Oil Slick - BMO Nesbitt Burns

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A look ahead at the Canadian and American economies
November 13, 2014
Oil Slick
United States



Booming shale energy output, global growth concerns and a
surprising price cut by Saudi Arabia have slashed world oil prices
25% since June to four-year lows. That’s not great news for the tight
oil industry and two states, Texas and North Dakota, in particular.
However, most shale energy drilling will continue unless prices drop
further. As well, the production foregone in an industry that accounts
for less than 1% of GDP is more than offset by the impact of lower
energy costs on consumer spending, corporate profits and global
demand. In all, lower oil prices could lift U.S. GDP about 0.2% in the
year ahead. However, a stronger greenback and milder global outlook
prompted us to trim our growth forecast to 3.0% in 2015.
The economy is on a higher growth track, led by an 8% advance in
business spending in the past year. Not surprisingly, firms are also
hiring at the fastest rate since 2006, with 2¼ million jobs added this
year. Payrolls have risen more than 200,000 in each of the past nine
months, a streak unmatched in two decades. The unemployment rate
has fallen to six-year lows of 5.8%, below long-term norms. A jump in
full-time positions and more jobs in high-paying industries are
supporting income and spending, lifting auto sales and consumer
confidence to pre-recession levels. However, households are still
holding back somewhat due to soft wage growth. Meantime, last
year’s sizeable fiscal drag from tax hikes and sequestration has faded,
while municipal governments are spending more and cutting taxes.
The recovery in housing markets has resumed in response to lower
mortgage rates and a recent easing in lending standards, though price
appreciation has slowed. After expanding 3.5% in Q3 (with a big
assist from defense spending), real GDP likely slowed to 2.8% in Q4.
However, this still tops average 2.1% growth in the first four years
of the expansion.
ECONOMIC RESEARCH
1-800-613-0205 • www.bmocm.com/economics
Sal Guatieri, Senior Economist
416-359-5295
[email protected]
HIGHLIGHTS
 Lower oil prices will help the U.S.
economy but hinder Canada’s
expansion
 Cheaper fuel, record stock prices and
low interest rates should propel the
U.S. economy 3% in 2015
 A weaker outlook for oil-rich Alberta
prompts a slight downgrade for
Canadian growth, but a sagging
loonie will help
 The Fed has stopped easing policy,
and will likely start raising rates in
mid-2015
 A dovish Bank of Canada will lag the
Fed’s tightening cycle
 Higher U.S. interest rates will further
weaken the Canadian dollar
The Republicans’ strong showing in the Midterm Elections could
support business confidence and investment. By regaining control of
Congress, the GOP will have a firmer platform to reform corporate tax
laws, reinstate the bonus depreciation allowance on capital
equipment, build the Keystone XL pipeline, repeal the oil export ban,
and pass key trade deals with Asia and Europe. While it’s unclear
whether a more equal division of power will lead to more productive
legislation or to further gamesmanship and gridlock, recent
conciliatory comments from both parties are encouraging. If both
sides can work together on issues that have some bipartisan support,
such as corporate tax reform and trade agreements, then the chance
A Publication of BMO Capital Markets Economic Research • Douglas Porter, CFA, Chief Economist, BMO Financial Group
Page 2 of 7
of renewed showdowns over the continuing resolution to fund the
government, debt ceiling and budget deficit should diminish.

Inflation continues to retreat amid falling gasoline prices, a stronger
dollar, and intense retail competition. The CPI rose 1.7% y/y in
September, while the PCE price index (the Fed’s preferred inflation
guide) climbed 1.4%. While inflation is expected to remain low in
2015, an upturn to 2% is expected due to perkier wages. Tentative
evidence suggests wages are responding to lower unemployment and
isolated labour shortages. The employment cost index rose 2.8%
annualized in the past two quarters, the fastest pace in six years.
However, provided that wage growth doesn’t exceed combined
increases in inflation and productivity, it is more likely to support
demand than stoke inflation.

