Canadian and U.S. Economic Outlook: Navigating Through Challenging Times

1. ECONOMICS I RESEARCH Canadian and U.S. Economic Outlook:Navigating Through Challenging Times RBC Spring Economic Briefing Paul Ferley (416) 974-7231 Assistant Chief Economist Paul.ferley@rbc.com May 2013

2. Questions to be addressed: 1. What is the forecasted growth for the Canadian economy? 2. What is forecasted to happen with the Canadian dollar exchange rate? 3. What is forecasted to happen with interest rates? 4. What are the major risks on the horizon in 2013? • Canadian & GTA housing market? • Eurozone crisis? • China's slowdown? • U.S. fiscal policy?

3. U.S. Economic Outlook: The Gradual Pace of Recovery Leaves the U.S. Economy Vulnerable to Possible Negative Shocks

4. The U.S. economy has grown for fifteen quarters since pulling out of recession mid-2009 5

5. However, the pace of growth has been historically modest and has left the unemployment rate high relative to the pre-recession levels and thus the economy vulnerable to a negative shock

6. Potential negative shocks include a worsening in the European sovereign debt crisis and/or the U.S. failing to address its fiscal imbalances

7. For growth to be sustained, it will also be necessary to see continued modest strengthening in employment growth going forward

8. Assuming policymakers in both the Eurozone and the U.S. address pressing fiscal issues, highly stimulative monetary conditions are expected to sustain U.S. growth in 2013 and 2014 10 10

9. However, this represents a very ‘sub-par’ recovery with activity restrained by the fallout from the last recession in the form of high household and government debt levels and impaired financial markets

10. The projected pace of GDP growth will put only modest downward pressure on the unemployment rate

11. Slack in labour markets will keep inflation quiescent despite commodity prices remaining historically high and aggressive central bank easing

12. High unemployment and low inflation will result in the Fed keeping policy accommodative with hikes to Fed funds not expected until 2015

13. Canadian Economic Outlook: Strong Demand for Natural Resources a Benefit For Canada Though Growth is Still Largely Dependant on Sustained U.S. Recovery

14. The recovery in Canada has generally been stronger than in the U.S. though growth has been hit by bouts of transitory weakness such as in the third and fourth quarter of last year

15. Canada’s bounce post-crisis is impressive, not just against the U.S. Source: Haver Analytics, RBC Capital Markets

16. The Canadian economy has benefited from strong, albeit slowing, demand from emerging markets, particularly in Asia, for various natural resources…

17. …which is putting upward pressure on oil, base metal and grain prices though forestry prices have benefited less

18. Our expectation is that this strength for most commodity prices, such as for oil, will generally be maintained through the forecast though some, like for natural gas, will be weighed down by supply factors

19. High commodity prices and low interest rates are expected to result in business investment being a mainstay of Canadian growth this year and next

20. The investment story hangs on natural resources Source: Statistics Canada, RBC Capital Markets

21. High levels of Canadian household debt as a share of income are a concern…

22. As they surpass other countries on a relative basis… Source: Statistics Canada, Federal Reserve Board, Bureau of Economic Analysis, Australian Bureau of Statistics, Office for National Statistics, RBC Economics Research

23. …though with servicing costs still manageable…

24. …these balance sheet constraints will limit, though not prevent, continued growth in consumer spending

25. High debt levels are expected to keep demand for new housing units subdued with the prospects of higher rates and announced mortgage rules changes having advanced some activity to 2012 at the expense of this year and next

26. All major housing price indices showing moderation Source: RBC Capital Markets, Haver Analytics

27. Strong business investment, rising U.S. demand, modest gains in consumer spending, and accommodative Bank of Canada policy are expected to help sustain growth in Canada through 2014 offsetting declining residential investment 31

28. A handover from consumer to net trade, gov’t spending to investment? Forecasted contributions to GDP Growth: Canada Percentage points Source: Bank of Canada, RBC Capital Markets

29. The composition of growth in the U.S. should help moving forward

30. The outlook for growth will put further downward pressure on unemployment rate 35

31. Though the unemployment rate has moved lower, there remains sufficient slack in the economy to keep core inflation below target near term despite high commodity prices 36

