1.58 CADJPY 89 89 90 91 91 88 AUDCAD 0.91 0.91 0.90 0.93 0.92 0.91 GBPCAD 1.67 1.66 1.66 1.65 1.65 1.64 CADCNY 5.36 5.41 5.45 5.42 5.37 5.30 CADMXN 14.66 14.77 14.80 14.56 14.62 14.59 *Forecasts for end of period NBF Economics and Strategy Canadian Dollar* 6

Economics and Strategy Montreal Office Toronto Office 514-879-2529 416-869-8598 Stéfane Marion Matthieu Arseneau Warren Lovely Chief Economist and Strategist Deputy Chief Economist MD & Head of Public Sector Strategy stefane.marion@nbc.ca matthieu.arseneau@nbc.ca warren.lovely@nbc.ca Krishen Rangasamy Paul-André Pinsonnault Marc Pinsonneault Senior Economist Senior Fixed Income Economist Senior Economist krishen.rangasamy@nbc.ca paulandre.pinsonnault@nbc.ca marc.pinsonneault@nbc.ca Kyle Dahms Jocelyn Paquet Angelo Katsoras Economist Economist Geopolitical Analyst kyle.dahms@nbc.ca jocelyn.paquet@nbc.ca angelo.katsoras@nbc.ca 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. 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