The Fed had few qualms about ending its asset purchase program in
October. During QE3’s two-year lifespan, five million jobs were
created and the unemployment rate fell two percentage points, by all
means marking “substantial” progress in labour markets. With slack
no longer deemed “significant”, the focus now shifts to when to
remove the stimulus. While a “considerable time” could still elapse
before we see tighter policy, the Fed has warned markets of the risk of
a near-term rate hike should the economy surprise to the upside. Still,
no move is expected until June 2015, based on the FOMC members’
rate projections and benign inflation. The first increase in policy rates
since 2006 and a gradual tightening course should lift the 10-year
Treasury yield from 2.3% currently to 3.0% at the end of 2015 and to
3.7% in late 2016, still low by historical standards.
Canada

While lower oil prices will support the U.S. expansion, the same
cannot be said for Canada. A cutback in oil and gas investment
could carve up to 0.2% from GDP growth next year. Alberta will take
the brunt of the hit, likely slowing to a sub-3% rate for the first time
since the recession. Saskatchewan and Newfoundland will also share
the pain. However, the manufacturing-heavy regions in Central
Canada will benefit from both lower energy costs and a weaker
currency. We therefore shaved our 2015 growth forecast only
slightly to 2.4%. This would still mark the best annual performance
in three years and a modest pickup from estimated 2.2% growth in
the second half of 2014.

Exports will drive the expansion, with support from business
spending. Goods exports are up 8% in the past year to September
amid widespread gains across industries. Meanwhile, imports have
moderated as fewer Canadians are shopping stateside. As a result,
job growth is picking up (1.0% y/y in October) after slowing earlier
this year. Now that the export train has left the station, it won’t be
November 13, 2014
Page 3 of 7
long before capital spending (outside of the resource sector) gets
pulled along. Announced tax relief by the federal government will
also support consumers next year, especially in July when parents
will receive retroactive Child Care Benefit payments. Nonetheless,
elevated household debt and higher interest rates will act as a
moderate brake on spending.

Higher interest rates will also cool red-hot housing markets in
Calgary, Toronto and Vancouver. While other regions have steadied
or weakened this year, notably Atlantic Canada and Quebec, these
three cities have strengthened, with sales well above year-ago levels
in response to strong demand from immigrants and millennials.
Prices have accelerated faster than family income, further straining
affordability. Consequently, some correction is anticipated in Toronto
and Vancouver when interest rates eventually rise. As a rough guide
to potential price declines, if interest rates rose two percentage points
in the next three years (while income continued to trend higher), the
price of a Toronto bungalow would need to decrease 11% to maintain
mortgage service costs at current levels for the typical buyer. While
supportive demographics and an influx of foreign wealth should
cushion the blow, it’s difficult to see prices staying at current lofty
levels if interest rates don’t stay at current crisis levels.

Despite a firmer economy and higher inflation, the Bank of Canada
has no intention of lifting rates soon. Citing almost one million
involuntary part-time workers, the Bank claims the economy’s
“considerable” slack will suppress inflation for the next two years.
Accordingly, it has downplayed the recent upturn in the CPI to the
2.0% target, citing transitory factors such as higher meat prices and a
weaker loonie. Moreover, though acknowledging perkier exports, the
Bank still sees global headwinds as a threat. In addition, Governor
Poloz believes the consequences of a downward inflation surprise are
greater than an upside surprise, implying a bias to avoid tightening
prematurely. As a result, we see no rate hike until October 2015, four
months after the Fed’s liftoff and five years after the Bank last raised
rates. The 10-year Canada yield should climb gradually from 2.0%
currently to 2.7% by late 2015 and to 3.3% in late 2016.