32. To sustain growth, the Bank of Canada is expected to remain on the sidelines until the middle of next year though the hikes will be moderate, reflecting the modest rebound in growth

33. The Canadian dollar to remain strong though slightly below parity reflecting historically high commodity prices and the Bank of Canada tightening in advance of the Fed

34. Global Technical Outlook – Spring 2013 Risk Dominoes and Reverberations: A Changing Landscape FIC TECHNICAL STRATEGY I RESEARCH George Davis, CMTManaging Director and Chief Technical Analyst RBC Dominion Securities Inc. (416) 842-6633 george.davis@rbccm.com May, 2013 This report was priced between March 11-15 and April 29-30, 2013 unless otherwise stated. Please see page 26 for Required Disclosures.

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36. Intermarket Focus: A Reassessment of Risk SECTION I An analysis of some of our intermarket and fusion metrics shows early signs of a breakdown in some of the traditional “risk on/risk off” relationships. The behaviour of the USD and equities are a major factor and catalyst in the breakdown of some of these relationships. Suggests that the market may be moving toward a new valuation dynamic where traditional economic responses to data are more dominant. Removal of “tail risk” in the Eurozone and various QE programs are having the greatest impact on asset classes.

37. S&P 500 Index Goes “All In” For Risk ….. The S&P 500 Index is in a powerful uptrend, as defined by the ascending channel pattern that has been in place since 2009. We note that the 40-week (200-day) moving average has contained pullbacks since early 2012. In addition, the Index has traded above the Ichimoku Cloud since that time. Prices are now poised to test a key double top that has formed against the secular high at 1576. A weekly close above this level would add to bullish price momentum, exposing the 1600 threshold ahead of the channel top at 1673. Our colleagues in the equity Trend & Cycle group are concerned about a correction materializing in Q2 2013. Indeed, the overbought nature of the weekly studies corroborates this possibility, with a return below initial support at 1536 opening up the trendline at 1459 in this regard. However, we stress that the channel base at 1326 will have to be pierced in order to trigger a bearish long-term trend reversal. Close above double top @ 1576 would add to bullish sentiment, highlight channel top @ 1673 Ascending channel delineates uptrend and positive risk sentiment; key support against channel base @ 1326 Weekly studies move to overbought levels Source: Bloomberg Sharp rally in the S&P 500 Index underscores positive risk sentiment 51

38. ….. As Global Stimulus Measures Underpin the Market Stimulus measures have been the prime catalyst in underpinning risk sentiment during these challenging and uncertain times. In the chart on the left, we illustrate how the various stimulus measures introduced by the Fed, ECB and more recently the BOJ have served to place a ”floor” under stocks. We have included a chart depicting the ratio of the Fed balance sheet to that of the ECB as a proxy to depict the various stimulus programs that each central bank has undertaken since 2008. On some occasions, such as QE1, the market has rallied in response to the introduction of a stimulus program. However, since that first policy initiative, the market has usually rallied in anticipation of new stimulus measures being introduced to quell a decline in the market resulting from weakening growth metrics. This begs the question as to how long such a policy response/conditioning mechanism can persist – and what would happen if the central bank liquidity “punch bowl” were suddenly taken away. QE3 and Japan QE1 LTRO 1 & 2 QE2 Source: Bloomberg Investors have been “conditioned” to expect a stimulus response to declining markets 52

39. Yet Something is Amiss: Risk Relationships are Breaking Down To us, the most interesting byproduct of recent price action has been the breakdown in some of the more traditional “risk on/risk off” intermarket relationships that have persisted since the US credit crisis began in 2007-2008. The first chart to the left in this regard is an overlay chart of the DXY versus the S&P 500 Index. After displaying an increasing negative correlation from 2008 through 2011, we note that the correlation has recently reached its lowest level in 2 years, moving from -0.86 to -0.23. As an offshoot of this development, both instruments have begun to trend upward in unison since the end of January. Hence, “risk on” via rising equities does not necessarily imply a weaker USD in the current environment. On the flip side, USD strength no longer reflects the “flight to liquidity” response normally associated with periods of “risk off” behaviour (i.e. the USD may be losing its safe haven status). SPX and DXY both began to trend upward in late January Negative correlation between SPX and DXY moves to its lowest level in 2 years Source: Bloomberg Inverse relationship between S&P 500 Index & DXY erodes; USD loses safe haven status 53