Sliding oil prices have pulled the Canadian dollar to five-year lows
below 88 cents US, with an assist from still-dovish BoC banter. The
thrashing likely isn’t over, even if oil prices firm as expected to $85
dollars a barrel by late next year. With the Bank likely to lag the Fed’s
tightening cycle, and longer term Canada yields already below U.S.
rates, the loonie could weaken to 85 cents by late 2015.
November 13, 2014
Page 4 of 7
November 13, 2014
Forecasts
CANADA
2014
2015
ANNUAL
2014
I
II
III
IV
I
II
III
IV
2013
1.0
3.6
2.2
2.1
2.3
2.5
2.7
2.6
2.0
2.3
2.4
1.3
3.7
2.3
1.6
1.9
2.1
2.2
2.0
2.5
2.5
2.1
-2.5
1.8
1.3
1.7
2.3
4.3
3.7
4.2
2.6
-0.3
2.7
Consumer Price Index (y/y % chng)
1.4
2.2
2.1
1.9
1.7
1.5
1.8
2.4
0.9
1.9
1.8
Unemployment Rate (%)
7.0
7.0
6.9
6.6
6.6
6.5
6.4
6.4
7.1
6.9
6.5
Housing Starts (000s : a.r.)
175
197
199
188
189
186
184
181
188
190
185
-48.1
-47.5
-43.9
-54.3
-49.0
-46.2
-43.9
-40.9
-60.3
-48.5
-45.0
Overnight Rate
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.25
1.00
1.00
1.05
3-month Treasury Bill
0.87
0.93
0.94
0.89
0.89
0.89
0.89
1.15
0.97
0.91
0.96
10-year Bond
2.47
2.35
2.14
2.00
2.02
2.12
2.29
2.55
2.26
2.24
2.25
90-day
82
90
91
87
87
79
56
59
91
88
70
10-year
-30
-27
-35
-30
-31
-32
-33
-35
-9
-30
-33
-2.1
4.6
3.5
2.8
2.9
3.0
2.8
2.7
2.2
2.2
3.0
Consumer Spending
1.2
2.5
1.8
2.8
3.2
3.3
3.0
2.9
2.4
2.2
2.9
Business Investment (non-residential)
1.6
9.7
5.5
5.0
4.7
4.7
4.5
4.4
3.0
5.9
5.1
Consumer Price Index (y/y % chng)
1.4
2.1
1.8
1.7
1.8
1.8
2.0
2.2
1.5
1.7
2.0
Unemployment Rate (%)
6.7
6.2
6.1
5.8
5.6
5.4
5.2
5.0
7.4
6.2
5.3
Housing Starts (mlns : a.r.)
0.93
0.99
1.02
1.06
1.18
1.27
1.31
1.31
0.93
1.00
1.27
Current Account Balance ($blns : a.r.)
-408
-394
-367
-391
-402
-412
-427
-439
-400
-390
-420
Fed Funds Target Rate
0.13
0.13
0.13
0.13
0.13
0.21
0.46
0.71
0.13
0.13
0.38
3-month Treasury Bill
0.05
0.03
0.03
0.02
0.02
0.10
0.33
0.56
0.06
0.03
0.25
10-year Note
2.76
2.62
2.50
2.30
2.33
2.44
2.63
2.90
2.35
2.55
2.57
US¢/C$
90.6
91.7
91.8
88.7
87.8
86.8
85.8
85.1
97.1
90.7
86.4
C$/US$
1.103
1.090
1.089
1.127
1.139
1.153
1.166
1.175
1.030
1.103
1.158
¥/US$
103
102
104
111
113
114
115
117
98
105
115
US$/Euro
1.37
1.37
1.32
1.26
1.27
1.25
1.24
1.22
1.33
1.33
1.25
US$/£
1.66
1.68
1.67
1.61
1.61
1.60
1.58
1.57
1.56
1.65
1.59
Real GDP (q/q % chng : a.r.)
Consumer Spending
Business Investment (non-residential)
Current Account Balance ($blns : a.r.)
2015
Interest Rates
(average for the quarter : %)
Canada/U.S. Interest Rate Spreads
(average for the quarter : bps)
UNITED STATES
Real GDP (q/q % chng : a.r.)
Interest Rates
(average for the quarter : %)
EXCHANGE RATES
(average for the quarter)
Note: Shaded areas represent BMO Capital Markets forecasts
Page 5 of 7
November 13, 2014
FINANCIAL STRESS STILL LOW
CREDIT RISK ALSO LOW
United States (as of November 11, 2014)
United States (ppts)
VIX 2
Ted Spread 1
500
100
400
80
300
60
200
40
100
20
Corporate Bond Spreads 1
5
4
3
0
2
0
07 08 09 10 11 12 13 14 15
1
1
07 08 09 10 11 12 13 14 15
2
3-mnth Eurodollar minus 3-mnth T-bills (bps)
07
1
CBOE market volatility index
08
09
10
11
12
13
14
After a recent brief spike higher
Complacency setting in?
CANADIAN DOLLAR TO WEAKEN FURTHER
OIL PRICES HIT BY SUPPLY GLUT
(US¢ : as of November 12, 2014)
Commodity price range since start of 2014
Canadian Dollar
Materials & Foodstuffs
Metals & Energy
(as of November 11, 2014)
(as of November 11, 2014)
110
Lumber
Parity
100
15
15-year BoA Merrill Lynch AA Corporate Yield less 10-year Treasury Yield
90
Soybeans
(US$/bu)
88.39¢
Gold
328.50 [current]
(US$/
1000 sq ft) 297.00
(US$/oz)
369.80
1156.50
1142.00
Oil
10.09
8.83
15.29
(US$/bbl)
1385.00
77.94
77.19
107.62
80
Wheat
(US$/bu)
70
forecast
60
03
04
05
06
07
08
09
10
11
12
13
14
15
7.42
Corn
(US$/bu)
Natural Gas
4.63
4.17
(US$/mmbtu)
4.25
3.56
Copper
3.40
2.79
(US$/lb)
4.99
6.15
3.03
2.92
3.37
Grain prices dampened by bumper crop; Gold sold
ECONOMIES ON FIRMER TRACK
U.S. CONSUMER SPENDING TO PICK UP
(y/y % change)
(y/y % change)
Real GDP
Real Personal Consumption Expenditures
6
6
Canada
4
Canada
4
2
2
0
0
-2
-4
-6
12
Canada 1.9
US
2.3
00
02
13
2.0
2.2
04
14
2.3
2.2
15
2.4
3.0
06
-2
U.S.
08
10
forecast
12
14
U.S.
-4
00
02
04
06
08
10
forecast
12
Canadian spending to moderate
14
Page 6 of 7
November 13, 2014
EXPORTS TO BOOST CANADIAN INVESTMENT
U.S. HOME PRICE GROWTH MODERATING
(y/y % change)
Existing Homes (y/y % change : 3-month m.a.)
Real Non-Residential Business Investment
Prices
Sales
30
80
Canada
20
20
Canada
60
15
Canada
10
10
40
U.S.
0
5
20
-10
0
-5
0
U.S.
-10
-20
-20
forecast
-30
00
02
04
06
08
10
12
-15
U.S.
-40
14
-20
00 02 04 06 08 10 12 14
00 02 04 06 08 10 12 14
U.S. JOBLESS RATE BACK TO NORMAL LEVELS
INFLATION HAS STEADIED
(percent)
Consumer Price Index (y/y % change)
Unemployment Rate
United States
Canada
14
6
6
12
Headline
forecast
Canada
Headline
10
8
2.1%
3
33-Year
Low
forecast
Core
Core
6
1.7%
3
0
0
1.7%
2.0%
4
U.S.
forecast
2
70
75
80
85
90
95
00
05
10
-3
15
-3
07
09
11
13
15
07
09
11
FED ON HOLD UNTIL JUNE 2015, BOC WILL LAG
LONG-TERM RATES TO RISE SLOWLY
(% : as of November 12, 2014)
(% : as of November 12, 2014)
Overnight Rate
13
15
10-Year Bonds
6
7
forecast
6
forecast
U.S.
5
5
4
4
3
Canada
3
3.00%
2.30%
Canada
2
2
U.S.
1%
45-Year Low
1
1.0%
0%–0.25%
0
01
03
05
07
09
11
13
15
2.65%
(year end
2.33%
2.00% ’15)
Canada 2.04%
(year end
Canada-U.S. Spread -29 bps ’14)
U.S.
1
0
07
08
09
10
11
12
13
14
15
Page 7 of 7
November 13, 2014
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(“BMO Financial Group”) has lending arrangements with, or provide other remunerated services to, many issuers covered by BMO Capital Markets. The opinions, estimates and projections contained
in this report are those of BMO Capital Markets as of the date of this report and are subject to change without notice. BMO Capital Markets endeavours to ensure that the contents have been
compiled or derived from sources that we believe are reliable and contain information and opinions that are accurate and complete. However, BMO Capital Markets makes no representation or
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