40. Stocks and US 10-Year Yields Start to Move Together Stocks and US 10-year yields have been on a divergent trend path since 2010. However, note the shift in late 2012 – when stocks and yields began to rise together. This hints at a breakdown in one of the traditional “risk on/risk off” relationships. Notably, yields are no longer staying depressed due to QE. Rather, they appear to be trading off of more traditional macroeconomic responses: i.e. strong economic data leads to higher yields and vice-versa. Stocks and yields started moving higher together in H2 2012, reversing a prior divergent trend Source: Bloomberg US 10-year yields are becoming more responsive to economic data 54

41. The Current Problem: Will This be a Repeat of 2011 & 2012? 2010, 2011 and 2012 all began with a firmer trend in the US economy – only to be followed by a sharp deterioration in growth. In the chart to the left, note how the RBC US Economic Scorecard (blue) peaked in Q1 2011 and Q1 2012, followed by sharp moves lower. This caused downward pressure on 10-year yields as the market anticipated new potential QE programs. The market is currently concerned that we are in the same predicament! Source: Bloomberg The market is worried that economic growth is faltering again 56

42. Foreign Exchange Overview SECTION II We are turning more bullish on the USD relative to our Fall 2012 update. The USD has posted bullish trend reversals against many G10 currencies, favouring additional gains for the greenback. Valuation metrics and study divergences have introduced downside risks for the EUR crosses.

43. CAD Weakness in 2013 Independent of Oil Spread The spread between WTI and Western Canadian Select widened out significantly between September and December 2012. This was the main catalyst behind the weakening in CAD – which began just as the spread began to widen. However, we note that the spread peaked above 40 in January and has moved continuously lower since then – breaking below 20 in the process. Regardless, USD/CAD has diverged and traded higher despite the tightening in the spread. Thus, the breakdown in the spread suggests that the CAD is weakening independently of the oil dynamics (other factors are now at play). USD/CAD continued to rally in early 2013 despite a sharp reversal lower in WTI-Western Canadian Select spread Divergence suggests other factors caused CAD to weaken Source: Bloomberg Oil spread no longer a negative factor for CAD 60

44. CAD Correlation With Stocks Makes a Hasty Reversal The negative correlation between USD/CAD and equities has been one of our preferred intermarket metrics to assess the risk backdrop. We note that this relationship exploded on the scene in 2008 after the onset of the credit crisis gave way to the “risk on/risk off” dynamic that has been driving price action in the asset classes ever since. However, USD/CAD has not been moving to new lows of late despite global equities reaching cyclical highs. The breakdown in this relationship is yet another indication that the risk dynamic is changing. 2-year CA-US swap spreads are currently the most significant variable for USD/CAD, reflecting the recent shift in the interest rate dynamic in Canada. It is interesting to note that crude oil has largely had the least significant negative correlation with USD/CAD – and this has been the case for most of the past year. Correlations are based on 1-year weekly rolling changes Significant shift in correlations suggests an evolution/change in the underlying risk dynamic Equities the main proxy for the “risk on/risk off” trade since 2008 Source: Bloomberg, RBC Capital Markets Equities are no longer the most relevant correlational variable for USD/CAD 61

45. USD/CAD Tests Key Triangle Top Amidst Consolidation Phase Key Support & Resistance Levels: Support: 0.9992 0.9765 0.9576 Resistance: 1.0278 1.0447 1.0658 Source: Bloomberg, RBC Capital Markets • USD/CAD remains within a broad consolidation that has been in place since 2010-2011, as illustrated by the triangle pattern. • However, we note that prices are now probing the triangle top at 1.0278 after failing to reach the base of the triangle in September 2012. • A weekly close above 1.0278 would resolve the triangle pattern to the topside and end the multi-year consolidation phase after clearing the Ichimoku Cloud pattern. • The resulting bullish trend reversal would establish 1.0447 and 1.0658 as the next topside targets in this regard. • Although a weekly close below initial support at 0.9992 would nullify the topside risks that are present and cement a continuation of the consolidation, a break below the triangle base at 0.9576 will be required in order to resolve the pattern to the downside and set a new bearish phase in motion. • Our bias is to use pullbacks to support at 0.9992 and 0.9765 as a buying opportunity, with 1.0447 serving as a target. • Implement 0.9576 as a stop loss for this view. Close above key triangle top @ 1.0278 would suggest that a long base has formed; target 1.0447 and 1.0658 next Must pierce triangle base @ 0.9576 in order to commence a new bearish phase Studies approach overbought valuation levels 62

46. The “risk on/risk off” dynamic is eroding somewhat, giving way to a more traditional response to economic data. • Recent slowdown in Canadian and US economic growth is a headwind for CAD gains • Prefer to fade selloffs in USD/CAD in the current environment Key Themes: • Moves to 0.9992, 0.9765 and 0.9576 are viewed as a buying opportunity • Reduce exposure on a weekly close above 1.0278 (stop loss level) • Monitor correlations to see if “risk on/risk off” dynamic returns to the forefront Buyers of USD/CAD: • Use rallies to resistance at 1.0278, 1.0447 and 1.0658 as a selling opportunity • Reduce exposure on a break below support at 0.9765 (stop loss level) • Keep a close eye on the triangle top at 1.0278 for hints relating to directional bias Sellers of USD/CAD: USD/CAD – Hedging Strategies for H1 2013

47. Crude Oil Holds Above Key Support Trendline at 85.90 Crude oil prices have been consolidating for the past two years, as evidenced by the formation of a symmetrical triangle pattern. We note that the most recent selloff in crude stalled right against the base of the triangle at 85.90 (also 61.8% Fibonacci retracement of the 2009-2011 rally) – thereby sustaining the consolidation phase. However, when viewed as a continuation pattern, the triangle does harbor bearish implications. Suggests that resistance at 97.15 and 104.87 will attract selling interest. A weekly close below 85.90 would affirm the downside risks, exposing a key double bottom at 81.19 next. A close below this level would be an extremely bearish development as it would signal an increase in downside price momentum. The resulting breakout would shift the focus down to 76.76 (76.4% retracement of the 2009-2011 rally), followed by 70.61. Place a stop loss above 110.18 for this view. Key Support & Resistance Levels: Support: 85.90 81.19 70.61 Resistance: 97.15 104.87 110.18 Source: Bloomberg, RBC Capital Markets Resistance located @ 97.15 and 104.87 61.8% Fibonacci retracement flush with triangle base Watch triangle support @ 85.90 Neutral valuations 68

48. Natural Gas Price Correction Continues Natural gas prices have been undergoing a correction for the past year, rebounding to 4.50 recently from a low of 2.96 last April. We note that prices are currently straddling 38.2% Fibonacci retracement of the 2011-2012 decline at 4.42 as an ascending channel pattern defines the current uptrend. Needless to say, a weekly close above the 4.42/4.50 region is required in order to sustain the current advance. This would then shift the focus up to secondary resistance levels that are denoted by 50% retracement at 4.86 and 61.8% retracement at 5.31. The ascending channel top is located between these two levels at 4.96. Support is located at 3.93 and 3.82 (the 40-week/200-day moving average), followed by the channel base at 3.31. A weekly close below 3.31 is required in order to nullify the current uptrend via a bearish trend reversal. Key Support & Resistance Levels: Support: 3.93 3.31 2.96 Resistance: 4.50 4.86 5.31 Source: Bloomberg, RBC Capital Markets Close above 4.41/4.50 region would expose 50% and 61.8% retracement levels @ 4.86 and 5.31 next 38.2% Fibonacci retracement @ 4.42 has contained rallies so far Pivot for corrective uptrend @ 3.31 Neutral valuations 69